In 2018, the federal government passed the Tax Cuts and Jobs Act (TCJA). This law greatly benefited landlords looking to get the most out of their rental property taxes.
The TCJA introduced many changes, but one of the most valuable for landlords was its effect on cost segregation.
Cost segregation allows landlords to maximize their depreciation deductions in a much shorter time than the typical, listed recovery periods.
Thanks to the TCJA’s expansion of bonus depreciation, several types of depreciation can now be accelerated. This means higher tax refunds and more access to funds in the short-term to reinvest in your rentals.
Want in on these benefits? Here is an overview of cost segregation to help you take advantage of these tax opportunities for 2022.
Cost Segregation: The Basic Idea
Cost segregation, in short, is the process of taking a property you purchased and dividing it into its individual components to be depreciated separately.
For instance, let’s say you bought a single-family home for $315,000. This price is a sum of all the property’s components, including its land improvements (like a swimming pool) and other personal property (furniture, appliances, equipment, etc.).
Cost segregation is the process of separating out these costs. For instance, the pool might be worth $35,000 and the personal property might total $20,000. Land is not a depreciating asset, so you can’t segregate the cost of the land itself.
Land improvements and personal property are traditionally depreciated in 15 years and three to five years, respectively. However, the TCJA allows you to write off 100% of the cost of these assets in one year, using a special kind of accelerated depreciation called bonus depreciation. Congress passed this law to encourage business owners to purchase new assets and stimulate the economy.
This 100% deduction will be reduced in subsequent years (it will be 80% in 2023). But cost segregation can still help you secure substantial tax deductions this tax year. It’s worth your time to learn about it now.
Benefits of Cost Segregation
Combined with the TCJA benefits, cost segregation is an excellent strategy for your rental business. Its primary benefit is that it gives you access to more funds in the short-term that you can use to continue growing your rental business.
For instance, let’s say you hire a CPA or tax professional to perform a cost segregation study. They find that your property’s land improvements can be valued at $150,000.
Normally, you’d have to wait 15 years to recover that full $150,000. Using straight-line depreciation, that’s deducting only $10,000 per year.
However, if you purchased the property before September 27, 2017, bonus depreciation allows you to deduct the entire land improvement this year. You’d have access to that $150,000 immediately, and you can reinvest it however you like to generate more cash flow. And the longer you own your property, the more that invested cash can grow into profit.
It’s no wonder that cost segregation study benefits are highly attractive to many landlords.
Drawbacks of Cost Segregation
Despite its benefits, cost segregation does not always make sense for every landlord.
There are three main drawbacks to consider before you move forward with cost segregation.
1. High Cost
The first drawback is that cost segregation studies are expensive. A study conducted by cost segregation professionals can cost between $5,000 and $25,000 and take up to six weeks to complete. If you can’t afford the time and expense, cost segregation could do you more harm than good.
2. Passive Loss Limits
Secondly, your first-year deductions from cost segregation are limited by passive loss rules. These rules prevent you from deducting losses over $25,000 unless you meet certain professional criteria. Even if you do meet the criteria, your deductions can still be rejected if your annual income exceeds $150,000. For this reason, you should only pursue cost segregation if you believe you’ll have enough passive income to absorb the losses you can’t deduct with bonus depreciation.
3. Depreciation Recapture
Lastly, cost segregation might not be beneficial if you’re planning on selling your property.
Why? The answer has to do with the tax implications of selling. When you sell your property, the IRS “recaptures” some of the depreciation benefits you took on your assets by taxing them at 25%. The longer you own your property, the less recapture impacts you, as you’ve had more years to reinvest your tax savings into your business and generate more revenue.
This means, if you’re planning to sell your property in the next three to five years, you won’t have enough time to truly benefit from the depreciation deductions you took on your personal property.
Cost segregation offers great benefits to landlords looking to maximize their tax season. However, its efficacy depends on your business’s unique situation. Be sure to enlist the help of a tax professional before using cost segregation in your rental business.