Residential Cost Segregation: How to Increase Tax Write-offs on Your Rental Properties

While a great investment strategy, residential real estate comes with many expenses, including taxes. Savvy investors are able to take advantage of tax savings strategies to reduce their yearly burden, and cost segregation is one that can help you get more value out of your investments.

Residential cost segregation is an IRS-approved tax savings method that allows you to break down your property into different components, and then accelerate the depreciation period for certain components. So, rather than taking the standard depreciation period, you take a partially accelerated depreciation that you can claim much faster.

This article will teach you what cost segregation is for residential properties, how it works, and how you can use our low-cost method to maximize your tax advantage.

What is a residential cost segregation study?

To reduce your tax burden through cost segregation, you need an IRS-compliant cost segregation study. Historically, these studies have been produced after an engineer goes to your property to take thorough measurements and photos. They then hand that off to a CPA who decides which components of your property are eligible for accelerated depreciation, and for what period of time they’re eligible (5, 7, 15, or 27.5 years). The CPA provides you with an official cost segregation study report that you can use on your tax return.

Your tax accountant will file this report with form 3115 (change of accounting method). This is a well-known tax strategy that the IRS provides to help investment property owners reduce their tax liability by increasing their depreciation in a more reasonable timeline. If done right, it is a completely legitimate way to reduce your income taxes faster.

How does cost segregation work for rental properties?

Rental property components are typically composed of land, buildings, land improvements (such as fencing and walkways), and personal property (such as furniture, heaters, and washing machines). The purpose of cost segregation is to identify what percentage of your property fits into these different categories, and then determine how much of your property is eligible for an accelerated depreciation period.

After a cost segregation study, residential property components will be accelerated within these time ranges:

  • Land: No depreciation
  • Building: 27.5 years (this is the standard depreciation period at which all of your building will depreciate if you don’t do a cost segregation study)
  • Land improvements: 5, 7, or 15-year depreciation
  • Personal property: 5, 7, or 15-year depreciation

The cost savings come as a reduced income tax burden. Let’s go through an example where you’re able to take 20% of your property’s $1M value as 5-year depreciation, 10% at 7-year depreciation, and 10% at 15-year depreciation. We can compare that to the standard 27.5-year depreciation period if you don’t do a cost segregation study. In this example, we’ll assume an income tax bracket that has you paying 35%.

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
First-year depreciation: $36,364
First-year depreciation: $82,771
Reduced income tax burden: $12,727
Reduced income tax burden: $28,970

Because you are taking your depreciation expenses sooner rather than spreading them out over 27.5 years for your entire property, you are able to save an additional $16,000+ in the first year after the study. Keep in mind that this is a way of speeding up depreciation expenses, and technically you will have the same amount if you depreciate over a longer period of time. However, it’s possible that you’ll sell the property or something else will happen during that time, so it could be to your advantage to take those savings now rather than later.

Essentially, this is a way to unlock the ‘time value of money’. You can access these tax savings now so you can do more with the money, whether that be investing it, passing it along to your children, or something else.

What about different types of rental properties?

A cost segregation study can be done on any kind of residential property, whether that be a single-family home, condominium/apartment complex, or a small multi-family unit.

Are cost segregation studies too expensive for rental properties?

People sometimes make claims that cost segregation only benefits expensive properties, but that isn’t necessarily true. Expensive studies that require engineers and CPAs to get involved might only benefit higher-value properties. However, doing a cost segregation study through Rental Property Refund is valuable for lower-value properties as well.

By using specialized software to automate the cost segregation process, Rental Property Refund is able to provide IRS-compliant cost segregation studies for about ⅕ the cost of a traditional study. All you need to do is fill out a series of questions about your rental property with actuals or reasonable estimates, then our software crunches the numbers to determine which of your property’s components are eligible for accelerated depreciation.

You’ll receive your cost segregation report within 2-3 business days via email (this is so our team of CPAs can review it for accuracy and make sure there’s nothing on it that would be a red flag). Then, you can use your report on your next tax return and start saving more.

How much could you save from a cost segregation study?

If you’re interested in finding out how much you could save by doing cost segregation on your rental property, check out our Rental Property Refund Calculator. It provides a quick and easy estimate based on your property’s data and can help you decide if cost segregation is worth it.

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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