Understanding Real Estate Cost Segregation

Cost segregation is a tax planning tool some real estate investors use to speed up depreciation deductions. This article explains what it is, who it may fit, and what to ask before you hire a firm.

This is general information, not tax advice. Tax rules change and every owner’s situation is different. Talk to your CPA or tax advisor before you decide.

Who this is for

This is written for investors who own residential rental property in Massachusetts and want to understand the concept before talking to a CPA. It is not for owner-occupied homes. Green Ocean manages rentals. We don’t perform cost segregation studies or give tax advice.

What Is Real Estate Cost Segregation?

Cost segregation is an engineering-based study that breaks a building’s cost into components. Some components (certain fixtures, equipment and site improvements) can be depreciated over shorter periods than the building itself. The result can be larger deductions in the early years of ownership and smaller ones later. Whether that helps you depends on your income, how the property is held, and your tax situation.

Residential rental buildings are generally depreciated on a straight-line basis over 27.5 years, which works out to a little over 3.6% of the depreciable basis per year. Land is not depreciable, so the purchase price has to be split between land and building. See IRS Publication 527. The IRS describes how shorter-lived property can be separated out in its Cost Segregation Audit Techniques Guide, which also sets out what the IRS looks for in a study.

A cost segregation study reclassifies part of the cost into shorter recovery periods, so more of the deduction comes earlier. The total depreciation over the life of the property does not increase. It is mostly a timing difference.

Why Investors Consider It

Early in ownership, a property may not throw off much after the mortgage and operating costs. Larger early depreciation deductions may help offset taxable income in those years, if your tax situation lets you use them. Rules on bonus depreciation and other accelerated methods have changed more than once, so check the current IRS guidance and ask your CPA what applies to the year you buy or place the property in service.

What to Weigh Before You Commission a Study

• Cost versus benefit. Study fees vary with the size and complexity of the property. Ask for a written quote and have your CPA estimate the benefit first.
• Whether you can use the deductions. Passive activity rules and other limits can affect how much of the deduction helps in a given year.
• What happens when you sell. Accelerated depreciation can be taxed differently on sale (depreciation recapture). Ask your CPA to model it.
• State tax treatment. Federal and Massachusetts treatment of depreciation may not match. Confirm with your CPA.
• Study quality. The IRS notes that no official standards exist for preparing these studies, and it looks for documentation and sound methods. Ask any firm how it supports its numbers.

Related reading

See our guide to rental property tax deductions and our explainer on how real estate depreciation works.

Rental Property Management Support

If you or anyone you know is looking for a property manager to help with owning and managing an investment property, think of Green Ocean Property Management. You can also contact us with questions about managing your rental.