Real Estate Cost Segregation: How Does It Work?

When I first heard about cost segregation, I was intrigued but also a bit skeptical. The idea of creating massive tax savings sounded great. But the process seemed complex and daunting. However, after diving in and getting my first real estate cost segregation report, I realized it was not only manageable but incredibly beneficial.

Since then, Selenid and I have performed cost segregation studies on all 8 of our rental real estate properties.

Here’s how we do it and what you can expect during the process. I’ve also asked a key resource and our cost segregation servicer, Jeffrey Butler of Cost Segregation Authority, to help with this post.

The what and why of real estate cost segregation

One of the great things about real estate investing is that you can write off passive “paper” losses against the profits of the investment property.

These passive “paper” losses come largely in two forms:

• Expenses from running the property and
• Depreciation

The government and IRS says that each real estate property loses value each year. In fact, after 27.5 years, the value of any property is $0 in the IRS’ eyes. And this 27.5 years resets every time a property is sold or changes hands.

So, each year, every property you own loses 1/27.5 of its value. This loss in value is the depreciation of the property and is considered a passive loss. You can then use this passive loss to offset passive income – like rental income. You can do this even without REPS.

This is a huge advantage. Especially when you realize that your property didn’t actual lose value but provided immense value as a source of rental income and possible appreciation!

But wait, theres more! You can accelerate this depreciation…

By hiring a cost segregation company to “cost segregate” your property, you can divide items and parts pf your property that actual depreciate to $0 in much less time than 27.5 years.

After doing the cost segregation, you can take advantage of forced appreciation to claim much more depreciation of value for your property. You can use these massive passive losses to offset more passive gains or carry them forward to future tax years.

The problem is that most people don’t have huge amounts of passive income. But they have huge amounts of active income, like from W2 jobs in our case.

This is where Real Estate Professional Status (REPS) comes into play

By qualifying as REPS, you can now take these massive “paper” depreciation losses and not just offset passive income, but also offset active income like from your W2 job.

In this way, you reduce your taxable income for that tax year immensely and owe way less in taxes!

For a full breakdown of REPS and how to qualify, check out this post. But for now, the main point is to understand how cost segregation unlocks these massive tax saving opportunities.

The steps to perform our cost segregation analysis

My initial hesitation

Like many property owners, I had my doubts. I thought:

• I don’t have enough time to go through this process.
• I don’t have enough knowledge about real estate cost segregation.
• It sounds too good to be true. Am I even eligible to qualify?

But then I started talking to other property owners who had gone through the process. Their stories were encouraging. They shared their successes and the significant tax savings they achieved. This gave me the push I needed to explore cost segregation further.

Finding the right team

In real estate, creating your team is one of the most important factors in your success. Here are the main team members you need. But a great cost seg specialist is another important member.

So, we needed to find a qualified real estate cost segregation specialist. I reached out to a few firms and scheduled consultations. During these meetings, I asked about their experience, especially with properties similar to mine. I wanted to ensure they had a solid understanding of tax laws and could provide a detailed proposal outlining the scope of work, timeline, and fees. 

The company I chose, Cost Segregation Authority, had a construction and accounting background. They let me know if my property qualified for a cost segregation study based on years of expertise. They even provided a no-cost estimated benefit analysis to give me a good idea of the amount of tax savings I could expect. 

Gathering the necessary documentation

Once I chose a specialist, the next step was data collection.

This involved gathering a few relevant documents. Mainly the closing statement for the property involved. It felt a bit overwhelming at first, but the specialist guided me through the process, making it much more manageable.

Overall, the process on my end was very simple, taking just an hour or so to complete.

The site visit

A crucial part of the process was the site visit.

The specialist set up the inspection for my property, identifying and documenting the various components. This hands-on approach ensured that nothing was overlooked and that every potential tax-saving opportunity was identified.

Most property types are eligible for virtual site visits, which are quicker and much more cost efficient. This also gives a high degree of flexibility in working with your schedule. This is what we did and it made the process super easy.

Analysis and report preparation

After the site visit, the specialist analyzed the collected data and classified the property’s components into different asset categories.

This step was critical as it determined the appropriate depreciation periods. The specialist then prepared a comprehensive report detailing the findings and recommended depreciation schedules. 

Reviewing and Implementing the report

The final report was reviewed with my tax advisor to ensure accuracy and alignment with my overall tax strategy. Once approved, the new depreciation schedules were implemented in my tax filings.

The result? Significant tax savings and improved cash flow.

My real-world example

To give you a concrete example, let’s look at a cost segregation study I performed with Cost Segregation Authority a couple years ago for our 3rd rental property located in Buffalo, New York. You can see a full 2 year breakdown and analysis of this property here.

But what is important to know now is that the total cost basis of this property was $199,900.

By reclassifying 39% of the 5 year and 15 year assets of the property, I was able to depreciate $84,500 in the first year with 100% bonus depreciation in 2021.

This accelerated depreciation resulted in substantial tax savings at a value of $31,000 given my tax brackets in the early years of ownership, significantly improving my cash flow. 

We then used this money to buy another rental property. Rinse and repeat! That’s a big part of why the tortoise beats the hare in real estate investing…

Reflecting on the experience

Looking back, the process of getting a cost segregation report was not as daunting as I initially thought.

It required some effort and collaboration with a knowledgeable specialist, but the benefits far outweighed the challenges. If you own property, I highly recommend considering a cost segregation study. The potential tax savings and cash flow improvements can be substantial.

Like anything in life or in real estate investing, don’t let hesitation hold you back. Overcome analysis paralysis. If I can navigate the process of getting a cost segregation report, so can you.

Take the first step, find a qualified specialist, and unlock the financial benefits that come with accelerated depreciation.

A quick side note

It is worth mentioning that 100% bonus depreciation began sunsetting in 2023. It is decreasing by 20% annually until it completely sunsets in 2027.

However, there is bipartisan legislation on the table that will hopefully be passed after the 2024 election to bring it back!

And here are some additional high yield resources for any physicians interested in real estate investing:

• 4 Reasons That Cash Flow Is King in Real Estate
• How To Actually Buy A Real Estate Investment Property
• 3 Massive Ways Real Estate Tax Savings Can Backfire
• In Depth Analysis of a Bad Real Estate Deal

What do you think? Do you have any rental properties? Have you performed a cost segregation analysis? What was your experience? Let me know in the comments below!