For rental property owners, taxes are often a dreaded responsibility.
However, many landlords overlook how taxes can benefit their rental businesses. For instance, one tax strategy—cost segregation—allows you to take advantage of shorter recovery periods to save more money in the short term.
Cost-segregation allows you to take advantage of depreciation to increase your cash flow, which you can then re-invest in your rentals. It’s a great strategy to grow your business and use taxes to your benefit.
Nevertheless, you shouldn’t apply cost segregation haphazardly. You should understand its implications for your business or enlist a tax professional who can caution you against potential problems.
Here are three potential issues you may run into while applying cost segregation to your rental taxes.
#1: Your deduction might be capped by passive loss rules.
The first thing you should know about applying cost segregation is that your deduction might be limited by the passive loss rules.
Let’s say you bought a property with substantial land improvements worth over $100,000. Cost segregation should allow you to separate those improvements from the cost basis of your property and depreciate them separately.
This means your land improvements can be depreciated over 15 years instead of 27.5. You’ll recover the full cost of those improvements almost twice as fast. Sounds great, right?
It gets better. Thanks to the Tax Cuts and Jobs Act (TCJA) of 2018, you can now use bonus depreciation, a method of accelerated depreciation, to write off 100% of the improvement’s cost in the first year, if it was purchased after September 27, 2017 (note that this limit will eventually phase down—80% by next year, 60% in 2024, etc.).
This is all wonderful news for landlords. However, the problem arises when your bonus depreciation deductions grow very high. The passive loss rules prevent you from deducting losses over $25,000 unless you’re a real estate professional, and even then, the IRS will reject losses over that amount if your income exceeds $150,000.
The key, then, is to make sure you’ll have enough passive income to absorb your losses for a while so that you don’t exceed the passive loss limits.
If you can’t achieve this income, cost segregation might not be as worthwhile.
#2: It won’t be as helpful if you’re planning on selling.
Another situation in which cost segregation might not be effective is if you’re planning on selling your property in the next three to five years.
This is primarily due to depreciation recapture. When you sell your property, the IRS “recaptures” the depreciation deduction amounts that you took throughout the property’s recovery period by taxing those gains at a slightly higher rate than the usual capital gains rate.
The longer you own your property, the less recapture will harm you, since you’ve had more years to turn your tax deduction savings into more profits. However, if you’re planning on selling soon, you won’t have had the opportunity to really take advantage of the deductions afforded by cost segregation.
If you’re unsure how your sale will affect your property taxes, see a tax expert. Cost segregation professionals can help you determine whether cost segregation is still a good idea.
#3: Your cost segregation study could be expensive.
Lastly, you might find that cost segregation is an expensive strategy in itself.
To apply cost segregation, you’ll first need to hire a professional to perform a cost segregation study. A cost segregation study is an analysis of the cost basis of the various components of your property. The goal is to separate the value of land improvements, equipment, and personal property from the cost of the building itself.
Cost segregation studies are expensive. A professional study can cost between $5,000 to $25,000, and it usually takes around four to six weeks. This makes cost segregation a costly endeavor for your business, both in time and money.
However, there are many cost segregation study benefits that continue to make the strategy valuable for landlords who can afford it. For instance, the expense of a cost segregation study is deductible as a business expense, as outlined by IRS Section 162. And the results of the study could help you recover the value of large capital assets in as soon as one year.
It is possible to conduct a cost segregation study yourself. However, your research must be extremely thorough to avoid an IRS audit. If you decide to forego a professional study, you must keep detailed records of all your calculations.
Like many tax terms, cost segregation is poorly understood. Many landlords miss out on the benefits of this tax strategy simply because they aren’t aware of the new benefits offered by the TCJA or bonus depreciation. Don’t be one of them. By researching and understanding cost segregation, you can take advantage of this powerful tool to save on your taxes.