My all time favorite tax deduction (everyone has a favorite, right?) is the depreciation deduction for real estate. I love it becuase it’s a phantom deduction. By that I mean, it doesn’t require an actual expense. If you collected $10,000 in rent and were able to write off $8000 in depreciation, the net result is $10,000 in your pocket but tax liability on only $2,000 of income. It’s as close as you’ll get to free money.
So What’s Better Than Free Money?
If depreciation is one of the better tax deductions available to owners of rental properties, how can we make it better? By doubling down and getting more of it through cost segregation.
Depending on the nature of your property, you’ll depreciate the value of the building linearally over 27.5 (residential) or 39 (commercial) years. I love free money but that’s a long time to wait for it. Moreover, because of time value of money and inflation, that deduction is worth a lot more in the first few years of the buildings life than it is towards the end, assuming you still even have the building at that time.
One way to make sure you get as much of that deduction as you can now is to use cost segregation. The IRS acknowledges that the components within a structure have varying life spans and if you’re willing to conduct a study separating the 5 year, 10 year, and 15 year property from the 27.5 or 39 year, then they’ll let you front load the depreciation expense. For someone whose held his property for 7-10 years, that means a HUGE upfront acceleration of all the 5 year and most of the 10 year property in this years tax return!
Why Doesn’t Everyone Do This?
The main reason people don’t bother conducting cost segregation studies is becuase of the traditionally high cost of the analysis. However, there are companies in existence today that have greatly streamlined the process. Much like how an insurance company can provide a quote with basic structural information, these firms use that same data to generate a report that can identify most (though not all) of your 5 and 10 year property within the building.
Another reason is the passive activity loss limitation rule. Income from rental real estate is generally considered passive income unless you qualify for an exemption such as a real estate professional. This is critical, because passive losses like depreciation can only offset passive income. For those of us that use real estate as a side hustle you have to make sure your passive income can absorb the tax deduction. If you’re already deducting most of the income from your real estate ventures, then that passive loss will go to waste against active income like your w2 compensation.
Become a real estate professional? Maybe not as crazy an idea as it would seem at first glance. But more importantly, do the math and check for yourself if a study like this makes sense. It may require a bit of legwork but there are a number of reputable companies you can find online who can perform the study for you at a reasonable rate. Bottom line, if your passive income supports it, this could be a huge windfall.