Cost Segregation Residential Rental Property

Save tens of thousands on by significantly reducing your taxable income.

What is a Cost Segregation for  Residential Rental Property

A real estate developer planning on building a new apartment complex needs to know how much they can spend on construction. This will allow them to determine whether or not the project is economically feasible, which influences their decision to pursue it. 

By performing cost segregation on a rental property, your client can decrease the depreciation life of certain assets and reclassify them as shorter-term assets. This allows for accelerated depreciation, lowering their tax liability in the year of purchase, so they have more funds available to spend on construction during that same time.

Organizing, managing, and deploying the real estate portfolio is one of the primary responsibilities of any investor. Cost segregation can help your client take control of their investment by accelerating depreciation, which means they will spend less on income tax over time.

When a property owner doesn’t reclassify their assets, they are likely to have a higher tax liability when sold, which means the investor would have less money left over to put toward their next purchase.

Cost savings for landlords.

Landlords can use cost segregation to boost cash flow. They can keep more of their rental income because qualified improvement costs are depreciated over the shorter of five, 15, or 45 years whereas land improvements are depreciated over 27.5 years. Landlords can increase after-tax savings by paying off low-interest rate debts with high-interest rate gains, such as credit cards. The self-employed can use the cash to pay off debts and purchase equipment for their businesses.

Capitalizing on unrecaptured gain.

Individuals who sell a principal residence after owning it for at least five years and not having claimed the home sale exclusion (up to $250,000 per person on a joint return) can pay taxes on up to 25% of the profit as unrecaptured gain. They owe 15% of the amount that exceeds the exclusion. Use short-term debt to raise cash for those transactions, and increase after-tax wealth by saving some capital gains for high tax years. Individuals who have alternative minimum tax exposure can use short-term debt to generate ordinary investment income.

Cost savings for tenants.

Tenants save on their tax bills by renting a home that landlords have used cost segregation to improve. Renters can reduce their effective rent by nearly 2% if they are in the 25% tax bracket.

How does cost segregation deliver such benefits? 

Cost segregation delivers benefits with the following:

  • Reduced financing costs—Qualifying for a mortgage is more manageable, and obtaining favorable terms is more likely when lenders see that you’re managing your tax liability with cost segregation and other strategies.
  • Increased borrowing power —The increased equity in the building means more leverage, which means additional buying power for future acquisitions.
  • Preservation of capital —Since your client doesn’t have to worry about the IRS snatching away an increasing share of their profits, they can focus on more substantial returns—which means more money in their business.
  • Extra cash flow to meet goals —With no surprise tax bills every April, your client has more options when it comes to achieving personal and professional goals.
  • Improved cash flow studies —Quantifying the building’s performance is vital for all stakeholders, but especially when it comes to determining whether or not your client can afford additional leasing costs associated with new tenants.

What are the steps involved in implementing cost segregation for a residential rental property?

  1. Contact a firm specializing in cost segregation to provide a study & report for your client’s property.
  2. Designate a person responsible for overseeing the implementation of recommendations from the study & report, and communicate regularly with that person throughout the implementation process
  3. When construction on the building is complete, perform another cost segregation study to identify more costs to be reallocated.
  4. Look at the previous two years of 1040 tax returns for existing buildings and identify costs that can now be reclassified as a shorter depreciation life.
  5. If your client has already filed taxes for this year, they can petition the IRS directly through an appeals process known as IRS Form 843
  6. Once benefits are realized, continue performing cost segregation studies on your client’s properties every 3-5 years to keep the tax deductions coming.
  7. Work with your client’s CPA firm to implement recommended changes in their accounting procedures.

The benefits of investing in a property with cost segregation, including increased cash flow and lower taxes, are not immediate. How can a property owner plan for these benefits in the future? 

The benefits of cost segregation, including increased cash flow and lower taxes, are realized over time when your client’s building is sold or refinanced.

  • Impact on valuation—Your clients will likely see at least a 10% increase in their building’s market value, which can help them achieve goals related to retirement or estate planning.
  • Impact on future financing—Properties with cost segregation are more attractive to lenders, so your clients have a better chance of qualifying for lower interest rates and favorable terms.
  • Increased borrowing power—The increased equity in the building means more leverage, which means additional buying power for future acquisitions. 
  • More cash flow to meet goals—With no surprise tax bills every April, your client has more options when it comes to achieving personal and professional goals.
  • Increased borrowing power—The increased equity in the building means more leverage, which means additional buying power for future acquisitions.
  • Preservation of capital—Your client can successfully plan for the long-term, knowing they have a successful investment portfolio with passive income and future growth opportunities.
  • Improved cash flow studies—Quantifying the building’s performance is essential for all stakeholders, but especially when it comes to determining whether or not your client can afford additional leasing costs associated with new tenants.
  • Inventory/Tenant Mix—Understanding the impact on future cash flow is essential, so it’s time to take a closer look at its composition. Is the building occupied primarily by long-term tenants or short-term tenants? What is their credit profile? Do they have pets or other special needs that require additional care and expense? These are just some of the factors that will influence your client’s next steps.
  • Impact on the rental market—Even though your client may see immediate benefits, it’s important to remember that other investors in the market do not know about cost segregation. While they are making their own decisions based on what is happening in the marketplace, your client can use the benefits of cost segregation to increase rents and attract a better tenant mix.

Why should you invest in a property with cost segregation today?

If you’re a tenant, you’ll save money in today’s tax structure. If you’re a landlord, cost segregation provides rapid return on investment and can reduce rent and development costs.

Taxpayers who use cost segregation benefit from:

  1. Accelerated depreciation allowing faster write-offs of actual expenditures to speed cash flow. Property improvements are classified as Section 1245 (5, 15, or 45 years) rather than Section 1250 (27.5 years).
  2. A shorter recovery period for land improvements (15 or 27.5 years versus 27.5 years), allowing more significant depreciation deductions to reduce taxable income and maximize cash flow.
  3. Depreciating qualified improvement costs over five years instead of 27.5 years for residential rental property, resulting in a higher depreciation deduction and reduced taxable income.
  4. Allowing up to 100% bonus depreciation on new assets installed into the building from 2011 through 2013 rather than 50%. This allows business owners to write off these expenditures as an expense rather than a capital improvement.
  5. Paying off credit card debt with tax-free income to improve their cash flow.
  6. Decreasing the landlord’s effective rent by nearly 2%. Rent payments are based on the after-tax net rental income, which is lower due to allowable depreciation deductions, decreasing property taxes, and real estate insurance costs.

Want to see how much your Business  can save?

We put together a free savings potential calcualtor that can help you see just how much you can save.