By Jason Watson, CPA

Updated June 12, 2024

You are buying real estate for business or rental use. Usually, you can depreciate the entire purchase price, minus the land value, over 27.5 or 39.0 years. This can feel like it takes a very long time. For example, if you purchase a $400,000 single-family rental property and $100,000 is attributed to the land, you can depreciate about $10,909 annually. This is 3.64% of the $300,000 value attributed to the building.

At a mid-range marginal tax rate of 24%, this puts $2,618 into your pocket. Not shabby. But what if you could depreciate in big chunks? What about $50,000 in one year (which is a good starting point using our example above)? Now you get to put $12,000 extra in your pocket during the first year. Accelerated cash flow is always nice. Yay!

How does all this black magic work? With a cost segregation report, all the bricks are figuratively torn down and put into different piles. Some piles are eligible for instant depreciation (unlike the hominy grits in My Cousin Vinny), one pile might be a 5-year pile and the remaining pile might revert to the 27.5- or 39.0-year typical rental or business use depreciation.

Technically — and with full-on geek-speak — cost segregation separates property elements that are “dedicated, decorative or removable” from those that are “necessary and ordinary for operation and maintenance of the building.” These piles are called asset classes, and they are maintained separately within your property’s depreciation schedule.

The cost of a cost segregation study varies between $750 to a bajillion dollars. There is a depreciable property value of about $500,000 where things change. Below that value, the statistical reliability and therefore predictability is very good, and most cost segregation reports can rely on basic property vitals such as address, age, price, square footage, etc.

Said another way, the cost segregation report is relying on a slew of prior reports to homogenize the data and draw correlations to the basic property vitals. Plus, this technique has been successfully defended in multiple courts.

Conversely, if your property is above $2 million(ish), then a “full” cost segregation report is needed where a specialist with an appraiser’s mind analyzes every component of the property and essentially does the brick-and-pile thing mentioned above. Appliances, floor coverings, window treatments, among several weird things, are considered 5-year property. Decks, driveways, and landscaping are considered 15-year property.

In other words, you are identifying certain elements of the property that are eligible to be depreciated using a shorter period of time.

Is there more? Yes there is! You can do a cost segregation study in 2022 on a property you purchased in 2020, and deduct the accelerated depreciation on your 2022 tax return. It requires a Form 3115 Change in Accounting Method and a Section 481(a) adjustment, but that is for your tax professional to worry about.

There are two big pitfalls and a couple gotchas.

Pitfall #1. If you are considering a cost segregation study on a rental property, and that activity is considered a passive activity, your tax deduction is limited to $25,000 (passive loss limit). If you earn over $150,000 as a household, your tax deduction might be limited to $0. Yes, you are reading that zero correctly.

There are two ways to get around this. First, if you qualify as a real estate professional, then your passive loss limits go away. To be a real estate professional as defined by the IRS and not what you hear at the bar, an individual must spend the majority of his or her time in real property businesses.

In addition, more than half of the personal services performed in all businesses and activities during the year must be performed in real estate activities. Read this again! If you have another full-time job in which you work 40 hours a week, you will need to work more than 40 hours per week in your real estate business. Having a W-2 is a red flag, as they say, straight out of the audit techniques guide (ATG) from the IRS.

Finally, your hours worked in real estate activities must be more than 750 hours. Any work performed as an investor cannot be counted. There are a bunch of other devils in the details. Yes, most real estate agents qualify, not because they are real estate agents but rather time spent on real estate.

The other way to get around the passive loss limits is to have the activity not be considered passive. Makes sense right? Let’s just pencil-whip this activity and add the word “non-“ in front of it all. Done!

To be a non-passive activity, the average stay in the rental must be 7 days or less. Your typical VRBO AirBNB situation. Alternatively, for average stays of 30 days or less, you provide hotel-like services like changing linens during the stay. These two situations are considered non-passive and losses are not limited. As a sidebar, the first example is reported on Schedule E and the second is on Schedule C.

Pitfall #2. If you can’t escape the passive loss limit, then you must have net rental income from the property or from other properties to absorb the accelerated depreciation expense and grab that accelerated cash.

Gotcha #1. Recall that depreciation is a tax deferral. When you sell the property, you have depreciation recapture, and you must pay back the deferred taxes. There is some tax arbitrage here, however, since recapture is limited to 25% where you might have deducted depreciation at a 37% marginal tax rate. You can also escape this gotcha with a Section 1031 like-kind exchange (we talk about that in our real estate investment blog).

Gotcha #2. The cost of the report must be significantly lower than the improved time-value of the accelerated cash flow. In other words, the juice must be worth the squeeze, including the audit risk.

Cost segregation, or “costseg” as the cool kids say at the party, can be extremely beneficial. But there are problems to navigate through, and like Robert Plant used to sing, (not) all that glitters is gold and sometimes words have two meanings.

Another consideration- should you benefit from a cost segregation study and the related big tax deduction, then perhaps pairing this with a Roth conversion on your traditional IRA makes sense as well.

Jason Watson, CPA is a Senior Partner of WCG Inc., a business consultation and tax preparation CPA firm located in Colorado Springs, and is the author of Taxpayer’s Comprehensive Guide on LLC’s and S Corps which is available online and from mostly average retailers.