If you own or have considered owning rental real estate, you may have come across the term “cost segregation.” This is one of those real estate buzz words that is often misunderstood, so I’m going to break it down for you like you’re in kindergarten.
What is it?
When you purchase rental real estate, you just pay one big price for the land, the building, and everything inside the building. All these assets are treated differently for tax purposes when it comes to taking depreciation. Remember, depreciation is the deduction you take for the value of assets over time. Land is not depreciable, the building is depreciated over long periods of time (27.5 or 39 years depending on the type of building), and many other assets are depreciated over shorter periods of time (5, 7, or 15 years). For some assets, you can also take accelerated depreciation (section 179 or bonus) and write off the value of the asset in the year of purchase.
The problem in real estate is that the prices for these different kinds of assets are not broken down for you on your closing statement. You just have a closing price that includes all of these different kinds of assets. You are responsible for allocating a portion to land, but the rest goes towards the building by default, which gets depreciated over 27.5 years for residential buildings or 39 years for commercial buildings.
The purpose of a cost segregation study is to break out the values of the assets within the building that may have shorter depreciable lives, such as HVAC systems, plumbing, and other improvements. This allows real estate investors to take more tax deductions up front rather than taking smaller amounts over longer periods of time. Cost segregation studies have be very detailed in order to work properly, so most real estate investors pay a professional to do the study for them. They take the results of that study and break out values on their tax return for each type of asset, allowing them to depreciate some of the assets faster.
Benefits and Drawbacks
The main benefit of doing a cost segregation study is to take larger tax write-offs for depreciation in the first few years of owning a building. If I’m a real estate investor purchasing a commercial building, I have to write off the cost of the building over 39 years. Since I could very well be dead by the time I recover my entire cost of the building, it might make sense pay for this study and receive some of the tax benefits earlier. Tax benefits, in my experience, are more appreciated by alive people.
These studies especially make sense for larger property purchases, such as commercial buildings. The benefits of cost segregation are generally greater when the purchase price is greater. They may also make sense in more profitable years, such as a year when you sell another building and do not do a 1031 exchange.
The biggest drawback I’ve seen with these studies is that they can be expensive. Most cost segregation experts will encourage you to do it, touting the tax savings. However, for many small investors that are not real estate professionals for tax purposes (to be defined next week), they may already be limited in the amount of losses they can take in a given tax year. Remember suspended losses from a previous article? If you’re already showing a loss and you’re unable to deduct it, you’ll suspend the loss into the future. Accelerating depreciation deductions will only increase the amount of suspended losses that you have, which means you’re not technically receiving the tax benefit this year anyway. If it’s going to be suspended until you eventually sell the property, you might as well just depreciate the building and call it a day. The results will be substantially similar, and you’ll have saved yourself some money by not paying for the study.
So be cautious when evaluating this decision and make sure it actually makes sense for you. Ask your accountant before the cost segregation expert. In other words, don’t ask a barber if you need a haircut.