This article was published in Forbes on 4/2/2024.
A few years ago, I helped a client renovate a gorgeous set of cottages that the owner decided to use as short-term rentals. He made good money from the cozy beach bungalows, but hosting family vacations and bachelor parties weekend after weekend quickly started to take a toll on his newly renovated investment. Soon, parts of the property were depreciating at a rate much faster than the 27.5 years depreciation that he was being taxed at.
That tax season, I was discussing this issue with my accountant, who mentioned that a cost segregation study could help these quickly aging beach cottages claim more depreciation in the early years and reduce the owner’s tax bill for the year. Despite the initial upfront investment, the study paid for itself in the first year, and I’ve been recommending them to friends and clients ever since. If you’re a property manager or owner like me, here are some reasons to discuss this type of study with your CPA or tax professional.
What is a cost segregation study?
Residential properties generally depreciate over a 27.5-year period, allowing you to decrease your taxable income. However, not all parts of your property depreciate at the same rate. The foundation might depreciate evenly over the course of those three decades, but carpets, cabinetry and decorative lighting fixtures tend to take the big hits early and often. Much like rock stars, they live hard and fast and rarely make it past the age of 27.
Without a cost segregation study, real property, personal property and land improvements are all depreciated together, but with the study, they can be divided and depreciated at rates much more accurate to their realistic life spans, giving you a more accurate deduction for the depreciation and potentially adding to your short-term cash flow (which never hurts).
If you haven’t heard of these studies till now, it may be because they’ve grown in popularity over the last few years. In fact, there has been a recent surge in the popularity of cost segregation studies.
What does a typical study entail?
Most accounting firms will start with a feasibility analysis to determine if the property is right for the study and if the benefits outweigh the upfront costs. One key factor to consider is how long you’ll be keeping the property. If you’re planning on keeping the properties for five years or less, a study may not make as much sense due to depreciation recapture rules unless you’re also deferring through a 1031 exchange (a trade of one property for another).
After the feasibility study deems the property a good match for cost segregation, an accounting firm will send in their engineers for a property inspection. They’ll take measurements, document construction materials used and audit past invoices, all to identify which components of the property qualify for short-life treatment.
Once the inspection is complete, the study results should be organized into a detailed report that is audit-ready and mirrors the IRS’s own audit technique manuals, to avoid any unnecessary back and forth down the road. In the end, the whole process typically takes 30 to 60 days. So, if you’re reading this in early spring, you still have time to start!
As property managers, our job isn’t just to make repairs and collect rent but also to really help our clients achieve the greatest value from their income property. I want to encourage other property managers to become familiar with these kinds of basic investment strategies to save their clients money down the road. And if you’re a property owner, I recommend regularly seeking progressive ways to enhance your ownership experience, like cost segregation studies.
The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.
