What is a cost segregation and why should I care if I am not a real estate professional?

If you hang around commercial real estate investors for any length of time, you will hear the term “cost segregation” come up.

It is spoken about almost mythically, like it will magically solve all of your investment problems and turn an ok deal into a fantastic one.

In reality, for most LPs, a cost segregation is an important and useful part of a property’s tax strategy. But it isn’t magical. It can even have some downsides if not properly used.

A cost segregation is the official term for an analysis which breaks down the value of the property (what you paid for it) into its component pieces, so that they can be properly depreciated. You already likely know that you can’t depreciate the land (the value of the dirt doesn’t decrease over time). However, there are a number of different categories that the remaining improvements can be placed into. For example, a carpet is typically considered 5 year property, while a driveway may be expected to last 15 years. The cost segregation takes everything – the landscaping, the wiring, the lighting, the roof, and the basic structure of the building – and puts it into the appropriate category for depreciation. It then assigns a portion of the current value of the property to each item.

This approach lets you depreciate each item over the appropriate timeline – 5 year property can be depreciated over 5 years while 15 year property can be depreciated over 15 years.

If you don’t do a cost segregation, everything is considered to be part of the building and is depreciated over 39 years (for commercial buildings). So by doing a cost segregation, you get to speed up the depreciation by depreciating the shorter lived assets faster. And, under current law (slowly phasing out over the next few years), you can further accelerate the depreciation using “bonus depreciation” which lets you take a percentage of the depreciation (currently 80%) for all items that are 15 years and less in the first year.

While accelerating the depreciation is helpful, the biggest benefit is typically only for real estate professionals – who can use depreciation to offset their active income. For the rest of us, depreciation can only be used to offset passive income. That does mean that you will not be paying taxes on your passive income until your gains outweigh your paper losses. But it doesn’t mean that you can offset the income from your day job. The good news is that the depreciation doesn’t go away if you don’t use it in the first year. You just keep carrying it forward until you need it. And, eventually, you will need it. So there is no harm in accelerating the depreciation.

There is an interesting exception to this rule. If you have a short term rental (STR) property (with an average stay of less than 7 days) that you actively manage [1], then that is considered a business not a real estate investment, and the income and losses are considered to be active. For this reason, many people look to actively participate in their STRs so they can offset their active income (for example, from a W2 job). Once that deduction is obtained, they can offload the management of the property to a property manager and take a more passive role in the investment. This isn’t a strategy I have used, but it seems to be one of the few ways to reduce the tax burden of a high income job.

While depreciation is incredibly useful, when you sell the property, you are going to owe money based on the difference between your basis and the sales price of the property (unless you use other strategies like a 1031 exchange [2]). Your basis is the deprecated value of the property – in other words the amount you paid for the property minus the depreciation that you claimed.

You likely already understand that you will owe long term capital gains on the profit you are making from the sale of the property (sales price – purchase price) and know that this is taxed at a lower rate than your normal tax rate (maximum of 20%[3]).

You should also be aware that you will be taxed on the depreciation that you took as well. This is known as depreciation recapture [4]. You might think that since you have to pay taxes on the depreciation you took, that you are no better off taking it. That isn’t true. There are three subtle but important advantages to taking the depreciation anyhow.

First, you have delayed paying the taxes on your passive income. By accelerating the depreciation you pull those savings forward in time and defer earning a paper profit until some point in the future. In many cases, you can generate sufficient deductions to defer paying taxes until you sell the building. At the very least (even with very high cash flow) you have deferred paying these taxes for 5 years, 10 years, or even longer. Not only do you have access to that money during that time – meaning you can keep it invested and earning more money – but you are paying the taxes back in money that has been devalued by inflation (the purchasing power of a dollar today is more than a dollar in 10 years, so if I have to pay you 1 dollar, I would rather do it in 10 years than today).

The second advantage is that the tax rate you will be paying on the depreciation is less than the standard tax rate. Depreciation recapture is paid back at a maximum of 25%. So, unless you are making very little money now compared to what you will be making in the future, you reduce your taxes by the difference between those two rates – which can be 10% or more depending on your current tax bracket. While that difference may not seem like a huge amount, it can add up when talking about real estate investments. Saving 10% on a profit of $100,000 by converting that profit to capital gains instead of passive income taxed at your normal tax rate is $10,000 you would not have to pay the government – not a trivial amount for doing nothing other than making use of the tax code.

The final advantage is that the IRS assumes you have taken some level of depreciation and calculates your taxable gain accordingly. If you haven’t done a cost segregation, the standard, straight line depreciation will be assumed to have been taken and the amount you would have taken there will be taxed. So you will need to be taking some depreciation anyhow. Given that, you might as well get as much value as possible when doing so.

The biggest potential disadvantage of cost segregations is the cost. This analysis needs to be done by licensed professionals and can cost anywhere from a few thousand to tens of thousands of dollars depending on the job. As a result, they only make sense when you are going to have a tax benefit large enough to offset those costs. For example, it would not make sense to do a cost segregation on a $100k home or a $10M piece of farmland with a couple of small barns since in neither case would the depreciation be sufficient to offset the cost of the study.

Of course, you also need an accountant familiar enough with real estate investing to know how to reflect the passive losses and carry them forward over time until you exhaust them.

Depreciation is one of the most powerful tax benefits that real estate provides and cost segregations allow you to unlock the benefits of depreciation faster. While that may not make a huge difference as a passive investor, it still has incremental benefits that you can benefit from – especially if you hold the property for a long period of time. If you are invested in a deal that hasn’t done a cost segregation, ask why. There may be a valid reason. Or you might be dealing with someone who isn’t familiar with all of the benefits that these deals can offer investors.

If you have any questions or comment about this post, please email them to me at blog@mbc-rei.com, I will reply to the questions that are straightforward and will turn the questions requiring more detailed answers into future blog posts.

For additional reading:

This article is my opinion only, it is not legal, tax, or financial advice. Always do your own research and due diligence. Always consult your lawyer for legal advice, CPA for tax advice, and financial advisor for financial advice.