As an ambitious residential real estate investor, you likely want to grow your portfolio faster. To achieve this, you need significant cash upfront.
Instead of getting the cash by going to the bank and borrowing at an expensive ~7%, you can get it by deferring taxes far into the future, effectively getting a loan from Uncle Sam at 0%. You do this by doing a cost segregation study for residential rental property.
Your rental property likely qualifies for significant tax savings through cost segregation. Talk to our team today to get a free savings estimate.
Why Cost Segregation Matters for Real Estate Investors?
Most real estate investors understand the power of depreciation. The idea is that your building wears out by a specific amount every year, and you can claim it as an annual tax deduction.
The IRS says you can depreciate your residential building over 27.5 years. For instance, take a residential building with a depreciable value of $900,000. You can claim an annual depreciation of $32,727.27 for 27.5 years.
We do know, however, that a significant portion of the building has a significantly shorter useful life, and it doesn’t make sense to allocate the costs over a period that long. The IRS agrees. Below is how long the IRS expects some of your part components to last:
- 5 years: Floor coverings, appliances, window treatments, decorative lighting, furniture, kitchen cabinets, etc.
- 15 years: Parking lots, driveways, sidewalks, curbs, fencing, landscaping, outdoor lighting, utilities, swimming pools, etc.
- 27.5 years: The main building structure.
Cost segregation is essential because it helps you identify and classify these building components and subject them to depreciation schedules consistent with their actual useful lives.
By fully depreciating parts of your property in five and fifteen years, you claim bigger deductions upfront, significantly reducing your tax bill.
How to Identify Eligible Residential Rental Properties
How do you determine if you are a good candidate for a cost segregation study for residential rental property?
The typical residential property has a decent mix of short- and long-life assets. Therefore, most properties are eligible. That said, if you hold a residential rental property valued at $450,000+, you are an excellent candidate for a Seneca Cost Segregation study.
At Seneca Cost Segregation, we’ve consistently helped property investors turn 20 to 40% of their properties’ costs into immediate tax savings. Moreover, with cost segregation bonus depreciation, our clients average a first-year deduction of $171,243.
The better question to ask is whether or not the potential tax savings warrant a cost segregation study. If a cost segregation study costs you a couple of grand but gives you a deduction of $171,243, is it worth it?
IRS Guidelines for Residential Cost Segregation
The Cost Segregation Audit Techniques Guide is the key resource for understanding how the IRS views cost segregation for all properties, including residential rental properties.
It’s an extensive resource, with several detailed guidelines. Below are some of the guidelines for residential cost segregation:
- Property inspection: An inspection of the property is required to accurately classify assets.
- Expertise and experience: The IRS prefers that you get a professional with engineering, construction, or tax experience to do the study.
- Asset reclassification: Classify shorter-lived assets into five-year personal tangible property and fifteen-year land/property Improvements.
- Cost basis: The allocated costs must reconcile with the total cost basis.
- Detail: The IRS requires you to detail your cost segregation methodology and provide detailed documentation to support your cost allocations.
- A comprehensive report: Create a final report detailing your methodology and findings.
- Bonus depreciation: For properties placed in service after September 27, 2017, bonus depreciation is allowed on the shorter-lived components per the phase-out schedule.
Given how extensive the Cost Segregation Audit Techniques Guide is, it is best to use the services of industry specialists like Seneca Cost Segregation to ensure compliance with all IRS rules.
Key Tax Benefits of a Cost Segregation Study
A cost segregation study affords a residential property investor several tax benefits, including:
- Opportunity to wipe out your entire tax bill: Larger deductions in the early years could result in depreciation outpacing your rental income, resulting in a loss, which means you won’t owe any taxes on your passive rental income.
- Improved cash flow: A lower or nil tax bill significantly improves your cash position. You can aggressively expand your portfolio while keeping leverage ratios in check.
- Better returns in the long run: By front-loading depreciation and reinvesting tax savings, you get better returns in the long term because of the compounding benefits of the time value of money.
- It provides predictable tax savings: Cost segregation is a proactive tax strategy. You can do cost segregation studies year-round to lock in massive tax savings early instead of waiting until tax season to scramble for deductions.
One of the most potent benefits of cost segregation is that it allows you to qualify for bonus depreciation. Bonus depreciation is a tax incentive allowing investors to deduct a significant portion of a qualifying asset’s depreciable value in the first year.
Personal property with a useful life of under 20 years qualifies for bonus depreciation. Because the properties that would benefit from accelerated depreciation under cost segregation have useful lives of five, seven, or fifteen years, they qualify for bonus depreciation.
The 2017 Tax Cuts and Jobs Act (TCJA) allowed for 100% bonus depreciation through 2022 with the following phase-out schedule:
- 80% in 2023
- 60% in 2024
- 40% in 2025
- 20% in 2026
- 0% in 2027
The One Big Beautiful Bill Act signed into law on January 4, 2025 reverses the old phase-out schedule. Bonus depreciation is now back to 100% for qualified properties purchased and put in service after January 20, 2025.
