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As you may be aware tax advantages are one the main reasons investors choose to buy real estate. This article will focus on two popular tools to improve the tax advantages of owning real estate: 1) Cost Segregation and 2) Bonus Depreciation.
Requirements
We often get the question, “can I apply cost segregation to my personal residence?” Unfortunately, the answer here is no. The property must be an investment property which is not your primary residence.
How do I apply cost segregation or bonus depreciation? First, the cost segregation must be done by a professional, so the final product is an engineer based cost segregation. There are a number of companies that offer virtual assessments, but they should be avoided. If the IRS determines the cost segregation analysis is not correct or untenable they will simply toss it out. Second, cost segregation is a necessary condition of bonus depreciation. In other words, bonus depreciation cannot occur without first conducting a cost segregation analysis.
What is Cost Segregation
Cost segregation is one the most valuable tools available to real estate investors. As you grow your net worth in this industry or another, cost segregation will only become more critical for longer term growth.
Any real estate investment property you own has a set depreciation schedule (Residential 27.5 years / Commercial 39 years). This means that you can depreciate the property every year and use that depreciation to offset income generated from the property. See what this looks like below:
- $200,000 Property Value (tax assessed value)
- 75% Improvements / 25% Land (since land cannot be depreciated, your CPA must determine the improvement-to-land ratio. This can vary depending on the market)
- 75% of $200,000 = $150,000
- 30% of $150,000 = $45,000 (unfortunately, not all of the improvements value will qualify for cost segregation, this percentage is determined by your specialist at cost seg analysis.
Here you are left with $45,000 that does not have to depreciated over 27.5 years, but can depreciate quicker over 5 or 15 years. This allows you to write off more income. Note, extra depreciation that is not used to offset income generated by this property, can be applied to other forms of passive income. However, it cannot be used against your W2 income unless you meet one of the qualifications mentioned below.
What is Bonus Depreciation
Bonus Depreciation is something that actually started in 2006, but was only available to developers. This changed in 2017 with the Tax Cuts and Jobs Act. Anything with a class life of 20 years you can now take in accordance with bonus depreciation. This class life of 20 years or less is where the cost segregation analysis is applied. Since the asset itself does not qualify with a class life of 27.5 or 39 years, cost segregation becomes necessary as the items placed on 5 or 15-year depreciation schedules suddenly qualify for bonus depreciation.
In the above scenario, bonus depreciation would allow the investor to take a big chunk of the $40,000 in the first year. How big of a chunk is determined by Congress. As written, the Tax Cuts and Jobs Act of 2017 allowed for 100% through 2022. However, the bill contained a sunset provision that scales down to 80% in 2023, 60% in 2024, 40% in 2025, and so on until it is phased out in 2027. Just a heads up there is a new bill called Tax Relief for American Families and Workers Act which contained a provision to renew bonus depreciation to 100%. In 2024, this bill passed the House with overwhelming bipartisan support – 357 to 70. However, the bill stalled in the Senate due to disagreements over the Child Tax Credit which was embedded. Most experts expect bonus depreciation to come back since all parties agree, but how soon is yet to be determined.
In the cost segregation example above, you as the owner could put up to $40,000 against all passive income in the first year of owning the property. The example above illustrates a small residential property, but the same applies with larger commercial multifamily. Specifically, in a syndicated property, a cost segregation study is done before renovations then the bonus depreciation is split between investors, which can be a rather significant amount.
I mentioned earlier depreciation can only be applied to passive income unless you fall into an exception. This exception is being a real estate professional. If you are a real estate professional, dedicating over 500 hours a year to real estate and no other employment supersedes the number dedicated to real estate then the IRS considers you a real estate professional. If you have attained this status you can apply the depreciation against your W2 income. Also, if your spouse has attained this status and you file jointly then you can use depreciation against your W2 income.
There is also, a short term rental loophole, that will allow a full-time working household to transform passive income to active thus offsetting W2 incomes. The IRS uses a 7-step test for this exception. We will cover this in a separate article.
As you can see, cost segregation and bonus depreciation are tools that, if used properly, can grow wealth in a short amount of time. If you have questions about cost segregation and bonus depreciation generally, feel free to reach out. For specific questions regarding your current property under ownership please consult a licensed CPA
