Summary: What is cost segregation and bonus depreciation? And more importantly, what are the benefits of cost segregation and bonus depreciation? In this article, we will dive into both. When you are a Real Estate Professional or you materially participate in your vacation rental, you gain access to a whole host of tax advantages that are not available to the average tax-paying high-income professional. Cost segregation/bonus depreciation is just one example of that powerful tax advantage.
[Disclaimer: We are not accountants, lawyers, or financial advisors, so please consult your own team of professionals about the topics covered in this article.]
Most real estate investors know that investing in real estate has many tax advantages. They file their taxes and see that their tax rates are lower than before they started investing in real estate, but not all are taking full advantage of the tax benefits that investing in real estate has to offer.
One of these benefits is the ability to accelerate depreciation. You can accelerate depreciation by doing something called a cost segregation study. Which we’ll describe further below. Before we do that, you need to first understand depreciation.
What is Depreciation?
For tax purposes, the federal government considers all investment properties as losing value each year. This is called depreciation.
The IRS allows you to count the depreciation of your investment as an expense each year on your taxes. This depreciation expense is spread out over 27.5 years for a residential property, and 39 years for a commercial property. The part that depreciates is the building, not the land.
For example, we have a four-plex that we bought for $500,000. The land is valued at $100,000 and the building is valued at $400,000. It is considered a residential property. Therefore, the building is depreciated over 27.5 years.
Each year, the building loses $14,545 worth of value (400,000 divided by 27.5). As described above, the government allows us to count this as an expense against rental income.
In most cases, this depreciation expense offsets the income on paper and we’ll show a loss on our tax return for this property. This is how you can make money from your rental property and still show a loss on your tax return, which we covered in a prior article.
This is the amount that we can charge as an expense against rental income each year going forward if we don’t take advantage of cost segregation and bonus depreciation.
What is Cost Segregation?
Cost segregation is a study that is performed by an engineer. The engineer evaluates the components of the building and assigns a different tax life to each of the components.
So instead of broadly depreciating our four-plex over 27.5 years, they separate each of the building components into different tax lives. Depreciable assets are divided into 5, 7, 15, or 27.5 years. How they’re separated depends on the life of the component.
Broadly, anything structural has a 27.5-year life.
The non-structural components have a 5, 7, or 15-year life. Items like appliances or carpets take 5 years to depreciate. Land improvements, like fencing, are depreciated over 15 years.
The cost is spread out over a much shorter time period (5-15 years instead of 27.5 or 39 years). Therefore, the amount of your depreciation expense goes up significantly in the first few years of your ownership of the property.
This is called accelerated depreciation.
What is Bonus Depreciation?
Bonus depreciation adds another very significant benefit on top of accelerated depreciation.
We think of it as a turbocharged version of accelerated depreciation.
Bonus depreciation isn’t a new concept. However, it’s something that got better for real estate investors with the 2017 Tax Cuts and Jobs Act (TCJA).
Bonus depreciation allows you to take the components that have a 5-15 year lifespan and expense it all in one year instead of spreading it out.
For properties purchased prior to September 27, 2017, you could take 50% of this cost-segregated amount and expense it in Year 1. With the new law, for properties purchased after September 27, 2017, you can take 100% of the cost segregated components as a depreciation expense in Year 1.
So for our example property, instead of a depreciation expense of $14,545, with bonus depreciation, our depreciation expense in the first year went up to $125,000!
When added to the other rental expenses, our expenses now far exceed rental revenue (on paper). Therefore, the property will show a significant loss. However, these losses can be used to offset income from other sources.
How to Maximize the Benefits of Cost Segregation and Bonus Depreciation
Bonus depreciation helps you generate significant losses. Unfortunately, the majority of doctors and high-income professionals are not able to take full advantage of this loss.
In order to take advantage of these losses and use them to offset W2 or 1099 income, you need to be actively involved in your rental properties.
For long-term rentals, you need a status called Real Estate Professional Status (REPS). You can read about REPS HERE.
For vacation rentals, also known as short-term rentals, you need to materially participate in the rental activity. You can read about the short-term rental tax benefit HERE.
The reason is, that rental losses are passive losses by default. Passive losses are in a different category than active income like W2 or 1099 income. So the losses don’t offset active income.
Therefore, unless you have significant passive gains, your passive losses remain unused in a category called suspended passive losses. Passive gains could be those earned through investing in syndications or say a passive investment in a surgical center.
How Much Does a Cost Segregation Study Cost?
Cost segregation typically requires you to pay a professional (usually an engineer) to perform the study. You could do it yourself (or have your CPA do it if he/she is comfortable). However, there is a risk to doing so.
According to IRS guidelines, the person doing the study should have knowledge of “both the construction process and the tax involving property classifications for depreciation purposes.” If you or your CPA isn’t a construction engineer or an architect, it’s probably best (and safest from an audit perspective) to outsource the cost segregation study.
Remember, we’re not tax professionals. So you should seek guidance from a CPA or other professional you trust.
In our case, we used a national company that flies their engineers around the country to do these studies. For our four-plex, the study cost us $3,000.
What is This Really All About?
The reality is that cost segregation/bonus depreciation only shifts the timing of your depreciation expense. It doesn’t increase your depreciation expense overall. In fact, once we claim the bonus depreciation in Year 1, our depreciation expense in future years actually goes down from where it would have been if we just followed the 27.5 year depreciation schedule.
So why do we go through all of this effort?
The answer is compound growth.
If you can front-load your tax savings and get your money working for you sooner, your money grows much faster than if you were to take those tax savings in small increments over a longer period of time. In fact, when modeling this with our own portfolio, we found that a large portion of our return (11% of the 25% return) is due to compound interest on the money saved. You can read more about this here.
Key Takeaways
Remember, you likely won’t be holding onto these properties for 27.5 years or 39 years. So it’s in your best interest to maximize your depreciation expense while you still own the property. If you use a 1031 exchange when you sell the property, you’ll get to continue to defer paying the taxes on your gains. In this way, you continue to maximize your tax savings early on in your investing career to supercharge your growth.
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