How to Calculate Depreciation on a Residential Rental Property
The traditional approach to calculating depreciation on a residential rental property allocates the entire depreciable building value linearly over 27.5 years.
Consider a property with the following cost breakdown:
- Purchase: $1,000,000
- Improvements: $50,000
- Land value: $150,000
Cost Basis = Purchase + Improvements – Land = $900,000
Straight-line depreciation = $900,000 ÷ 27.5 = $32,727.27
With a cost segregation study, you can separate the shorter-life personal property components from the long-life real property and subject them to shorter depreciation schedules. More importantly, you get to qualify for bonus depreciation.
Assume you put the property in the cost segregation study example above into service in 2024, meaning you qualify for 60% bonus depreciation. Assume also that a Seneca Cost Segregation study finds that 12% is personal property and 16% is site Improvements.
- 12% of $900,000 = $108,000
- 16% of $900,000 = $144,000
The remaining 72% ($648,000) is real property to be depreciated over 27.5 years.
What will your total first-year deduction look like?
Personal Property x Bonus Depreciation = $108,000 x 60% = $64,800. The remaining 40% comes in over the next 5 years.
Site Improvements x Bonus Depreciation = $144,000 x 60% = $86,400. The remaining 40% comes in over the next 15 years.
Real Property / 27.5 = $648,000 / 27.5 = $23,563.64 every year until Year 28
TOTAL 1st year deduction = sum of all = $174,763.64
Additional 1st year depreciation = Bonus Depreciation 1st Year – SL depreciation 1st year = $174,763.64 – $32,727.27 = $142,036.37
The client then gets a tax deduction of $142,036.37 instead of $32,727.27. At a 39% federal tax rate, this nets them a check from the IRS for $55,394.18.
How to Hire a Cost Segregation Specialist
Cost segregation is an IRS-approved real estate tax strategy. Nonetheless, you must take steps to reduce audit risk by working only with the best cost segregation companies.
The best specialists in the field typically share the following attributes.
- An engineering-based methodology: An engineering-based cost segregation study leads to robust studies with more accurate property classifications. The cost seg report is much more likely to withstand IRS scrutiny.
- Verifiable industry experience: How many projects similar to yours has the firm handled? You should work only with firms with verifiable testimonials and references.
- Post-study support and audit defense: You should be able to count on the specialists in case you and your CPA need help implementing the report or when the IRS calls.
Knowing what a good firm looks like, you can proceed to hire one by:
- Short-listing promising candidates
- Requesting a free consultation with the finalist to ascertain fit
The specialist will likely also be okay with doing a preliminary analysis of your property to help you gauge how much you can save with a cost segregation study for residential rental property.
At Seneca Cost Segregation, we offer this initial assessment at no extra cost. You can confidently rely on our extensive industry experience, having completed over 1,200 cost segregation studies nationwide.
Contact our team to lower your tax bill with a cost segregation study.
Frequently Asked Questions (FAQs)
Let’s explore some of the common questions residential rental property investors ask about our cost segregation services.
How Long Does a Cost Segregation Study Take for a Residential Property?
The duration of a cost segregation study depends mainly on the size and complexity of the property and the capacity of the cost segregation firm.
At Seneca Cost Segregation, we usually conclude studies on residential properties within two to four weeks.
Can I Do a Cost Segregation Study without an Engineer?
There’s no law requiring you to hire an engineer to do a cost segregation study. Nonetheless, we strongly discourage doing your own cost segregation study as it significantly increases audit risk.
You need specialized engineering and construction experience to do a reliable cost segregation study and generate a report that can stand up to IRS scrutiny.
What Is the Minimum Property Value for a Cost Segregation Study?
You can do a cost segregation study on a property of any value. We strongly encourage you to consider a study if your property is valued at $500,000+.
Generally, if the potential tax savings significantly outweigh the cost of the study, your property is a good candidate.
Does Cost Segregation Trigger an IRS Audit?
Doing a cost segregation study won’t automatically trigger an IRS audit.
The IRS approves of cost segregation. Think about it – without cost segregation, you’ll treat shorter-lived personal property and longer-lived real property the same, which is improper.
Big real estate firms have been doing cost segregation for decades. You’re probably considering it now because firms like Seneca Cost Segregation have made it more accessible.
Conclusion
When you do cost segregation on a residential rental property, you are not gaming the system. It’s the right approach. The alternative is actually technically wrong, but the IRS is okay with it because it allows them to collect more taxes early.
You now know better, and you can start taking corrective action to improve your cash position by lowering your tax bill legally.
If you’ve never done cost segregation on your properties, you are likely sitting on substantial tax savings. Contact our team today to find out how much you can save with a cost segregation study.
