• Landlord Taxes

Overview of Cost Segregation

January 7, 2025 6 min read

A Landlord's Guide To Cost Segregation

When reporting and depreciating your capital expenses, it can be a while before you see a sizable return, even with bonus depreciation. For residential rental buildings, the recovery period as per the IRS is 27.5 years, meaning it will take you that long to take all the depreciation deductions allocated to that asset. Lucky for you, if you’re looking to maximize your tax benefits and deductions each year, then you have options—one of them being cost segregation.

Below, we’ll talk about one of the best long-term methods for increasing your deductions and tax savings, how it works, how to utilize it, and how to avoid any complications throughout your cost segregation real estate endeavors.

What is Cost Segregation?

Cost segregation is an accelerating depreciation deduction tactic that strategically divides large assets into smaller ones so that you can take advantage of shorter recovery periods. The IRS allows business owners to separately depreciate individual components of large assets like buildings so that you can see a quicker financial turnaround. If you plan on keeping the property in your possession for longer than five years, then it may be beneficial for you to reap the benefits of this strategy.

Let’s say you purchase a property with a pool installed along with a building. With cost segregation, you would essentially be able to depreciate the building and the pool separately from each other. So rather than recovering the cost of the building and the pool together in 27.5 years, you’ll fully recover the value of the pool in only 15 years (and the building in 27.5), which will lead to more money in your pocket each tax season. This line of thinking can apply to wiring, plumbing, light fixtures, and more, and can give you more financial freedom in the long run.

A Quick Example

Let’s dive into a simplified example of cost segregation at work.

Imagine that you’ve purchased a rental property worth $700,000. The land itself is worth $100,000, so we’ll start by subtracting that cost as land does not qualify for depreciation. That leaves you with a depreciable asset worth $600,000. If you use straight-line depreciation for the entire building and all of its assets together ($600,000), then your annual tax deduction for this property (over its 27.5-year depreciation term) will be $21,818. As usual, you’ll be able to subtract this number from your yearly income in order to decrease your annual taxable income for this property.

But with cost segregation, you can see even more each year. If you were to conduct a cost segregation study, your expenses would be broken down much further. The study might find that the building itself is worth $500,000, its appliances are worth $50,000 (10-year depreciation term), and its outdoor pool is worth $50,000 (15-year depreciation term). All of this still amounts to the original cost of the building ($600,000), but your assets depreciate separately—and faster.

Breakdown

In total, with this cost segregation, your annual tax deductions will amount to around $26,515.15, compared to your original total using straight-line deduction of $21,818.

Even with this extremely simplified example, you can gain around $5,000 for your annual tax deduction. When dealing with more expensive properties, more complex breakdowns, and more realistic numbers, it’s easy to see how these numbers grow very quickly. It’s important to note, however, that you must conduct a quality cost segregation study before implementing any cost segregation real estate tactics. It’s not as simple as searching online for average costs or making an educated guess as to what your assets are worth.

What is a Cost Segregation Study?

A cost segregation study, also known as a cost segregation analysis or a cost allocation study, is a very intricate process. Business owners cannot just estimate the prices of their property and segregate those costs accordingly. It’s a science, and there are professionals who specialize in this exact science. Though you technically can carry out a cost segregation study on your own, it’s highly discouraged, as you will be held directly liable by the IRS if your numbers seem a little bit off.

To avoid errors, you’ll need to contract a certified financial firm or professionals with experience in cost segregation studies, which can cost anywhere from $5,000-$15,000 depending on the size and scope of the study. The team will likely consist of tax and engineering professionals who will collaborate during their study of your property to assess the exact costs and provide you with a cost segregation report.

You’ll need to be patient, as these meticulous studies can take up to two months until you receive any concrete results. If you plan on utilizing this tax break, be sure to plan ahead. That being said, the patience and money required will pay off when more money starts pouring in.

What’s the Catch?

With cost segregation, there is no “catch” per se, but there are a few things you need to be careful of.

Recapture

As previously mentioned, unless you plan on holding onto this property for more than five years, then conducting a cost segregation study may not be worth it. This is because when you eventually sell the property, the IRS will recapture the deductions you utilized by taxing the portion of your profit attributable to them, and if you don’t have enough time to actually benefit from the larger up-front deductions, then a cost segregation study might cost more than the value it provides you.

Passive Loss Rules

You’ll also have to be careful with which income you deduct rental losses from given the fact that rental income qualifies as passive income. Passive loss (PAL) rules prevent you from deducting passive losses from your active or portfolio income. There are a few exceptions to the PAL rules—for example, small landlords and property owners can generally deduct up to $25,000 from their non-passive income, and real estate professionals can deduct passive losses from active income as well. However, you must meet specific IRS criteria to qualify for both exemptions. It’s important to research these tax regulations with a tax professional before you choose to go full steam ahead with cost segregation.

Conclusion

All in all, cost segregation is generally more straightforward than it sounds. It’s no walk in the park, but it’s accessible to real estate investors and anyone else in the real estate field, regardless of how small or large your portfolio is. Do careful research on the team you choose to hire for your cost segregation study and sit down with a trusted tax advisor before making any moves to ensure that it’s right for you.