Cost Segregation Studies for Rental Properties: Benefits, Drawbacks, and Key Considerations

Cost segregation studies have become a popular tax planning tool for owners of rental properties, offering the potential for significant tax savings and improved cash flow. However, these studies also come with important drawbacks and compliance considerations. Below, we explore the main benefits, potential pitfalls, and special rules that property owners should weigh before undertaking a cost segregation study.

Benefits of Cost Segregation Studies

1. Accelerated Depreciation and Tax Deferral

A cost segregation study breaks down the costs of a rental property into various asset categories, such as land, buildings, land improvements, and personal property. By reclassifying certain components (e.g., appliances, carpeting, landscaping) into shorter-lived asset classes (5, 7, or 15 years), owners can claim larger depreciation deductions in the early years of ownership. This front-loading of deductions defers tax liability to later years, freeing up cash in the short term and increasing after-tax cash flow.

2. Bonus Depreciation and Section 179 Expensing

Qualifying assets identified in a cost segregation study may be eligible for bonus depreciation or Section 179 expensing, allowing for immediate expensing of certain costs. This can result in substantial first-year deductions, especially for newly acquired or improved properties.

3. Increased Cash Flow

By reducing taxable income through higher depreciation deductions, property owners pay less in taxes, which directly increases after-tax cash flow. The additional cash can be reinvested in the property or used for other business needs.

4. Deductibility of Study Costs

The cost of a professional cost segregation study is itself deductible, and the tax savings often outweigh the expense within a short period.

Drawbacks and Considerations

  1. Depreciation Recapture Risk

Accelerated depreciation increases the risk of ordinary income recapture on sale or exchange. When a property is sold, the IRS requires recapture of all depreciation taken on Section 1245 property as ordinary income, which can result in a higher tax bill at disposition compared to Section 1250 property.

2. Cost of the Study

A high-quality cost segregation study typically requires the expertise of engineers, appraisers, and tax professionals, which can be expensive. The cost is usually justified for larger or more complex properties, but may not be economical for smaller investments.

3. Audit Risk

Cost segregation studies are subject to IRS scrutiny, especially if the allocations appear aggressive or lack proper substantiation. Poorly documented or unsupported studies can trigger audits, adjustments, and even penalties.

4. Complexity and Compliance

The process is technically complex, involving detailed analysis of construction documents, invoices, blueprints, and site inspections. If a study is performed after the initial tax return is filed, implementing the results requires a change in accounting method and the filing of Form 3115, adding further complexity.

Special Rules and Limitations

  • 27.5-Year Recovery Period:

Residential rental property is generally depreciated over 27.5 years using the straight-line method under MACRS. Cost segregation allows certain components to be depreciated over shorter periods, but the primary building structure remains subject to the 27.5-year rule.

  • Bonus Depreciation Eligibility:

Personal property and land improvements identified through a cost segregation study may be eligible for bonus depreciation, unless the taxpayer is required to use the Alternative Depreciation System (ADS), in which case bonus depreciation is not available.

  • Passive Activity Loss (PAL) Rules:

Depreciation deductions from residential rental property are generally subject to the passive activity loss rules. Losses from passive activities can only offset income from other passive activities unless an exception applies (e.g., the $25,000 active participation exception).

  • Short-Term Rentals:

Short-term rentals may not qualify as residential rental property for depreciation purposes if the average rental period is seven days or less, or if significant personal services are provided. In such cases, the property may be classified as nonresidential real property and depreciated over 39 years.

Conclusion

Cost segregation studies can provide substantial tax benefits for rental property owners by accelerating depreciation and increasing cash flow. However, they also introduce complexity, potential audit risk, and the possibility of higher tax bills upon sale due to depreciation recapture. Property owners should carefully weigh these factors and consult with qualified professionals to determine whether a cost segregation study is appropriate for their specific situation.

For more detailed guidance, consult the relevant IRS publications and authoritative tax resources or click Contact to speak with an experience tax advisor.