Imagine having a study performed on your property to get an immediate $20,000-plus in after-tax cash in your pocket this year. You’re probably thinking it’s too good to be true. But it isn’t: you can get this cash infusion with a cost segregation study on your rental property or newly built dental building thanks to tax reform. We’ll explain cost segregation, when and how it might make sense, and the tax headaches it can cause.
Cost segregation breaks your real property into its components, some of which you can depreciate much faster than the typical 27.5 years for a residential rental or 39 years for nonresidential real estate. When you buy real property, you typically break it into two assets for depreciation purposes:
- land, which is non-depreciable; and,
- building (residential is 27.5-year property; nonresidential is 39-year property).
With a cost segregation study, you make your property much more than a building on land. Here’s what’s possible with a cost segregation study:
- land, which is non-depreciable
- 5-year property
- 7-year property
- 15-year property
- for the remainder, 27.5-year property or 39-year property, depending on building use
With a cost segregation study, you front-load your depreciation deductions and take them sooner, but you’ll take the same total depreciation amount over the lifetime of the property.
Why You Want to Accelerate Depreciation
The key is the time value of money—the principle that a dollar today can be invested in today’s dollars and compound over the future. Cost segregation creates new buckets of tax money that you can invest immediately if you are not limited by the passive loss rules discussed below.
Tax Reform Bonus
Tax reform under the Tax Cuts and Jobs Act boosted bonus depreciation from 50 percent to 100 percent, and this new law also allows bonus depreciation on qualifying used property. Cost segregation is made to take advantage of these new law changes.
Rental Loss Problems
By accelerating your depreciation deductions, you’ll turbocharge your rental losses and put more after-tax cash in your pocket today. But if the passive activity loss rules kill your ability to take immediate rental losses, you could end up with the short end of the stick because of your cost segregation study. There are four ways you can overcome this passive loss hurdle and use your rental losses immediately:
- You have other passive income, such as rental properties creating taxable income. This allows you to use losses to the extent of the passive income.
- You actively participate in the rental activity. This allows you to use up to $25,000 of your losses if your adjusted gross income is under $150,000.
- You or your spouse qualifies as a tax-law defined real estate professional, and you and your spouse materially participate in your rental so that you qualify to deduct your rental losses immediately.
- If your rental is a separate LLC that owns your dental building, like most dentists, you may meet the requirements to aggregate. The building and practice can be viewed under tax law as a single economic unit, and the large depreciation deductions in the LLC from cost segregation can be used to offset dental practice income, with an appropriate election.
Disposition of Components
Your cost segregation study also gives you a leg up when you repair or improve your building because the study breaks out the components. Under the repair regulations, when you replace a component (such as a roof), you can assign a value to the old component and write off its undepreciated basis.
Example. Your cost study on the building you buy today shows a $25,000 value on a roof that’s already 17 years old. You are depreciating this roof using straight-line depreciation over 39 years.
Result. In 2025 when the roof is 24 years old, you replace it with a new roof. Because of the cost segregation study, you can quickly identify that this roof has a $20,500 undepreciated basis that you can write off immediately.
The second benefit is that the cost study component write-off is usually larger and more beneficial taxwise than you would get from the IRS regulations that contain a formula you can use for writing off the old roof.
Death is good for depreciation and reducing your income taxes. Inherited property gets a step-up in basis to its fair market value on the date of death of the owner. This restarts depreciation from square one and erases recapture from prior depreciation. If you live in a community property state, property owned by two spouses as community property gets a full step-up in basis when only one spouse dies. Once you get your stepped-up basis, you can use cost segregation to accelerate your depreciation deductions— maybe for the second time on the same property.
Example. Joan and Bob, who live in a community property state, buy a rental property in 2018 and do a cost segregation study, creating a bonus depreciation deduction of $100,000 in 2018. In 2019, Joan dies. The cost basis resets to the fair market value on the date of Joan’s death. Assuming the value is the same as in 2018, Bob can take another $100,000 of bonus depreciation in 2019—and there’s no recapture for the $100,000 taken in 2018.
- Section 1031 trouble. Tax reform took away your ability to do a like-kind exchange for non-real property. Therefore, if you do a like-kind exchange, you’ll have taxable gain attributable to everything that’s not 27.5-year or 39-year property.
- Ordinary gain on sale. When you sell your real property, the 5-year and 7-year components are generally Section 1245 property, and depreciation recapture on those assets creates ordinary gain.
By the Numbers
Let’s assume you want to put a new single-family home in service as a rental property in 2018. The home, purchased for $341,817, had a depreciable cost basis of $256,363. We used a commercially available cost segregation calculator to show you the power of the cost segregation strategy. After we input the specific details about the property, the calculator determined the following breakdown for depreciation purposes:
- 5-year property: $20,231
- 15-year property: $30,909
- 27.5-year property: $205,223
This study identifies $51,140 that you can write off this minute using bonus depreciation. If you are in the 40 percent combined federal and state tax bracket, this puts $20,456 in your pocket today.
A cost segregation study is always a good tax reduction strategy when it accelerates your depreciation deductions and puts more after-tax cash in your pocket today. Now, thanks to tax reform’s 100 percent bonus depreciation and expansion to include used property, cost segregation can give you even better, perhaps huge, up-front tax deductions (think immediate cash). Of course, you need to examine the passive loss and aggregation rules to make sure that you will realize the benefits of your cost segregation study.
And remember three notes of caution:
- Make sure the cost of the study doesn’t eat up most of the tax savings.
- If you plan to like-kind exchange the property, consider the impact of having to pay taxes on any property not considered real property because of the cost segregation study (a downside of tax reform in this area).
- Factor in the additional ordinary income depreciation recapture taxes that you will pay when you sell components that benefited from the cost segregation study.
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