Cost segregation is a tax strategy that you can utilize to reduce the taxable income from your investment properties. Segregating the costs of all the Items of your property allows you to write off the depreciation of each Item, according to its Asset Class, as an expense against your taxable income, which oftentimes can be faster than the depreciation schedule for the building as one whole asset. This tax strategy is like getting an interest-free loan from the government. With this “borrowed money”, you can reinvest those dollars to accelerate your net worth. To start, understanding the basics of real estate depreciation is essential for a successful real estate investor.
Basics of Real Estate Depreciation
When you invest in real estate, your property depreciates every year – according to the IRS.
Taxable Income & Tax Liability
The profit you earn from your investment real estate is taxed similarly to any other type of income, meaning you must pay the IRS on the profit you earn each year.
However, since profit is gross income minus expenses, if you can show an increase in the property’s expenses, you’ll show less profit on your real estate investment, which decreases the amount you’ll have to pay in taxes.
There are two types of expenses, when it comes to running a real estate investment business – operating expenses and depreciation. Operating expenses include expenses such as property taxes, mortgage interest, maintenance and marketing/advertising – the costs you incur in order to generate rental income.
Depreciation As An Additional Expense
Depreciation is an additional expense, against your rental income, for purposes of calculating your profit, also called your taxable income.
Different kinds of investment property depreciate at different rates: Residential buildings that are rented out (i.e. houses, condos and apartments) depreciate “straight-line” over 27.5 years, while commercial properties depreciate straight-line over 39 years.
Straight-line depreciation refers to the general depreciation of property without acceleration – you can depreciate one 39th of a commercial building’s basis over the first 39 years of owning it. This depreciation can be deducted against that property’s income, reducing your taxable income.
In addition to operating expenses, depreciation is an additional expense against your rental income. When you calculate your annual depreciation, you can deduct this amount against your rental income, along with your operating expenses, to determine your profit or taxable income on the property.
However, if you’re looking for additional expense deductions beyond this straight-line depreciation approach, the next step is to look into cost segregation.
Basics of Cost Segregation
Cost segregation refers to the process of appropriately accelerating the depreciation of parts of your real estate investment. With this process, you can assign shorter depreciation lives to some of the parts of your property. Once segregated, these parts can be considered tangible personal property under the law, and depreciate faster than the straight-line schedule of the structure of the building. This means that you get more depreciation deductions in the earlier years of owning the property. As a result, after segregation, your taxable income is reduced even further, compared to straight-line depreciation, which can further lower your tax liability this year. Ultimately, you will pay the same amount in taxes over the period of owning the property because you’ll get all of the depreciation deductions either way. However, through cost segregation, you can pay your tax liability further down the road, with deflated dollars, and no interest expense for “borrowing” this money that you would have otherwise paid to the federal government this year.
Types of Real Estate Included in a Cost Seg Analysis
The two main types of real estate that qualify for a cost segregation analysis – commercial properties and residential rental properties. One caveat with cost seg analysis: If your residential property is a short-term rental, meaning it’s available for rent for less than 30 days at a time, then it is treated as commercial real estate, like a hotel, not a residential rental.
Accelerated Depreciation Rates for Tangible Personal Property
In cost segregation, there are different classifications for different assets—those for “tangible” property and those for “real” property. Tangible personal property depreciates quicker than real property. You may receive more depreciation deductions in the early years of this property, which can be fully depreciated in 5-15 years, instead of 27.5 or 39 years of the real property building.
Is Cost Segregation Worth It?
The ability to segregate your investment real estate can be highly beneficial. However, consider your investment size and holding strategy, as well as your tax situation, to determine if cost segregation is right for you. If you’ve made significant improvements to your investment property or have many depreciable assets, and/or you have tax liability that can be reduced (or eliminated) with additional depreciation deductions, cost segregation would most likely benefit you. To better understand these benefits for your property, you can run a Matrix Benefit Estimate in Titan Echo.
