Should You Do a Tax Cost Segregation Study?
Tax cost segregation studies on investment properties could be one of the best kept secrets in real estate investment. But at The Realty Medics, we believe you should have as much information as possible to maximize your investment ROI. Everyone’s tax situation varies. So speak with your accountant to decide if you should do a tax cost segregation study on your rental property.
What the Heck Is Cost Seg Anyway?
Tax cost segregation studies provide investors the ability to do an engineering study for any kind of real estate. Although usually performed for commercial real estate, you can conduct a study on residential real estate as well.
Performed by a certified engineer, these studies (aka cost segs) break down the mechanical and personal aspects of residential homes. Then they demonstrate how those items depreciate faster than the actual building structure itself.
Residential real estate investors know their investment homes depreciate in 27 ½ years. But most things within a house will not last 27 ½ years. For example, water heaters and carpeting have a life of around five years. If you’re lucky, a roof may last 27 years, but more likely will need replacing after around 15 years.
Tax cost segregation studies break down all these components within a property and define them into certain boxes.
Benefits of Cost Seg
Residential real estate investors can do a cost seg for the tax year that they placed the house in service. This means when the house became available to rent out NOT necessarily when it was purchased. A cost seg can also be conducted when an owner puts a certain level of improvement into a rental home during a tax year.
However, taking all of those depreciations during the year an owner placed a house in service adds up quickly. In some cases, they can total up to 30% of the purchase price of the house. And that frees up funds for whatever you want (although we’d recommend using it towards the purchase of another rental).
Depending on the exact study, this can result in a much lower tax responsibility or a lot more passive loss. Only the certified engineer and your accountant can tell you how you’d benefit.
You do have to pay for the services of a professional firm. A typical fee is generally under $2,000, but results in 5-10 times that amount in actual cash back.
Note: the engineering firm will not file the owner’s taxes on their behalf. They should continue to use their usual CPA or tax professional. However, during discussions, accountants can join calls with the firm to keep everyone on the same page.
In addition to cost seg information, the owner will also need to submit a one-time Form 3115 to the IRS. This change in accounting form covers tax purposes in all 50 states since it’s a federal agency.
Also, owners who have multiple properties coming into service in a tax year can conduct studies on each of them. This multiplies the tax benefits for that year.
Again, only your tax professional and a certified engineering firm can determine a property’s eligibility for these tax benefits.
That said, if you plan to flip a house or sell it within five years, the math doesn’t work out. Mainly because the IRS will charge recapture fees from the depreciation. Generally, holding a property for longer than five years after a cost seg will result in more money back than the recapture fees.
Real estate professionals qualify for additional benefits, but based on their intricacies, we will not cover these here. If you have questions or would like recommendations on cost seg firm we use for our own rental properties, reach out! You can contact us at (321) 236-6690 or by using our online form.