A cost segregation study is a way to increase the amount of depreciation that you can take in the first years of owning a rental property so that you can take more of the depreciation up front. That reduces your taxable rental income, and usually means that your rental income will actually be negative. And you may also be able to use that negative rental income to offset the rest of your income to lower your overall tax bill.
How does it work?
When you have a rental property, you get to use depreciation to deduct a little bit of the cost of the property as an expense that you subtract from your rental income each year. For real estate, the depreciation period is set 27.5 years (or 39 years if it’s a short term rental). And so most people depreciate the house as a whole for that many years, letting you subtract 1/27.5th of the cost of the house each year.
But a property can be further divided into the components that it’s made of, and when you separate them out, some components of a house can be depreciated on a faster depreciation schedule. For example, cabinets, flooring, wall coverings, window treatments, ceiling fans, etc. can be depreciated over just 5 years. Improvements to the land like sidewalks and landscaping can be depreciated over 15 years.
A cost segregation study is a process where the components of the house are divided up into 5, 7, 15, and 27.5 (or 39) year categories so that a portion of the house can be depreciated faster. It’s typical for around 20-30% of the value of the house to qualify for the accelerated 5-15 year categories. That means that portion of the house can be depreciated faster to reduce your taxes during the early years of owning the property.
IRS publication 5653, the Cost Segregation Audit Techniques Guide is the manual that IRS agents use as their guidelines when auditing returns using cost seg, and it is the most comprehensive guide to all aspects of cost seg studies.
When is it too late to do a cost seg study?
The process to use a cost segregation study for your taxes is simplest if you do it starting with the first tax year that you put the property into service (when you first make it available to rent). The actual study can be done anytime before you file your tax return and applied to that tax return.
Making the adjustment becomes more complicated if it isn’t the first year the property is put into service. You usually cannot amend past returns to benefit from a later-year cost seg. Instead, you have to file form 3115 to make a “section 481(a) adjustment.” So there is some added complexity to your tax return, but it can be done if you have a tax preparer with experience in this area. If you bought the property many years ago, and you’ve already taken most or all of the depreciation, then it may not be worth it.
Combined with Bonus or 179 Depreciation
A cost segregation study lets you depreciate a portion of the house over 5-15 years. But you can additionally use bonus depreciation or section 179 depreciation to take the depreciation for those 5, 7, and 15 year categories all in one tax year. Bonus depreciation is being reduced each year starting in 2023, but the amount of bonus depreciation you can take depends on the year the property was put into service. Depending on the specifics of your tax situation, that can mean a big tax savings that you can take all at once in that one tax year.
Reasons Not to Do It
The first thing to be aware of is that this is a way to reduce your taxes in the early years of owning the property, but that means there is less remaining depreciation to subtract in the later years.
It also may not be beneficial if your net rental income is already low using the regular depreciation schedule. If your net rental income is low or negative, and you don’t qualify to use the negative rental income to offset your other taxes, there may be no benefit to accelerating the depreciation.
There is a cost to doing a cost segregation study in terms of the actual price you pay for the study, plus it adds to the complexity of your yearly tax return, which may also result in added cost for your tax preparation. You may need to use a tax preparer specializing in real estate since most tax professionals aren’t familiar with using cost segregation data. So it may not be worth it for the tax savings, especially for lower value properties, since the potential tax savings may not be worth it.
Depreciation Recapture
Using cost segregation to reduce taxes in the early years of property ownership might sound appealing if you don’t plan to keep the property for long. But there’s a catch. When you later sell it, you have to pay income tax on all that depreciation that you benefited from during the time you owned it. This is called depreciation recapture. So the more depreciation that you took, the more tax you’ll need to pay on it when you sell it.
Whether the tax savings from depreciation while you owned it will be more or less than the tax you pay as you sell it depends on a number of factors, primarily your income while you owned it relative to your income during the year you sell it.
But there is an added detail to be aware of. When you pay depreciation recapture on a real estate property, the tax rate is your ordinary income rate, but capped at 25% maximum (this is called “unrecaptured section 1250 gains”). But depreciation recapture on non-real estate assets is just taxed at your ordinary income rate, without the benefit of that 25% upper limit. And a cost segregation study moves more of your property’s assets from the 27.5 or 39 year real estate category, to the 5-15 year non-real estate depreciation categories, which can be taxed at a higher tax rate if your tax bracket is above 25% when you sell the property.
The only exceptions are if you use a 1031 exchange to defer the depreciation recapture (and capital gains taxes too). Or if you hold the property until your death, it can be passed onto an heir and the basis and depreciation of the property gets reset (“stepped up”) to the full market value at the time they inherit it. So in that case no one has to pay taxes on the depreciation recapture. Note that this means there is an even greater advantage to using this strategy for property that you plan to pass on to your heirs. In that situation, you may want to get a cost seg study to get the tax benefits, without later having to pay tax on any recapture.
See also our article on depreciation and recapture.
Choosing a Cost Segregation Company
The traditional process is to hire someone who looks at the specifics of the property and adds up the appraised value of each of the components of the property. From that they produce a report that lists the components and the totals. Companies that do that include Cost Segregation Authority, CSSI, and USTAGI.
An alternative process that has been more popular is a DIY approach where you provide some basic info about the property, and then the website uses software to estimate the approximate cost of the components of the property to product a cost segregation study. Companies that offer this included KBKG and DIY Cost Seg. This approach is much less expensive (costing hundreds of dollars rather than thousands of dollars). The trade-off is it might be less accurate if you don’t enter all the information correctly. And to avoid any potential tax issues, a DIY process may tend to be more conservative in their estimates, so the DIY study may allocate less value to the shorter depreciation categories than if you had an expert study done. There have been some reports of DIY cost seg studies having been rejected by the IRS during audits. However, such cases appear to be rare, and most people don’t encounter any problems using DIY cost seg studies.
For either approach, it’s a very good idea to make sure the cost seg company is providing audit protection. You don’t want to be responsible for defending the study if the IRS questions it, so be sure to get audit protection, even if it costs extra. Audit protection doesn’t guarantee that the IRS won’t reject the study, but it does at least ensure that the company will provide representation or support to try to defend it.
Frequently Asked Questions
What if the property has more than one owner? If there are multiple owners and you divide up the expenses/income then you can still do a cost segregation study and use the data for each of your portions of the property.
Should I have the study done before or after doing a renovations on the property? If you are planning on doing substantial rehab work on the property to significantly improve it, you can have the cost seg study done either before or after the rehab, or both. If you want the most accurate results with the least risk of scrutiny, the gold standard would be to have a cost seg study done on the property before renovations, and then again after renovations by the same company, which can then evaluate all the data from before and after the renovations to produce their final report. Some of the companies that offer a higher cost study may include both the before and after evaluations as part of their overall combined fee in this situation. If the renovations are straight forward and it’s easy to segregate the cost of the renovations into the proper depreciation categories (such as if you’re just replacing a few specific components such as flooring and cabinets), it may be fine to just have the study done before the renovations and then add the cost of the renovations as separate depreciation items after. But if it is a substantial renovation that impacts many parts of the property in a variety of ways, you would probably be better off either doing the study after the renovations, or both before and after. If you are unsure, it would be a good idea to discuss your plans with the cost seg company in advance. In some situations, you may be able to take advantage of partial asset disposition to deduct the cost of parts of the asset that were disposed of during renovations.
