You purchased several rental properties during the year and are looking for ways to reduce the income generated by the buildings. A cost segregation study may provide the tax benefits you want.
Cost segregation divides real property into its components, some of which may be depreciated faster than the normal 27.5 years for residential rental property or 39 years for nonresidential real estate.
When you purchase rental real estate, you typically break it into two assets to calculate depreciation:
- Land, which is non-depreciable; and
- Building (residential is 27.5-year property; nonresidential is 39-year property).
With a cost segregation study you allocate the building’s cost to much more than the building and land. The costs are typically classified to the following assets:
- Land, which is non-depreciable
- 5-year property
- 7-year property
- 15-year property
- For the remainder, 27.5-year property or 39-year property, depending on building use
Benefits and Drawbacks
The tax benefit derived from a cost segregation study is the front-loading of depreciation deductions, which allows you to deduct them sooner. This results in increased cash flow due to the deferral of income taxes and the ability to invest more money today. A dollar today is worth more than a dollar ten years from now. Keep in mind, the total depreciation you deduct with or without a cost segregation study will the same amount over the lifetime of the property.
Recent tax law changes increased bonus depreciation from 50 percent to 100 percent and also allows bonus depreciation on qualifying used property. Cost segregation is made to take advantage of these new law changes.
You can also use cost segregation for rental properties you acquired in the past and perform what’s known as a look-back study to claim depreciation for prior years.
If the passive activity loss rules affect your ability to take immediate rental losses, you’ll need to crunch the numbers to determine if you can benefit.
Tax reform eliminated your ability to do a like-kind exchange for non-real property. Therefore, if you perform a cost segregation study and then later use a like-kind exchange on that property, you’ll have taxable gain to report on the assets that’s not land or 27.5-year or 39-year property.
Illustration of a Cost Segregation Study
For purposes of our illustration we used a commercially available cost segregation calculator to demonstrate the benefit of a cost segregation study. This does not replace the need to engage a cost segregation professional to perform the study and provide you with a report supporting the cost allocations.
Assume ABC Properties LLC acquires an office building for $3,750,000 in 2020 with a depreciable basis of $3,000,000.
After entering the details of the property, the calculator allocated the costs as follows:
- 5-year property: $60,000
- 7-year property: $270,000
- 15-year property: $360,000
- 39-year property: $2,310,000
Based on a 40% combined federal and state tax rate the net present value (using a 6% discount rate) of the taxes deferred for the first five years is $116,700.
A cost segregation study is an excellent tax deferral strategy that should be considered by residential and commercial rental property owners. If you would like to investigate whether a cost segregation study can help your reduce your current taxes and increase your cash flow, please call us at 561-826-9303.