cost segregation and bonus depreciation

In short

A friend of mine bought a small rental house and was told she could write off a big chunk of it in the first year. If you own, or plan to own, income property, that same idea may touch your tax bill. A cost segregation study splits a building into parts that wear out at different speeds. The parts that wear out fast can be written off sooner through what the tax code calls bonus depreciation. The percent of bonus depreciation allowed is set by law and changes by year, so check the current figure at the current figure, which the official source publishes each year. Ask the IRS publication on depreciation, Publication 946, how your property is classed. Talk with a tax professional before you pay for a study, since the study has a cost of its own.

The whole of it

What it is

I once watched a neighbor take apart an old barn board by board, and he sorted the lumber into piles. Good beams here, scrap there, hardware in a bucket. A cost segregation study does something like that with a building, only on paper.

When you buy a rental property, the tax code treats the building as one big asset. For a home that is rented out, the law spreads its cost over a set number of years, called its recovery period. The IRS lists that period in Publication 946, How To Depreciate Property. Depreciation is a yearly tax deduction for the wear and tear on property used to earn income. Land does not wear out in the eyes of the tax code, so land is never depreciated.

A cost segregation study is a report, often prepared by an engineer or a firm that does this work, that breaks the purchase price into groups. The building shell stays in the long group. Items like carpet, certain fixtures, and outdoor work such as paving and fencing may land in much shorter groups. Shorter groups matter because the tax code allows a faster write off for property with a recovery period of twenty years or less. That is where bonus depreciation comes in. Bonus depreciation lets the owner deduct a set percent of the cost of that shorter life property in the first year. The rest is spread out as usual.

How it works

You have probably felt the pull of a deduction that arrives now instead of later. The idea is simple. Money saved on taxes this year is money in hand this year.

Here is the order of things. The owner buys the property and puts it into service as a rental. A qualified preparer studies the building, using plans, photos, receipts, and a walk through. The study sorts costs into groups, such as five year property, seven year property, fifteen year property, and the long group for the building itself. The IRS describes these property classes in Publication 946 and in the instructions for Form 4562, the form used to claim depreciation.

Next, the shorter life groups become eligible for bonus depreciation. The percent allowed is set by law and has stepped down over the years, so the owner should look at the current figure, which the official source publishes each year for the current figure. The owner may also elect out of bonus depreciation for a class of property, and then the usual yearly depreciation applies. The tax professional files Form 4562 with the return, and the study sits in the owner's records in case of questions.

Two more points deserve a plain word. First, depreciation taken is not free forever. When the property is sold, the IRS may count the depreciation already claimed as income, a rule called depreciation recapture. Second, a study made after the property was bought can still be used. A change in how the owner figures depreciation is generally reported on Form 3115, which is a request for a change in accounting method. A tax professional can say whether that applies.

The numbers, and where to find yours

I have always said that a figure you cannot check is only a rumor. So here is where each number comes from.

The bonus depreciation percent is set by law. Find the current value at the current figure, which the official source publishes each year. The recovery period for residential rental buildings is set by law too, and the IRS lists it in Publication 946. For the current figure, see the current figure, which the official source publishes each year. Rental income and passive loss limits also affect how much of a deduction an owner can use in a given year, and the IRS explains them in Publication 925, Passive Activity and At Risk Rules.

Your own numbers live in your closing papers. The purchase price is on your settlement statement. The land value is often on your county property tax bill, which splits land from improvements. The date the property went into service as a rental is the day it was ready and available to rent. Your tax preparer needs all three.

The cost of the study is a number you get by asking. Firms set their own prices, so get a written quote. Compare that quote to the tax savings your preparer estimates, and keep the quote with your records.

A worked example

Let me tell you about a woman named Dana. She bought a small rental house for $400,000. Her county tax bill said the land was worth $80,000, so the building cost $320,000.

Without a study, Dana would depreciate the whole $320,000 building over the residential recovery period. Her real period comes from the current figure, which the official source publishes each year, so for this story say it is 27.5 years, a round figure. One year of that is $320,000 divided by 27.5, which is $11,636. That is her first full year deduction, a little less if she started mid year, because the tax code applies a mid month rule.

Now suppose Dana pays $5,000 for a study. The engineer finds that $48,000 of the building cost belongs in short life groups, such as carpet, appliances, and outdoor paving. The other $272,000 stays in the building group.

For the short life $48,000, assume the bonus percent is 60 percent, just as a round figure for this story. Her real percent comes from the current figure, which the official source publishes each year. Sixty percent of $48,000 is $28,800. That is her bonus deduction in year one.

The remaining $19,200 of short life cost is depreciated the usual way. To keep the math simple, say that adds $3,000 in the first year.

The long group of $272,000 divided by 27.5 is $9,891 a year.

Add it up. $28,800 plus $3,000 plus $9,891 is $41,691 in the first year, compared with $11,636 without a study. That is $30,055 more in deductions up front.

If Dana is in a tax bracket of 24 percent, then $30,055 times 0.24 is $7,213 in lower tax for that year, if she can use all of it. Take off the $5,000 study fee and the gain is $2,213. Her later years carry smaller deductions, because she used some of them early. So the study moved deductions forward. It did not create new ones. Tax time arrives sooner, savings arrive sooner, and the bill may come due later.

Where it goes wrong

A friend of mine once paid for a study and then found out he could not use the deduction. That stung.

The deduction may be limited if the rental is a passive activity. The IRS passive loss rules, in Publication 925, can hold losses back until there is passive income or the property is sold. Some owners who actively take part may be allowed a limited amount against other income, and that allowance fades as income rises. A tax professional can check where an owner stands.

The study may cost more than it saves. On a small or cheap property, the fee can eat the gain, as Dana's numbers show. Short holding time matters too. If the owner sells soon, depreciation recapture may bring the tax back.

Quality matters. A weak study that cannot back up its numbers invites trouble in an audit. The IRS has a guide on these studies, the Cost Segregation Audit Techniques Guide, and good preparers know it. Ask a firm how it follows that guide.

The rules also change. Bonus depreciation has been phased down and reset by Congress before. Never plan on a percent you read in an old article. Look up the current one.

Questions to answer before you leave this page

Do you own the property now, or are you still deciding, and does your tax professional know which? What did you pay, and how much of that price is land that cannot be depreciated? What does the written quote for a study say, and how does it compare with the tax savings your preparer figured? Do the passive loss rules in Publication 925 allow you to use the deduction this year, or would it wait? How long do you expect to hold the property, and what would depreciation recapture cost if you sold? Which percent applies today at the current figure, which the official source publishes each year, and does your preparer agree that it fits your placed in service date? Who will keep the study and the receipts, in case the IRS ever asks?