The Potential Tax Benefits of Cost Segregation

July 10, 2024
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One significant tax benefit of owning residential rental property, commercial property or other types of investment property is depreciation. You can take a tax deduction without spending any additional money.

However, regular depreciation for real property is slow. Residential income property is depreciated over 27.5 years and non-residential property over 39 years. This results in a relatively small deduction each year.

How Can You Increase Depreciation Deductions?

Fortunately, there is a way you can speed up your depreciation deductions. “Cost segregation” is a strategy you can implement which can increase tax deductions during the first year or several years you own the property.

What is Cost Segregation?

Cost segregation is the technical term for separately depreciating the elements of property that are not real property. These are elements other than land, buildings and building components. They include:

  • Improvements made to the land, such as landscaping, swimming pools, paved parking areas and fences; and
  • Personal property items inside a building that are not building components. For example, appliances, furniture or flooring in residential rentals.

Using cost segregation does not increase a property owner’s total depreciation deductions. However, it does accelerate them over the first few years. This is because personal property has a five- or seven-year depreciation period and land improvements a 15-year period.

Cost Segregation + Additional Deductions

In addition, you can utilize bonus depreciation and/or Section 179 expensing to deduct all or most of the cost of personal property and land improvements the first year you own the property. This may provide a potentially enormous first-year deduction.

A cost segregation study must be conducted to identify which building elements are personal property and land improvements. Then, you can determine their depreciable basis. Studies can be conducted by engineers or done cheaper with other methods that the IRS views as less reliable.

When Not to Use Cost Segregation

Cost segregation may not be advisable for every property owner. For instance, it is not a good strategy when it results in a loss that can’t be deducted due to the passive loss rules. It is also not advisable when the owner intends to sell the property within a few years. Then, you’d have to recapture the cost-segregated depreciation deductions as ordinary income.

The best time to perform a cost segregation study is the same year you buy, build or remodel your real property. You can also choose to wait until a future year—perhaps when you have enough rental or other passive income to use the speeded-up depreciation deductions.

To learn more about cost segregation and other tax-advantaged strategies that may benefit you as a real estate investor, contact the team at Illumination Wealth to schedule an introductory financial consultation.