Cost Segregation and Residential Rental Real Estate
- Donald Feicht
- Apr 10
- 3 min read
What is Cost Segregation?
Cost segregation is a process defined by the Internal Revenue Service to establish the useful, depreciable economic life of the various components that make up a real estate property.
Real estate includes elements such as land, buildings, personal property, and land improvements. While land itself is not subject to depreciation, buildings, personal property, and land improvements can be depreciated over different recovery periods, which are as follows:
Buildings - 27.5 years
Personal Property - 5.0 years
Land Improvements - 15.0 years
Additionally, personal property and land improvements benefit from shorter recovery periods and utilize a double-declining balance depreciation method to accelerate their recovery.
What's the History of Cost Segregation?
The modern practice of cost segregation can be traced back to the late 1960s Supreme Court ruling in Hospital Corp. v. Commissioner. In this case, the court concluded that certain elements traditionally categorized as real property should be reclassified into faster depreciation categories because of their proven shorter economic lifespans. Consequently, the IRS established new classifications for personal property and land improvements, assigning them significantly shorter economic recovery periods of 5.0 and 15.0 years, respectively.
This development greatly benefited large institutional investors, such as Real Estate Investment Trusts and owners of extensive apartment complexes, but it offered little advantage to small investors. Although the principles applicable to small investors of single-family rental properties or vacation rentals were established, conducting a cost segregation study for smaller properties remained too costly and complex to be practical.
As a result, when an investor purchased a new property, accountants would capitalize the acquisition by subtracting the land value from the acquisition cost and then capitalizing the remaining amount over 27.5 years.
What's Changed?
Technology has evolved to allow much greater access to data, and AI has created opportunities to develop economic models to very accurately and economically segregate non-realty components from a real estate acquisition for cost segregation purposes. The results are huge to the non-institutional investors, greatly increasing depreciation deductions and increasing cash flow.
Case Study
Consider a rental property acquired for $250,000. Upon examination, the land is valued at $50,000, leaving a residual improvement value of $200,000.
Using traditional capitalization methods, the $200,000 in improvements would be capitalized over 27.5 years, resulting in an annual deduction of approximately $7,272.
However, a cost segregation study would reveal that approximately 25% - 35% of the total improvement cost could be reclassified into personal property or land improvements, greatly accelerating the deductible depreciation.
A side-by-side comparison of the depreciation deduction before and after a cost segregation study indicates a more than 300% increase in depreciation deduction in the first year, with a corresponding increase in tax savings.
The "Look-Back"
;
An overlooked provision in the Internal Revenue Service's "Audit Techniques Guidelines" for cost segregation is a provision to claim previously under-reported depreciation allowances from previous years without the need to file amended returns.
This provision can be a significant benefit for an investor who purchased a property (or properties) in the last decade. All the overlooked depreciation, as demonstrated in the example above, can be claimed in the current tax year, leading to a refund of thousands of dollars. This money can be reinvested in a new property to grow the investor's portfolio, saved in an emergency fund for unforeseen situations or necessary repairs, or simply added to the investor's bank account.
Assuming the same property detailed above had been purchased five years ago, and a cost segregation was performed before the fifth-year tax filing.
Applying the look-back provisions of the tax code, the investor can deduct an additional $51,400 in depreciation in the current tax year. At a marginal 30% tax rate, that's equates to a tax refund of over $15,400.
The Solution
D.P. Feichtco has conducted engineered cost segregation studies for numerous institutional property owners for over twenty years. Recently, we introduced our unique cost segregation program, REALTAX SAVER, designed for non-institutional real estate rental investors. REALTAX SAVER leverages market data and proprietary algorithms to efficiently and accurately conduct cost segregation studies for single-family homes, small multi-family units, vacation properties, and short-term rentals.
Traditional cost segregation studies can cost $5,000 - $35,000 or more, depending on their complexities and size. REALTAX SAVER cost segregation studies are available for a few hundred dollars and will return many times their cost in additional depreciation deductions.
A very simple process of completing a short questionnaire is all it takes to get started, and results are generally available within three days. Once the survey is completed, the information and report can be given to your tax accountant to implement for your tax filing.
For complete information, visit http://dpfeichtco.com or contact us at 216-772-7931.
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