Maximizing the benefits of rental property ownership can lead to significant tax savings. Two critical concepts to understand and potentially utilize are bonus depreciation and cost segregation studies. These techniques can potentially accelerate the depreciation on your rental property and can significantly reduce your taxable income.
Understanding the Basics of Rental Property Depreciation
The basics of rental property depreciation begin with the cost basis of the property. For instance, let’s say you purchased a residential property for $500,000, 25% of which is considered non-depreciable land. The rest, which you can depreciate, does so over a 27.5 year period down to zero.
For example, with a $500,000 property with 25% land value, the depreciable basis in the property is $375,000. Divide that by 27.5 years, and the annual depreciation is $13,636. This depreciation allows most rental properties to technically operate at a tax loss, potentially offsetting other forms of income.
However, the losses after factoring in your income from the property and the depreciation might be minimal. To increase tax savings, it’s possible to unlock more of the depreciable basis and accelerate depreciation to create more tax losses.
The Power of Bonus Depreciation
The IRS recognizes that not all components of a property depreciate at the same rate. For example, a roof depreciates slower than a gas stove. As a result, the IRS allows different components of residential property to be classified with a 5-year, 7-year, 15-year, or 27.5-year classification.
The Tax Cut and Jobs Act reformed bonus depreciation. It permits property owners to take accelerated depreciation in the first year for assets with a useful life of 20 years or less, essentially front-loading the depreciation to maximize tax losses.
As of 2023, the law has been phased out to allow 80% accelerated depreciation, down from 100%. Yet, by leveraging bonus depreciation, you could potentially realize losses of over $100,000 in the first year that you could use to offset W-2 income and other forms of income.
How a Cost Segregation Study Can Help
But how do you determine the lifespan of different property components? Enter the cost segregation study. It involves hiring a firm of engineers and CPAs who visit your property, take pictures, and analyze every component, from the dishwasher to light fixtures, to determine their depreciation classification.
A cost segregation study is a crucial tool for bonus depreciation, as it provides the necessary breakdown of property components. It offers substantial audit protection, fulfilling IRS requirements. The cost of such a study usually ranges from around $5,000 to $10,000, and you’ll need to consider this expense in your decision.
Three Tips for Optimizing Your Property Depreciation
- Be Aware of Recapture: Bonus depreciation is not a free lunch. If you sell the property a few years later, you will have to recapture the depreciation, impacting your tax planning. However, strategies such as a 1031 exchange could potentially defer the gain and the recapture.
- Active vs Passive Losses: Generally, a cost segregation study and bonus depreciation make sense if the losses from the property can offset your earned income. If the property is a purely passive investment in the eyes of the IRS, you may end up with lots of carry forward losses and more recapture issues down the road.
- Consider Your Taxable Income: The cost of a cost segregation study and the application of bonus depreciation may not be beneficial if you’re in a low tax bracket. The substantial cost may outweigh the tax benefits.
Bonus depreciation and cost segregation studies are complex but potentially lucrative strategies for maximizing tax savings on rental properties. If you want to see a video breakdown of this complex topic, check out our video below. If you want a comprehensive tax plan to reviews these type of issues, reach out to us, we’d love to help you!