When you purchase a rental property—whether a house, duplex, apartment building, or condominium—you pay a single lump sum to the owner, but you are actually purchasing more than one asset. Rental property consists of:
- the land the building sits on, as well as any other surrounding land included with the purchase
- improvements that have been made to the land, such as landscaping
- the building itself, and
- personal property items inside the building that are not building components—for example, refrigerators, stoves, dishwashers, and carpeting.
Most landlords depreciate all these items together (excluding the land, which is not depreciable), using the 27.5-year recovery period for buildings and the straight-line depreciation method—which is how buildings must be depreciated.
What Is Cost Segregation?
As an alternative to depreciating all rental property items together, landlords have the option of depreciating each asset separately. This depreciation method is more complicated, and will require more record keeping, but it will result in a larger total depreciation deduction each year during the first several years you own the property. This is because personal property and land improvements have much shorter depreciation periods than residential real property--usually five or seven years--and can be depreciated using accelerated depreciation. Your total depreciation deduction won’t be any different, but you’ll get it much more quickly.
The technical name for this type of depreciation is cost segregation.
You may wish to hire an engineer to conduct a cost segregation study to determine how to classify and value your property’s various components. The engineer should inspect the property and, wherever possible, use construction-based documents such as blueprints and specifications to determine the value of the building components. When estimates are required, they should be based on costing data from contractors or reliable published sources. The engineer should prepare a detailed written report that you can show to the IRS if you are audited and it questions your valuations. Such a study can be expensive—typically $10,000 to $25,000—but the cost is a tax deductible business expense. Whether paying for such a study makes sense for you depends on how much your rental property is worth. The speedier depreciation you’ll obtain may justify the expense if your property is worth $750,000 or more.
Alternatively, landlords can conduct their own cost segregation study. This involves identifying the personal property inside your rental building, such as kitchen appliances, and determining its fair market value.
Determining Fair Market Value of Personal Property
The tax basis of personal property you purchase as part of a rental property is its fair market value. If the property is new, or fairly new, you can use the cost to replace it. The new prices for any type of personal property, such as a refrigerator or washing machine, can easily be researched on the Internet, or using publications such as the Sears catalog.
If the property is older, you’ll need to figure out the value based on the new price minus an amount for the wear and tear the property has undergone. Look at classified ads and listings for similar property on eBay, or call people who buy and sell the type of property involved. If you think the property is extremely valuable, get an appraisal from an expert. Keep records of how you calculated the property’s value.
If you don’t want to spend a huge amount of time calculating fair market values, you can limit your segmented depreciation to big ticket items, such as kitchen appliances and carpets. But, the more personal property you separately depreciate, the faster you’ll get your deductions for the property.
Changing How You Depreciate Property
If you’ve already purchased a property and started depreciating it as a single entity over 27.5 years, it might not be too late to use segmented depreciation. You can do an analysis now and currently deduct the increased depreciation deductions that you could have taken if you had used segmented depreciation from the time you acquired the property. This type of catch-up depreciation can amount to a large cash windfall.
The difference between what was deducted and what could have been deducted is known as an I.R.C. § 481(a) adjustment. You can deduct the entire difference in a single year by filing IRS Form 3115 (Application for Change in Accounting Method) to request a change in accounting method. This type of change is ordinarily granted automatically by the IRS (see Rev. Proc. 2004-11) and you don’t need to file any amended tax returns.
This probably isn’t worth doing if your property was placed in service ten or more years ago. By that time, all your personal property would have been fully depreciated anyway, so you won’t get much benefit from segmented depreciation.
For more information on how landlords can maximize their depreciation deductions, see Every Landlord's Tax Deduction Guide, by Stephen Fishman (Nolo).