3 Surprising Examples of Cost Segregation for Single Family Homes

In any given year between 20% to 25% of single family homes purchased are investment properties. Unfortunately, many of these investors simple don’t understand how depreciation works.

Cost segregation studies are very commonplace for many experienced investors. They will accelerate the tax deductions by identifying and classifying building components into categories that have shorter depreciable lives than the building itself.

Specifically, cost segregation studies for single family homes will include a summary report that will break out the personal property of the home. This typically includes items such as the appliances, cabinets, floor coverings, counters, window treatments, fencing, landscaping, etc.

These asset components will be classified as personal property with a 5, 7 or 15 year life for depreciation purposes. I have observed situations where over 30% of a building's components have been classified into one of these depreciation classes.

But are cost segregation studies really cost effective for single family homes?

So here’s the big problem. Cost segregation studies can be expensive. Most studies will cost thousands of dollars. In fact, I often see reports that run $10,000 to $20,000.

But does that pricing work for single family rentals costing $100,000 to 200,000? In most cases, it doesn’t. But there is an easier and more cost effective approach that will work.

At Simple SEG, we only do cost segregation studies for single family homes under $500,000. Our modeling approach works for this type of property. This is why we can complete a study for just $299. It’s all we do.

In this post, I wanted to examine three different examples of cost segregation for single family rentals. This way, you can see the results for yourself.

Tax Reform

But before I jump into the examples, I want to examine tax reform. The Tax Cuts and Jobs Act of 2017 (TCJA) included important provisions including lowering tax rates and brackets for individuals and . It also added special pass-through entity provisions.

Before TCJA, only 50% bonus depreciation was allowed for certain qualified assets. However, bonus depreciation has increased to 100% for both new and used assets acquired after September 27, 2017.

Accordingly, cost segregation is very important for real estate investors who acquired property after September 27, 2017. For example, let’s assume a person acquires an apartment building in 2018 for $1.5 million and completes a cost segregation study. It is determined that approximately $200,000 of the cost relates to 15 year land improvements and then another $100,000 relates to 5 year personal property.

As such, TCJA allows the owner special bonus depreciation on the building. The investor can deduct $300,000 immediately. Assuming an overall tax rate of 30%, the result is $90,000 of tax savings.

So let’s dive into the examples. There are some key differences in these examples. These differences include location, price points and personal property allocations. I also assumed that a full year of depreciation is applicable.

Example #1: Single Family Rental in Nebraska

This first example is a ranch style home built in 1986 in Nebraska. The taxpayer acquired the home for $174,159 and intends to use it as a long-term rental. Let’s look at the specifics of the cost segregation study:

A couple things I want to note:

• You can see that all of the 5 year property and 15 year property can be fully deducted in the year placed in service. As we have previously discussed, this is a result of tax reform changes for used property. The ability to immediately expense these items has really been a game changer for the industry.
• The land value allocation is only 10% of the total cost. I often see CPAs use 20% or even 25% land allocation as a general “rule of thumb.” But the reality is that land value could be as low as 10% and may be as high as 50% or even 75%. In this example, land prices in this community are relatively low. When you take a look at comparable sales, this land allocation is reasonable. But such a low land allocation will not be that common in other more expensive areas of the county. You can see for yourself in the next example.
• The home has extensive carpeting and floor coverings that resulted in a higher value in the flooring allocation.
• The overall cost segregation study resulted in a first year depreciation allocation of over $55,000. This is 31% of the total purchase price. It is a little higher than normal, but it makes sense based on the situation.

Example #2: Small Single Family Home in Southern California

The next example is a rental purchased for $495,660 in Southern California. The price point is significantly higher than the Nebraska property and below our $500,000 maximum value.

Well we know that $500,000 will not get you as much home in California as it does in Nebraska. In this example, it will get you 1,300 square feet. But California has the steepest state income tax rates in the country, so a cost segregation study can be critical for many investors. So let’s take a look at the allocation:

A few things to point out:

• The land value is this case is substantially higher than our prior example. Land prices can be very high in California. Therefore, a land allocation of 23% is reasonable. We know that land is not depreciable, so a high valuation is not really beneficial to the investor.
• The flooring allocation was lower in this case even though the acquisition price is so much higher than our previous example. This resulted from the lower square footage, but also occurred because a substantial portion of the flooring was tile flooring which is not entitled to bonus depreciation.
• The fence and decking received a higher valuation. Many rural areas will have minimal fencing on the property, but urban areas often have stucco and block walls surrounding the house.

Example #3: Nevada Fixer

This last example was a property acquired by an investor in Las Vegas. The acquisition price is $265,000 and it was a acquired as a bank foreclosure. Let’s look at the specifics:

So let’s take a look at why this segregation study is so unique:

• Foreclosure properties will often result in valuation swings. As a result, this property had no carpeting, appliances, or window coverings. The study assigned no valuation for these items. This can be the case for bank owner or auction properties.
• The home did have cabinets and counter tops that were in reasonable condition. The property received a decent allocation for such items based on the condition.
• The final valuation was only $42,000 allocated to 5 year and 15 year property. This was the lowest overall personal property allocation of just 15%.

As you can see from the examples, cost segregation results can vary significantly. It is critical to consider the age, condition and property type as well as the personal property.

At the end of the day, cost segregation studies for single family homes and resident rentals can make a lot of economic sense. As a result of tax reform, it is an exceptional tax strategy for investors.

Real estate investors should always review their situation with an experienced CPA. Make sure you are taking advantage of all significant tax savings opportunities. This includes using both bonus depreciation and section 179. Ensure that you have an accurate cost segregation study in order to minimize your tax liability and keep your distance from the IRS.