To define,
cost segregation is the process of identifying and separating personal property, land improvements, and building components that can be depreciated over shorter recovery periods. By doing so, owners of rental properties can accelerate depreciation deductions, resulting in significant tax savings.
Let us explain how cost segregation works with a simple example. Suppose you purchase a rental property for $500,000, and you allocate $100,000 of the purchase price to land and $400,000 to the building. If you depreciate the entire $400,000 building cost over 27.5 years (the standard recovery period for residential rental property), you would be entitled to a depreciation deduction of approximately $14,545 per year ($400,000 ÷ 27.5 years).
However, if you perform a cost segregation study and identify $100,000 of personal property (such as appliances, furniture, and carpeting) and land improvements (such as landscaping and parking lots) that can be depreciated over shorter recovery periods, you can take advantage of accelerated depreciation. Let's assume that the personal property and land improvements can be depreciated over 5 years and 15 years, respectively.
The new depreciation schedule for the rental property would look like this:
- $100,000 personal property: 5-year recovery period, resulting in $20,000 depreciation per year.
- $100,000 land improvements: 15-year recovery period, resulting in $6,667 depreciation per year.
- $200,000 building cost: 27.5-year recovery period, resulting in $7,273 depreciation per year.
The total depreciation deduction for the rental property would be $33,940 per year, compared to $14,545 per year without cost segregation. That's an increase of $19,395 in annual depreciation deductions!
Now, let's assume that you are in the 35% tax bracket. The additional $19,395 in depreciation deductions would result in tax savings of $6,788 per year ($19,395 x 35%). Over the 5-year recovery period for the personal property, you would save a total of $33,940 in taxes. Over the 15-year recovery period for the land improvements, you would save a total of $101,820 in taxes.
The total tax benefits of cost segregation would be $135,760 over 20 years ($33,940 x 4 years for personal property + $101,820 x 16 years for land improvements). That's a significant amount of money that can be reinvested into your rental property or used for other investments.
Taking everything into account, cost segregation is a powerful tax planning strategy that can result in substantial tax savings for owners of rental properties. If you own a rental property and have not yet considered cost segregation, we highly recommend consulting with a tax professional to determine if it's the right strategy for you.
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