There are tax advantages that come with owning rental properties — most notably, deductions that will lower your taxable income.
Investors can deduct any expense associated with managing and maintaining their properties, from homeowner’s insurance and mortgage interest to business equipment and travel.
One major deduction worth strategizing around is depreciation, CPA Kristel Espinosa told Business Insider — and there’s an “easy strategy to maximize that depreciation deduction,” she added.
Depreciation is the loss of an asset’s value, and investors can claim the value of depreciation as a tax deduction for the entire expected life of the property, which the IRS has determined is 27.5 years for residential buildings and 39 years for commercial buildings. To calculate the annual depreciation on a rental, you divide the value of the property (not including the value of the land) by 27.5 or 39, depending on the property type.
A cost segregation study can help investors accelerate depreciation deductions and, as a result, increase cash flow. It reviews all of a building’s external and internal components, some of which can be written off much quicker than the building structure.
“An architectural engineer actually goes out to the property or reviews the blueprints and basically says: ‘You could break this building down into smaller components. There are partitions, there’s flooring, there’s electrical,'” explained Espinosa.
Some of those components can have tax lives that are much shorter — either five, seven, or 15 years — than the standard 27.5 or 39-year timelines. The cost segregation study may find that $100,000 of interior fixtures can be depreciated over five years, for example, and another $100,000 can be depreciated over seven.
“There’s a rule out there for tax purposes that says, if you have property that is less than 20 years in depreciable life then you can go ahead and take an immediate write-off of that depreciation expense up to 60%,” said Espinosa, referring to allowable deductions for bonus depreciation, which is 60% for 2024.
“That percentage changes every year but, as you can see, you can now take this huge depreciation deduction instead of having to wait the whole 39 years to get that depreciation,” she said. “You can take a big chunk in those first couple of years and basically put yourself into a loss position because the deduction is so large, and not have to pay any tax — and that loss generally carries over. If you don’t need all of the loss in the current year, that loss carries over into subsequent years, so those losses could shelter the rental income from this property for years to come.”
Timing is important, she added: “Act before bonus depreciation phases out completely, post-2026.”
How investors are saving seven figures in taxes doing ‘cost segs’
Hiring a professional to perform a cost segregation study will cost thousands of dollars, but the tax savings can easily outweigh the cost.
“Last year we helped one of our clients save probably $1.8 million in taxes just by doing a cost seg — and the cost seg only cost them about $10,000,” said Espinosa, whose firm operates out of Irvine, California. That wasn’t an extreme case for her client base, which includes high-income earners in top tax brackets who typically own large portfolios and commercial buildings.
The savings from a cost seg study can vary significantly depending on a property’s purchase price, type, and depreciation reallocation. As a general rule of thumb, “a cost segregation study typically allows 20% to 40% of a building’s cost to be reclassified into shorter depreciation periods,” said Espinosa. “This can generate first-year tax savings of $50,000 to $150,000+ per $1 million in building cost, depending on the study results and your tax situation.”
She gives the example of a $15 million commercial building. A cost seg may reclassify $3 million to $5 million into five-, seven-, or 15-year assets, she said. Assuming $5 million is eligible for bonus depreciation, multiply that by 60% to get $3 million in depreciation deductions.
“Take the $3 million in deductions and multiply it by their tax rate of 37% and that’s $1.11 million in federal tax savings alone,” said Espinosa. “There is even more benefit if you live in a state with high-income taxes.”
Smaller investors can also see big tax savings, she added: “Even a $2 million property can yield $100,000 to $300,000 in federal deductions.
Not every property will benefit from doing a cost seg. The strategy typically works best with commercial properties, as there are more components than a residential home.
While there is no IRS rule limiting the number of cost segregation studies you can do, you’ll want to use them strategically, said Espinosa: “Focus on new properties or major renovations. Avoid double-dipping on already classified assets.”
She advised retaining engineering reports and tax filings to defend against audits and work with CPAs and cost segregation specialists for accurate studies.
“Cost segregation is powerful but requires careful execution.”
