Over the past decade, real estate investments have surged in popularity among both seasoned investors and newcomers alike. Faced with the unpredictable nature of the stock market and sometimes misleading advice from Wall Street, investors are increasingly exploring alternative avenues to grow and protect their wealth. Both long-term and short-term real estate investments have become favored choices due to their predictability and potential for high returns. Alongside these benefits, real estate also offers substantial tax advantages.
As interest in real estate has grown, so has the use of specialized tax planning strategies tailored for property investments. Among these strategies, cost segregation studies have emerged as a significant tool, creating buzz within real estate investor communities across the country.
Cost segregation studies can be extremely beneficial if understood and implemented properly. If, however, you set out to implement a segregation study without knowing what you were doing, you could find yourself in a predicament down the road
So, what is a Cost Segregation Study?
Very simply put, a cost segregation study is the process of dividing your residential or commercial real estate property into components that can be depreciated more quickly than on a standard 27.5-year or 39-year depreciation schedule.
Commonly, residential real estate is depreciated over 27.5 years after the purchase price of the property is adjusted for the cost of land. Commercial real estate is depreciated over 39 years also after adjusting for the acquisition cost of the land.
A cost seg study sets out to determine what percentage of the building structure consists of Property components that can be depreciated more quickly. Property components are typically broken out into five-year property, 10-year property, and 15-year property. Examples of each category are:
5-year property: carpeting, specialized electrical, components, decorative, lighting, certain millwork, wiring, countertops and appliances.
10-year property: exterior land improvements, parking lot improvements, landscape, irrigation, and security systems.
15-year property: land improvements, site, paving, outdoor signage, certain utility installations, and fencing.
What happens after the Cost Seg Study?
After categorizing the structure into different component categories through a cost segregation study, you can accelerate depreciation on the property. Without such a study, residential property typically depreciates over 27.5 years. However, with a cost segregation study, you can depreciate 5-year property over just 5 years, 10-year property over 10 years, and 15-year property over 15 years.
This accelerated depreciation results in a quicker reduction of the property's cost basis. Greater depreciation leads to larger deductions, lowering your taxable income and thereby reducing your tax bill. These tax savings allow you to retain more capital in your household, which can be reinvested into purchasing additional properties or making other investments. Ultimately, the aim of conducting a cost segregation study is to enhance cash flow and maximize the financial benefits of your real estate investments.
When can I do a cost seg study?
Ideally, a segregation study would be completed in the year of which you purchase an investment property.
Completing the study in the first year would also allow you to get a good picture of your overall tax planning strategy and get an insight on what your tax liability will be.
However, if you have owned real estate investments for several years, it’s not too late to conduct a cost segregation study on those properties. There is a process to go back and retroactively implement a segregation study on your current real estate portfolio holdings. That process is slightly complicated and is beyond the scope of this article. We would encourage you to work with us or another capable tax professional to explore this option and determine if it is a good fit for your overall financial plan.
Where can I get a cost seg study and how much does it cost?
Cost segregation studies can be very simple to obtain an implement. There are hundreds of qualified firms that specialize in on site visits, data collection, component analysis, and categorization, and preparation of a study report. A quick Internet search would yield several options, but it’s important to interview a few people to get a good idea of their process, for the study, and their support in the event of an IRS audit.
Cost segregation studies will vary in price significantly, depending on the type of real estate investment, location, and other factors. You can expect to pay anywhere from $1000 for a simple residential building up to $20,000 for a large and more complex commercial structure.
Our firm has found working with Cost Segregation Specialists Inc. from Syracuse, New York particularly beneficial for simpler cases. They conduct thorough cost segregation analyses remotely, which not only reduces costs but also ensures a quick turnaround of approximately 24 hours for delivery of the study. Moreover, they provide robust support in case of an IRS audit and boast a flawless record of success when audits are challenged.
Case Study:
Morgan bought a townhome in Franklin, TN that he is planning on using as a short-term rental property on AirBnB and Vrbo.
He paid $650,000 for the property and the value of the land is $75,000 according to the Williamson County Property assessor.
Morgan is a musician and gets paid $300,000 per year on a W2 from his management company.
Here is a summary of how implementing a cost segregation study can help Morgan lower his tax bill in 2024.
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