This article will cover the most relevant distinctions between calculating rental property depreciation using the straight-line method and using a cost segregation study to accelerate depreciation expense. We’ll also explain the importance of accurately calculating depreciation and illustrate how each approach leads to different results.
Depreciation
Depreciation is a critical concept in real estate and other industries, and it’s a relatively simple idea. In everyday language, depreciation refers to the cost you incur when your assets lose value. However, even if an asset doesn’t lose value but in fact appreciates over time -- such as in the case of real estate -- the tax law still lets you take a depreciation expense against that asset’s taxable income for the year.
There was once a time when the IRS permitted taxpayers to determine their own depreciation calculations, but now the methods are more standardized. In most cases, and unless they elect to use a depreciation method with an even longer life, taxpayers are required to depreciate residential rental real estate over 27.5 years and commercial rental real estate over 39 years. Both calculations are done using the straight-line depreciation method.
What Is Straight-Line Depreciation?
To determine the annual depreciation of an asset using the straight-line method, you merely take the asset’s tax basis -- in the case of real property, this would be the building portion of its cost -- and divide that cost over the useful life as determined by the IRS (again, 27.5 years or 39 years for residential rental real estate and commercial rental real estate, respectively).
Note that for real estate the IRS requires taxpayers use the mid-month convention, which means that assets are considered to be placed in service in the middle of the month they were actually placed in service. This means that the depreciation amount for the first and last years that a property is held will differ from the depreciation amount for the in-between years.
So let’s say that in August you purchase and place in service a residential rental property for $500,000 with 55% of its value, or $275,000, allocated to building. Dividing $275,000 by 27.5 yields $10,000 of depreciation expense per year. Note that in the first year you must multiply this $10,000 by 4.5 / 12 to account for the mid-month convention, so the first-year depreciation is $3,750.
Cost Segregation
In the example above, your depreciation expense on a $275,000 taxable basis in most tax years is $10,000. This is a relatively small amount compared to the basis.
A cost segregation analysis, however, helps you identify assets to count as personal property for the purposes of depreciation, giving you the opportunity to calculate their depreciation over a shorter period of time.
Landscaping, paving, sidewalks, and other projects, on the other hand, are given a 15-year lifespan for depreciation. Smaller items such as some flooring and furniture can be depreciated over 5 years. Instead of calculating a low amount of depreciation over a longer period of time, cost segregation allows you to deduct more of that value up-front.
The Benefits of Cost Segregation
Cost segregation ends up giving you the same total deduction as straight-line in the long term, but that doesn’t mean that it’s always equivalent. In fact, cost segregation can lead to substantially more growth by putting more money back in your pocket today, and we all know that a dollar today is worth more than a dollar in 27.5 years. This enables you to maximize cash flow and use deductions now rather than later. The more you save in taxes this year, the more you have to save, spend, or reinvest.
While cost segregation was always a worthwhile strategy, it has become even more effective in recent years. The Tax Cuts and Jobs Act of 2017 introduced a number of new incentives that allow cost segregation to save you more money.
The most important change was that the bonus depreciation available with certain types of assets increased from 50% to 100%, enabling you to deduct an asset’s entire value in a single year. The law also made purchases of used assets eligible for bonus depreciation rather than only new property.
The primary downside to cost segregation relative to straight-line calculation is the cost involved in a cost segregation study. Cost segregation studies can be priced at hundreds or even thousands of dollars, potentially canceling out or at least cutting into the tax benefits they offer.
When deciding between straight-line depreciation and cost segregation, it’s important to include the price of the study in your calculations. If cost segregation could save you $5,000 but costs $5,000 to perform the study, it probably isn’t worth your time.
That said, it’s clear that cost segregation offers several unique benefits that make it worth considering for properties of all sizes. Make sure to compare the cost of several options when looking for a reputable cost segregation study service.
All information provided herein is for informational purposes only and should not be relied upon to make an investment decision and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Nothing contained herein constitutes investment, legal, tax or other advice nor is it to be relied on in making an investment or other decision. Readers are recommended to consult with a financial adviser, attorney, accountant, and any other professional that can help you understand and assess the risks associated with any investment opportunity. Private investments are highly illiquid and are not suitable for all investors.