Tax Benefits of Rental Property Ownership

Investing in rental properties offers several tax advantages. If done right, these savings can play a pivotal role in expanding an investor’s real estate portfolio.

Take Jill Green, for instance. She’s a full-time physician who invests in real estate with her husband. They’ve managed to acquire around one property each year, thanks in large part to the tax savings they’ve utilized.

A key strategy for their expansion is something known as cost segregation studies, which enable real estate investors to speed up depreciation processes.

Importance of Depreciation

Owning rental properties allows owners to lessen their taxable income by deducting various expenses, including transportation, equipment costs, mortgage interest, and insurance fees. Among these, depreciation stands out as a powerful deduction.

Essentially, depreciation allows investors to write off the property’s cost over a set period defined by the IRS—27.5 years for residential properties and 39 years for commercial properties. Owners calculate annual depreciation by dividing the building’s value (excluding land) by the relevant period.

For example, if a commercial building is purchased for $1 million, standard depreciation permits the deduction of 1/39 of its value annually.

However, a cost segregation study changes this equation.

Understanding Cost Segregation

Cost segregation studies, often called “cost segments,” fast-track depreciation by breaking a building down into components that can depreciate more quickly than the whole structure.

Engineers will analyze various elements of a property—like the flooring and plumbing—and reclassify certain aspects into shorter depreciation periods of five, seven, or 15 years. For instance, an electrical outlet might be viewed as a three-year asset rather than a 39-year one.

This means that instead of depreciating a $1 million building over 39 years, some parts could be eligible for quicker depreciation. As a result, this can lead to significantly larger deductions in the initial year.

Using the same $1 million scenario, an investor might benefit from accelerated depreciation, possibly ensuring hundreds of thousands of dollars in deductions instead of the usual $25,600 in the first year.

Claiming sizeable deductions early on not only reduces tax liabilities but also boosts available cash flow.

“Investors could see substantial returns initially, with deductions that might make it seem like they’re losing money,” said CPA Christel Espinosa. “If you don’t utilize all the losses this year, they can roll over to the next, shielding your rental income for years.”

It’s important to note that, usually, depreciation can offset passive income like rental earnings but not active income, such as wages. However, if investors qualify as real estate professionals according to IRS guidelines, they can offset rental losses against their ordinary income. Mr. Green’s spouse holds this qualification, enhancing the effectiveness of their cost segregation study. This allows for substantial deductions that yield immediate tax advantages.

Who Benefits from Cost Segregation?

Cost segregation studies can be pricey, often costing thousands and taking one to two months for completion. The feasibility can depend on factors like the property’s size, its purchase price, and the investor’s specific tax situation.

Espinosa suggests this strategy is particularly beneficial for high-income investors involved with commercial properties or extensive portfolios.

“Typically, cost segregation studies can allow for 20% to 40% of a building’s costs to shift into shorter depreciation periods,” she added. “Depending on the circumstances, first-year savings can range from $50,000 to upwards of $150,000 for every million spent in construction.”

As an example, consider a $15 million commercial property. If $5 million is categorized as a short-lived asset eligible for bonus depreciation, that could lead to a deduction of around $3 million. With a federal tax rate of 37%, this could translate to saving over $1 million just at the federal level, not accounting for state taxes.

In one instance, Espinosa noted that a client invested about $10,000 in their study and ended up saving approximately $1.8 million in taxes. For her typical clientele, which often includes high earners, such results are not unusual.

However, cost segregation studies aren’t appropriate for every property. Commercial buildings that consist of more components to reclassify and come with a heftier price tag usually yield higher returns.

Green mentioned that she consulted a certified public accountant before moving forward with her study. For a property she purchased at $123,000, it didn’t seem worthwhile, especially since she intended to sell it shortly after.

Espinosa emphasizes the importance of collaborating closely with qualified CPAs and cost segregation specialists while maintaining detailed technical documentation to prepare for potential audits.

“Cost segregation can be incredibly beneficial, but it also demands a careful approach,” she cautioned.