The Huge Value of Algorithm-based Cost Segregation Studies for Smaller (<1M) Rental Properties
Have you ever heard investors say that it really doesn’t make sense to do a cost segregation study unless your property cost over a million dollars? Have you seen the price tag on an engineered cost segregation study and thought – how could that possibly pencil on my small residential rental? The new Trump tax plan is a major boon for buy and hold real estate investors and you don’t have to own large properties and do engineered cost segregation studies to benefit. Even if you are a small-time investor you can use cost segregation studies as a way to legally reduce your tax bill. Read on for a quicker and less expensive alternative to an engineered cost segregation study.
This article presumes that you understand passive pass-through losses as a way to reduce your taxable income. If you don’t yet understand this concept please read my blog post entitled “Why Every W2 Employee Needs Rental Real Estate to Reduce Taxes” for a primer and come back to this article. Once you understand passive losses as a way to reduce taxable income then you’re ready to supercharge your losses with cost segregation studies.
Rental real estate has amazing tax benefits. You get to take an asset that is producing income and often increasing in value and depreciate it. As real estate investors we account for this depreciation, take our paper losses, use them to offset our income, and subsequently reduce our tax bill.
A cost segregation study takes a rental property and breaks it down into its component parts – wooden fences, carpet, light fixtures, etc. So instead of taking the whole cost of the property and depreciating it over a long time period, you are able split out the component parts with a faster depreciation schedule. The usual deprecation schedule for residential real estate is 27.5 years. So if you use regular depreciation you will take the cost of the property subtract out the cost of the land and claim that amount as depreciation every year. Example: buy a property for 200k, land is worth 30k, so you take 170k/27.5=$6,182/year in depreciation.
However, a cost segregation study splits out items on a faster depreciation schedule. The following items are on an accelerated depreciation schedule of 5 or 15 years:
Kitchen Cabinets & Countertops (5)
Kitchen & Appliance Plumbing (5)
Removable Flooring (5)
Ceiling Fans & Wiring (5)
Blinds & Curtains (5)
Appliance Wiring (5)
Other Site Improvements (15)
Driveway & Walks (15)
Everything else is on a 27.5 depreciation schedule.
In the cost segregation studies I have done about 20% of the total structure is on the 5 year depreciation schedule while another 10% is on 15 year depreciation schedule. The remaining 70% is still on the 27.5 depreciation schedule for residential properties.
You might be wondering, is it really worth doing a study for 30%? Under the new Trump tax plan there is bonus depreciation of 200% for these 5 year categories and 150% for the 15 year categories if your property was placed into service after December 31, 2017. So that 30% is even more valuable in the first few years. Make sure you check the tax rules with your accountant as this article is just an overview. The big picture is that there are big bonuses on accelerated depreciation for the next few years with the bulk of the benefit coming to you in Year 1 due to bonus depreciation.
Under the new Trump tax plan there is bonus depreciation of 200% for these 5 year categories and 150% for the 15 year categories if your property was placed into service after December 31, 2017.
On larger properties an engineer will come out to your property and actually figure out the age of each component part, then write you an engineered report that you will use when you submit your taxes for that property. However, you can do an algorithm report online for a fraction of this cost. Costs range from $300-$1500 for an algorithm-based study, depending on the size of the property and the company you use. The studies take you through questions about land value, square footage, year constructed, number of ceiling fans, flooring type, etc. Then averages from thousands of studies are used to calculate the component parts of your property. This is all from the comfort of your own couch (although you might need to go take a look at your property for flooring type and measurements if you don’t have them).
I personally use DIY cost seg for my studies. For a $50 discount on residential (SFH to 4plex) and a $100 discount on commercial use my coupon code: 1275. I personally use this company but you can do research and find another algorithm based cost seg company you like.
So seriously consider picking up a new rental property to do a cost segregation study on or doing one for one you already own. I’ve found it is best to do your study in Year 1. However, if you haven’t done that you just need to file a form with the IRS (Form 3115) to change your form of accounting when you file. It’s quick and easy and your accountant should be able to handle easily once you provide them with the cost seg study. If your accountant tells you not to do this consider finding a new accountant.