Can You Do Cost Segregation on Residential Rental Property?

Cost segregation is a tax strategy that allows property owners to accelerate depreciation deductions on their real estate holdings. This approach can be applied to residential rental properties, reducing taxable income in earlier years of ownership.

Understanding Cost Segregation

Cost segregation involves reclassifying components of a building that would be depreciated over a long period into shorter recovery periods for tax purposes. Real property, such as a residential building, is generally depreciated over 27.5 years, while commercial properties are depreciated over 39 years. However, many individual assets within a building have much shorter useful lives than the structure itself.

The process identifies assets considered personal property or land improvements, distinct from the structural shell of the building. These reclassified assets can then be depreciated over 5, 7, or 15 years. The goal of a cost segregation study is to accelerate depreciation deductions, which reduces taxable income and improves cash flow in the earlier years of property ownership. This defers federal and state income taxes.

Applying Cost Segregation to Residential Rental Property

Cost segregation applies to residential rental properties, including single-family homes, multi-family units, and apartment complexes. This strategy identifies specific components within these properties that qualify for accelerated depreciation, rather than the standard 27.5-year period for the overall structure. Examples of tangible personal property commonly reclassified in residential settings include carpeting, appliances like refrigerators and washers/dryers, and window treatments. These items are assigned a 5-year depreciation period.

Land improvements associated with residential rental properties can also be reclassified. This category includes features such as landscaping, sidewalks, fencing, parking lots, and outdoor lighting. These land improvements qualify for a 15-year depreciation period. Segregating these items allows property owners to align tax deductions with the actual, shorter useful lives of these components, providing upfront tax benefits.

The Cost Segregation Study Process

Obtaining a cost segregation study involves a detailed procedural approach, performed by qualified professionals. This analysis is conducted by a team that includes engineers, tax advisors, and sometimes real estate attorneys. These specialists use their expertise in construction methods, cost estimating, and tax law to accurately categorize building components.

The process begins with an initial assessment to determine if a study would be beneficial. Professionals then request specific documentation from the property owner, which may include property purchase documents, closing statements, blueprints, renovation costs, and appraisals. A physical inspection of the property is a step, allowing for a detailed inventory of components and photographic documentation. The collected information is then analyzed to allocate costs to the appropriate depreciation categories.

The final output is a comprehensive report detailing the asset breakdown, the methodology used, and the revised depreciation schedules.

Key Tax Considerations

A cost segregation study impacts a property owner’s tax liability by accelerating depreciation deductions. This acceleration reduces taxable income in the early years of property ownership, increasing available cash flow. An aspect of these benefits is the application of bonus depreciation, as outlined in Internal Revenue Code Section 168(k).

Bonus depreciation allows for an immediate expensing of a portion of the cost of eligible reclassified assets in the year they are placed in service. For assets with recovery periods of less than 20 years, such as 5-year and 15-year property identified through cost segregation, bonus depreciation enhances the immediate tax benefits.

It is important to acknowledge depreciation recapture upon the sale of a property. This means that a portion of the gain from the sale, up to the amount of depreciation previously claimed, may be taxed at ordinary income rates rather than lower capital gains rates.