The Benefits of Cost Segregation For Residential Properties

Cost segregation is a useful tax savings tool that mainly wealthy investment real estate owners and corporations use to reduce their income tax burden. However, smaller residential property owners might not be aware of the benefits of cost segregation and may even think it’s not worth it for them.

In this article, we’ll break down the benefits and drawbacks of doing a cost segregation study for your residential property. We’ll also provide you with a cheaper option that makes this tax advantage available to smaller property owners. 

If you’re looking for info on what a residential cost segregation study is, check out this article. If you’re ready to learn about the benefits, read on. 

Benefit 1: Immediate tax savings

Cost segregation is a useful tax savings tool that mainly wealthy investment real estate owners and corporations use to reduce their income tax burden. However, smaller residential property owners might not be aware of the benefits of cost segregation and may even think it’s not worth it for them.

By taking accelerated depreciation for a portion of your property’s components, you are increasing the amount of depreciation expenses you can claim on your next tax return. Essentially, you are able to claim these expenses faster (in either 5, 7, or 15-year periods) than the standard 27.5-year period. This means you are getting more tax savings now, rather than spread it out over a longer period. 

While you still would technically get the same tax benefit over the longer depreciation period, factors like inflation and major life events come into play. In my opinion, it’s always a better option to take the increased tax return now rather than later. 

To get an idea of how much you could reduce your tax burden over the course of five years by doing a cost segregation study on a $1M rental property, check out the table below (this table assumes a 35% income tax rate).

Rental property value: $1M

No cost segregation study Cost segregation study
100% - 27.5 year depreciation
60% - 27.5 year depreciation
20% - 5 year depreciation
10% - 7 year depreciation
10% - 15 year depreciation
Depreciation after 5 years: $181,818
Depreciation after 5 years: $413,853
Reduced income tax burden: $63,636
Reduced income tax burden: $144,849

Benefit 2: Increased cash flow

According to principles like ‘the time value of money’ and ‘compound interest’, it always makes sense to increase your cash flow in the present year rather than spread it out. If you consider the table above, the owner of this property has an additional $81,213 to spend over five years as a result of doing a cost segregation study (compared to standard depreciation), i.e. they have increased their annual cash flow by $81k.

With that extra money, they could help fund a year of their kid’s college education, invest in a new startup, or simply put it in an S&P 500 index fund and hope for 7% returns. Either way, it is more valuable to have that money now, rather than later.

Benefit 3: Retroactive savings

If you’ve owned your property for several years, it’s possible that you could do a cost segregation study and gain multiple years’ worth of savings in your first year after the study. That’s because you can apply retroactive cost savings to prior years, based on the accelerated depreciation timelines found in your study. Talk to your accountant before doing this to be sure.

Benefit 4: Extra year one savings with bonus depreciation

Before doing a cost segregation study, it’s important to understand bonus depreciation. This is an extra depreciation incentive that was extended back in 2017 as a result of the Tax Cuts and Jobs Act. Currently, it will allow you to take a ‘bonus’ of 20% of the value of your qualified cost segregation components in year one after you complete a study. While it doesn’t increase the total eligible depreciation savings, it pushes more of that savings into year one.

The 20% eligible bonus is available until 2026. However, it’s possible Congress will vote to extend it, as they have consistently done since 2002 when it was created.

Drawbacks of residential cost segregation to be aware of

Before you jump into ordering a study, there are some potential issues you should be aware of.

  1. Cost: Cost segregation studies can be expensive and even cost-prohibitive for smaller properties. Typical costs for an engineer-driven study can range from $5,000-$15,000, which makes the ROI less on smaller properties. However, we at Rental Property Refund have a solution for this (more below).
  2. Depreciation recapture: While you take more savings upfront, it’s possible that by doing so you will incur depreciation recapture taxes later on. This is a tax you would encounter when you sell the property. However, it should not be more than the money you saved by taking accelerated depreciation early on. Additionally, you can avoid much of this expense by purchasing a like-kind property through a 1031 exchange, which provides tax incentives for purchasing similar property types after selling.
  3. Negligence penalties for over-counting: You must provide reasonable estimates for a cost segregation study. If you report numbers that are above normal ranges, you could get flagged for an audit. Then, anything you over-reported would be subject to a 20% negligence penalty for underpayment of taxes. You could also get in criminal trouble for underreporting. It’s important to be as accurate as you reasonably can in your estimates and use a legitimate cost estimation tool like RS means, which Residential Property Refund provides.

How to make residential cost segregation affordable

Rental property cost segregation studies don’t need a CPA or engineer in order to be IRS-compliant. Using Rental Property Refund, you fill out a simple questionnaire that outlines the details of your property, then we use our proprietary software to complete your study in two to three business days (compared to two to three weeks for more expensive studies).

Our automated process is five times cheaper than traditional studies, bringing you 10-30x ROI.

Interested in how you could save with a residential cost segregation study? Calculate your potential savings with our Rental Property Refund Calculator.

About Author

Richard Bourgault

Graduating from Georgia Tech with a degree in Electrical Engineering, Richard has gained over a decade of expereince in Cost Segregation coupled with software UX.

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