January 30, 2023

The Real Estate CPA Explains: Cost Segregation

When it comes to proper real estate accounting, learning how to use cost segregation effectively can be the key to maximizing your tax deductions.

Cost segregation key takeaways:

  • Cost segregation is the practice of breaking up purchase price into smaller components
  • Cost segregation allows you to depreciate value over a faster time period than 27.5 years
  • You're able to claim bonus depreciation for any component with a useful life of less than 20 years

Hi, I'm Brandon Hall, a real estate CPA and CEO of Hall CPA, and in this video, we're going to talk about cost segregation studies.

A cost segregation study is the practice of breaking up a purchase price into smaller components.

The theory behind Cost Segregation studies goes like this:

When you go and purchase a rental property, you're going to break out the purchase price between improvements the building and land, and then you're going to depreciate that building value over 27.5 years for residential property and 39 years for non residential property.

But the reality is that you have many components inside of this building that are not going to last 27.5 years.

A cost segregation study identifies those components and assigns a value to them. It allows you to depreciate value over a faster time horizon than 27.5 years and when you depreciate something faster, you get the tax benefits faster.

Imagine being able to depreciate a $20,000 component over five years, yielding a $4,000 annual depreciation deduction versus having to depreciate that same component over 27.5 years which would only yield a $720 annual tax deduction!

A bigger deduction means reporting less taxable income to the IRS, and that gives you a tax benefit faster if you were to get a cost segregation study performed on your property.

You would receive a report after the cost segregation study is done and that report would show you how much value was allocated to 5 year property, 7 year property, 15 year property and 27.5 year property, and then you would depreciate the value of all of those property over the 5, 7, 15 or 27.5 years that they were assigned.

And remember, you can also claim bonus depreciation for any component with a useful life of less than 20 years. And that ultimately makes Cost Segregation studies even more valuable for landlords.

I do want to add one caveat:

If you do not qualify for an exception to the passive activity loss rules, or if you do not have a lot of passive income, then using a cost segregation study to create large tax losses might not be beneficial for you because it's just going to increase your suspended passive losses.

So you might end up not receiving a current year tax benefit. Make sure to work with a tax advisor that really understands the nuances of how all this works.

Brandon Hall is a real estate-focused CPA and the CEO of Hall CPA. Learn more about Brandon and his team over at https://www.therealestatecpa.com/

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