By following IRS guidelines, you can systematically leverage this lucrative tax strategy and benefit from this “interest-free loan from the government”.
How To Do Cost Seg on an Investment Property
Once you’ve decided to begin a cost seg study, you’ll need to start grouping the different pieces of your property together. To stay organized, plan on evaluating your property in Sections. Categorizing all the Items in your property into Sections makes cost segregation easier – and more efficient.
The Titan Echo mobile app has three main Sections of Items: the Site Improvements, Structure, and Interior Sections. Each Section has its own unique list of Components, and each Component has its own unique set of Items. Items are the building blocks of cost segregation. Ultimately, each Item needs to be evaluated under the body of law, to determine which ones can be reclassified from 1250 property to 1245 property.
Section 1245 vs Section 1250 Assets
Section 1250 Assets: Known as “real” property, these assets are components of the building itself. Structural Components such as the foundation, framing, exterior walls, and roof would be considered Section 1250 assets.
Section 1245 Assets: These assets, known generally as tangible personal property, are usually associated with the business conducted in the building. They are typically movable assets like furniture and equipment, but they can also include affixed items if they can be appropriately associated with the business conducted.
Site Improvements
Anything you’ve done to improve the site, such as landscaping, paving, and outdoor lighting, should be included in the Site Improvement Section of your investment property analysis. Site Improvements you’ve identified on your property can generally be reclassified as 1245 property, and will have an accelerated depreciation life of 15 years.
Structure
The structure of your property, including the framing, exterior walls, and other structural Components, typically remain 1250 property. Other components include the foundation, elevators, roof, and interior structure (like partition walls and stairs). Although there is no “accelerated depreciation” benefit of these Components, these Items need to be identified, quantified and costed, in order to determine “RCN” (more on this, below).
Interior
Different types of interior Components, including finishes, furnishings and plumbing, fall into the Interior Section. Depending on the type and usage of the interior Items you identify, many of these can be reclassified as Section 1245 tangible personal property, which would typically have a shorter depreciable life than the 1250 structure Items.
Universal Components
Additionally, Universal Components exist in all three Sections. HVAC, Electrical, and Equipment are Components that have groups of Items that can be found in all three Sections. So, in the Titan Echo mobile app, regardless of which main Section you’re in (Site Improvements, Structure or Interior), you’ll always have access to these three Universal Components.
Now that you understand how a property can be systematically divided into Items, it is time to begin a cost segregation study.
What is a Cost Segregation Study?
A Quality Cost Segregation Study is executed in three defined “Components of Scope”: On-Site Verification (OSV), Construction Cost Estimating (CCE), and Legal Analysis (LA). Titan Echo leverages our technology to streamline all three Components, with state-of-the-art tech and engineering support that ensures every aspect of your cost segregation study is completed efficiently, accurately and cost-effectively.
On-Site Verification (OSV)
The first step in any cost segregation study is the On-Site Verification. The IRS requires us to verify that the Items identified and reclassified actually exist. Through the Echo Learning Academy, you can learn how to do this yourself at your own pace. Of course, Titan is also prepared to handle the OSV for you, if you’d prefer.
Construction Cost Estimating (CCE)
Next, Titan’s engineering team will utilize the data from the OSV, along with data from other property documentation, to identify and quantify each item of the property and its associated cost. This will be used to determine the total cost to rebuild the property as new today, known as “Reconstruction Cost New” (RCN). This step is where quality matters, and Titan’s construction and engineering expertise allows us to complete the CCE more accurately and cost-effectively than trying to do this manually. Once RCN is established, Titan prorates all of the Item costs, so the sum total ties out to what the investor actually paid. This step is the most important factor in building a defensible cost seg calculation.
Legal Analysis (LA)
Once Echo’s engineering team has completed the CCE, it’s time for the Legal Analysis. This culminating step in the cost segregation process is all about evaluating each Item under the current cost seg body of law, ensuring everything we’ve done is up to date with the ever-changing federal laws. CPAs and tax attorneys may choose to carry this out themselves. Otherwise, Titan Echo will complete the LA for you.
