Why is Cost Segregation Beneficial for Landlords?

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Taxes are an overwhelming responsibility for many landlords.

There are a variety of tax tips and strategies you can apply to get the best deductions and save money on your rental taxes. However, if you aren’t aware of these strategies or how they work, you won’t be able to claim their benefits.

Cost segregation is one of these strategies. Cost segregation is a method of maximizing your depreciation deductions by taking advantage of shorter recovery periods.

To understand how cost segregation works, you must first understand depreciation deductions and recovery periods.

Here is an overview of the cost segregation tax strategy and how you can use it to save money in your rental business.

What is Cost Segregation?

Depreciation Basics

Before you can understand the benefits of cost segregation, you need to understand depreciation more broadly.

Depreciation is the decline in value of property over time. As your property wears out over time, the IRS allows you to take yearly depreciation deductions to account for this loss. 

Typically, you would depreciate a property you buy in its entirety over 27.5 years, which is the recovery period for residential real property. The whole property—the building, exterior structures, internal components, and land improvements—gets depreciated together. 

However, this might mean you depreciate certain items (e.g., furniture, pools) for longer than you need to. 27.5 years is a long time to depreciate a swimming pool, which may wear out much faster than a building would.

Cost Segregation

That’s where cost segregation comes into play. Cost segregation is the process of separating out and reclassifying individual components of your property. For example, you would consider the swimming pool a separate tax entity than the building, even if you purchased them together. 

This is possible for personal property and land improvements.  Both types of property can be depreciated over much shorter recovery periods. For instance, personal property is usually depreciated over three to five years, while land improvements are depreciated over 15. You can also use a type of accelerated depreciation called bonus depreciation, which allows you to deduct 100% of your most personal property and land improvements in the first year of ownership.

Benefits of Cost Segregation

Cost segregation can be immensely beneficial for you and your rental business. 

Think about it this way: The more you can deduct up-front (preferably within year one of ownership), the more funds you can access in the short-term. You can then re-invest this money in your rental business to generate even more money. This positive feedback loop continues until you sell your property.

Without cost segregation, you’d have to deduct the personal property and land improvements you purchased with the building over 27.5 years—a much longer time frame. Each year, you’d only deduct a small portion of that item, when you could have deducted the entirety of it in the first year with bonus depreciation. It would take much longer to realize the effects of the full deduction.

Cost segregation increases cash flow on a more immediate time frame by reducing the taxes you pay on your property. It can also be applied retroactively, so you can still use it even if you’ve already begun depreciating your property over the typical periods.

How to Apply Cost Segregation

So, how do you apply cost segregation? 

The first step is to complete a cost segregation study. This is a formal analysis of your property to determine which components are eligible for cost segregation. For instance, the study might reveal that out of your $250,000 property purchase, you can classify $100,000 as land improvements and $35,000 as equipment.

The cost segregation study benefits you by showing you exactly which assets you can separate and depreciate. It also helps you avoid an IRS audit by providing proof of the calculations you made.

Cost segregation studies are usually done by CPAs or qualified engineers, although you can complete the study yourself with adequate research. It’s generally better to enlist cost segregation professionals, who know the precise limits and rules.

Conclusion

Cost segregation is one of the easiest ways to save money on your rental taxes. While there are some downsides, such as the effects of passive loss rules or depreciation recapture, cost segregation might be worth its costs for your business.

Also Read: How Call Tracking Metrics Can Skyrocket Your Business.

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