Contributed by: CoryF, FreeTaxUSA Agent, Tax Pro
CAUTION: Executing the cost segregation tax strategy is complex and requires professional guidance to do it correctly. Please consult with (and consider using) a cost segregation study expert before trying to execute this tax strategy.
You just bought a rental property to make some extra income, and you heard about a strategy called cost segregation (CS). The first search on the internet showed companies that specialize in CS studies, but at a substantial cost to complete. What do you do and where do you go for more information?
What is cost segregation?
In this article we’ll discuss the concept of segregating the parts of your new property that depreciate at different rates, allowing you to apply the appropriate expenses to your rental Schedule E. accelerated depreciation, or using a shorter life of an asset, means more expenses on your tax return that may include losses-to-absorb income. The regular way to depreciate the whole rental property is by applying a straight-line method (under MACRS) of dividing the cost into 27.5 years, however with CS, the costs of assets with a shorter life can be recovered more quickly.
Cost Segregation application information
The concept of cost segregation can be as simple as dividing a home into parts. The building part (roof and four walls) must still be depreciated using 27.5 years. However, other parts of the building are identified as furniture, appliances, flooring, and land improvements. Each of these parts have different recovery periods (depreciating time) that are less than the main building previously mentioned. Here is a list of approved depreciation life by the IRS (page 14).
- Furniture includes beds, couches, armoires, bathroom cabinets, sinks, and kitchen cabinets. All have a depreciable life of 5 years (used in rentals only).
- Appliances include stoves, refrigerators, freezers, dishwashers, water heaters, washers and dryers, and air conditioning units. All have a depreciable life of 5 years.
- Carpets and other flooring choices have a depreciable life of 5 years.
- Land improvements include roads, shrubbery, fences, and sewers (septic systems) have a depreciable life of 15 years.
This method of identifying each asset takes more attention, such as keeping detailed records to include cost, purchase, and installation dates. If you purchased the rental with everything already included, segregating the parts will take careful detail and estimates of similar items using retail information by internet or similar trips to brick-and-mortar stores. Once your rental is segregated successfully and applied on your tax return, subsequent years and new purchases can be added using the purchase and installation cost information.
Accelerated depreciation: bonus depreciation
The IRS has created bonus depreciation for all assets with a 20-year life and below. Meaning, with CS, the savings in the first year can be even more than normal depreciation methods using MACRS (see the scenario below). In 2024, bonus depreciation is at 60% of the asset cost. These savings make it possible to invest more money into your business or recover income on your tax return.
Scenario with detailed information on cost segregation, depreciation, and savings
Residential property purchased at the beginning of the current year for $300,000.
Land value $75,000 (no depreciation calculated)
Building value $225,000. Normal depreciation (27.5-year life) equals a yearly expense of $7,841. Using Table A-6, IRS Publication 946
Calculation $225,000 x 3.485% = $7,841
Cost segregation example:
Building value (minus segregated assets): $115,000
Calculations using Table A-1 IRS Publication 946 :
MACRS 5-Year life half-year convention:
MACRS 15-year life half-year convention
Septic system $15,000 x 5.00% = $750
MACRS 27.5-year life mid-month convention
Building depreciation (table A-6) $115,000 x 3.485% = $4,008
Total depreciation expense using cost segregation:
Potential savings using cost segregation (first year) $23,758 - $7,841 = $15,917
Same scenario with bonus depreciation application
Potential savings using cost segregation with bonus depreciation $70,008 - $7,841 = $62,167
(With residential rental passive loss limitation, the full bonus depreciation expense may cause too much loss to be realized in the first year)
Conclusion
As you can see from the examples, there may be some short-term advantages of using a cost segregation strategy in the year that you purchase a new rental home. Consulting with a CS specialist is often the first step. A potential disadvantage would be less depreciation after 5 years when your income may be higher, thus less deductions and more income that is taxed as greater rates. Weigh the pros and cons as you apply this strategy to your financial situation.