A final report will be the penultimate document, after the LA is built, on top of the OSV and CCE efforts. This final report will show every step and every dollar behind your cost segregation study. It will also serve as your first line of audit defense should the IRS select you for review.
Cost Segregation Challenges
As beneficial as cost segregation is to real estate investment owners, it is not a walk in the park. There are several challenges that you should not overlook. These challenges should not turn you away from cost segregation; however, you should keep them in mind to have a complete understanding of the concepts, process, and detailed level of effort necessary for a Quality Cost Seg Study.
Attention to Detail
One major challenge in cost segregation is the attention to detail. The cost seg analysis process is extremely rigorous and demanding. Accounting for every Item in the property, calculating their costs to equal the original property cost, and then classifying each Item under the current law is not the most exciting stuff. However, it is of the utmost importance. As always, Titan Echo will do the CCE work and is happy to complete the OSV and LA for you, if you’re not up for the task.
Steep Learning Curve
However, if you want to be involved in the cost seg study process as the CPA (or directly as the investor), the learning curve you embark on can be steep. Cultivating a holistic understanding of cost segregation and real estate depreciation isn’t generally done in a day – but Titan has your back. Through the Echo Learning Academy and our knowledgeable and helpful engineering team, you won’t have a problem getting up to speed on the details and strategy quickly.
IRS Attention and Audit Defensibility
Although cost segregation isn’t necessarily a trigger for an audit, the IRS can review your return for any reason, including depreciation. In the event of an audit, Titan provides remote audit support for all projects run through the Echo Solution, at no additional cost. Each step of our cost segregation process will always follow strict IRS guidelines, and our success in IRS Exam is unparalleled.
Given the challenges that can come hand-in-hand with cost segregation, it’s important to note how the benefits of this strategy vastly outweigh them. Being aware of, and respecting these accompanying challenges will give you a better understanding of cost segregation and what to expect when undertaking a cost segregation study.
Common Misconceptions of Cost Segregation
There are several misconceptions surrounding cost segregation that you should consider. Here are some of the biggest misconceptions that we will clear the air on:
1:
Cost Segregation is only for more expensive, larger commercial buildings.
2:
You can’t perform a cost segregation study after your first year of owning a property.
3:
Cost segregation increases the chance of an audit.
4:
Only CPAs and tax attorneys can perform a cost seg study.
Check out our recent article that debunks these misconceptions, and more.
Cost Segregation FAQs
Can I Do My Own Cost Segregation Study?
Yes, with the Titan Echo Solution, real estate investors and CPAs can choose to conduct their own cost segregation studies. Our cost-seg software platform offers educational resources and cloud-based technology. Along with our back-office and remote engineering support, it empowers you to handle the aspects of your cost seg study that you’re comfortable with. Of course, Titan will always be in your corner to support the more intricate parts of the process at your request.
How Much Does a Cost Segregation Study Cost?
A cost seg study can typically range from $3,000 to $15,000 and usually depends on the property’s size and what Components of Scope you have Titan do for you. The best way to understand the cost of a study you’re considering is to run a Titan Echo Matrix Estimate. This way, you’ll not only know what the study costs but also have a solid idea of the benefits you’ll receive before you pull the trigger.
Can Cost Segregation Offset W2 Income?
Although tax laws are tricky, a cost seg study will generally not affect your W2 income unless your real estate income is considered “active” due to your involvement. If your real estate income is considered “passive” and not active, your W2 income will typically not be affected. However, you should verify this with your tax preparer before you commit to a cost seg study.
can You Do a Cost Segregation Study on a Condo?
Cost segregation studies cannot be done on your primary residence. However, if you own a condo and you rent it out, you can conduct a cost segregation study on it. Non-owner-occupied residential real estate purchased/used as investment property qualifies for cost segregation studies, but primary residences do not.
