The Complete Guide to Segmented Depreciation for Rental Property Owners

As a rental property owner, reducing your tax liability enables you to maximize your property’s profitability. One effective strategy to achieve this is through segmented depreciation. By understanding and implementing segmented depreciation, you can take full advantage of the tax benefits available to you.

What is Segmented Depreciation?

Segmented depreciation, also known as component depreciation, involves breaking down a rental property into its individual components and depreciating each part separately. Instead of treating the property as a single asset, segmented depreciation allows you to allocate different useful lives to different components, potentially accelerating depreciation and providing substantial tax benefits.

Benefits of Segmented Depreciation

1. Accelerated Depreciation: By separating components with shorter useful lives, you can depreciate certain parts of the property more quickly, reducing taxable income sooner.
2. Increased Tax Deductions: Segmented depreciation can lead to larger annual depreciation deductions, lowering your taxable income and, consequently, your tax bill.
3. Enhanced Cash Flow: Reduced tax liabilities translate to improved cash flow, allowing you to reinvest in your property or other investments.

When it comes to itemizing the depreciation of your rental property on your yearly tax return, there are a couple of options to consider. While the simpler (and standard) practice calls for landlords to simply divide the total value of a rental property by 27.5 years, taking roughly 1/27 of the property's value as a deduction each year, "segmented depreciation"---which splits the property into multiple assets that depreciate a varying rates---can ultimately save you money.

Modified Accelerated Cost Recovery System (MACRS) Explained

While the standard method of depreciation, also called "straight-line" depreciation, is certainly easier to understand, it has the disadvantage of not reflecting the reality when it comes to depreciating assets that last for a shorter period of time, such as carpets, refrigerators, and fencing.

In order to more accurately reflect this reality, the Internal Revenue Service developed the Modified Accelerated Cost Recovery System (MACRS) to account for the depreciation of investment properties. Using this method, landlords can divide their rental properties into several asset classes and depreciate them at varying rates.

Under this system, assets such as appliances, carpeting, and furniture depreciate fully over a period of five years, allowing for much larger tax savings each year. At the end of the five-year period, you can replace these assets and start the short-term depreciation process all over again.

Depreciation Life of Rental Property Components

Property owners should understand the depreciation life of various parts of their rental property to implement segmented depreciation effectively. Below is a detailed breakdown of the depreciation life for common components.

Building Depreciation Life

The primary structure of a rental property, including the roof, walls, and foundation, typically depreciates over 27.5 years for residential properties. This long depreciation period reflects the durable nature of these elements. However, major repairs or improvements can sometimes be depreciated separately.

Furniture Depreciation Life

Furniture in a rental property generally has a depreciation life of 5 years. Items in this category include sofas, tables, chairs, and beds. These shorter-lived assets wear out more quickly due to constant use by tenants. Regular updating of furniture can enhance tenant satisfaction and property appeal.

Carpet Depreciation Life

Carpets have a shorter depreciation life, typically around 5 years. They endure high foot traffic and stains, leading to quicker wear and tear. Carpeting needs replacement more frequently to maintain the property’s aesthetics and comfort.

Fence Depreciation Life

Fences usually depreciate over 15 years. This includes wooden, metal, and vinyl fences surrounding the property. Exposure to the elements and physical wear can affect their lifespan. Proper maintenance and occasional repairs can extend the functional life of fences.

Furnace Depreciation Life

Furnaces and heating systems are considered part of the building’s structure, and therefore are not eligible for segmented depreciation and depreciate over 27.5 years. The specific lifespan can vary depending on the system’s quality and the level of maintenance it receives. Regular servicing can help in achieving the upper limit of this depreciation range.

Appliance Depreciation Life

Appliances such as refrigerators, dishwashers, and stoves generally have a depreciation life of 5 years. These essential items face frequent usage, leading to wear and potential breakdowns. Upgrading to energy-efficient models can also offer additional tax benefits and reduce utility costs.

Plumbing Depreciation Life

Plumbing systems, including pipes and fixtures, are considered part of the building’s structure, and therefore are not eligible for segmented depreciation and depreciate over 27.5 years. Regular maintenance and addressing minor issues promptly can prevent major plumbing failures and prolong the system’s useful life.

Cabinet Depreciation Life

Cabinets in kitchens and bathrooms typically depreciate over 5 years. The material and frequency of use influence this lifespan. High-quality materials and good upkeep can help cabinets last longer.

Driveway Depreciation Life

Asphalt and concrete driveways are considered land improvements and are not eligible for segmented depreciation. This lifespan includes regular repairs and resurfacing to address wear from vehicle traffic and weather conditions.

Other Concrete Structure Depreciation Life

Other concrete structures within the property, such as sidewalks, patios and walkways, usually depreciate over 15 years. Environmental exposure and usage impact their longevity. Proper sealing and occasional repairs can help maintain their condition.

Implementing Segmented Depreciation

To effectively implement segmented depreciation, follow these steps:

• Conduct a Property Component Analysis: Identify and list all the major components of your rental property. This can include structural elements, systems, and fixtures.
• Determine Depreciation Lives: Assign the appropriate depreciation life to each component based on IRS guidelines and industry standards.
• Keep Detailed Records: Maintain comprehensive records of each component's purchase cost, installation date, and depreciation schedule. This enables accurate tax reporting and provides the information you’ll need in the event of an audit.
• Consult a Tax Professional: Segmented depreciation can be complex. Consulting with a tax professional or accountant who specializes in real estate ensures you maximize your tax benefits while remaining compliant with IRS regulations.

Example of Segmented Depreciation

Consider a rental property with a total cost basis of $500,000. By breaking down the property into components, the depreciation schedule might look like this:

• Building Structure: $400,000 (27.5-year life)
• Furniture: $20,000 (5-year life)
• Carpet: $10,000 (5-year life)
• Fence: $10,000 (15-year life)
• Appliances: $10,000 (5-year life)
• Cabinets: $10,000 (5-year life)
• Concrete Structures (sidewalks, patios): $10,000 (15-year life)

By applying segmented depreciation, you can accelerate the depreciation of shorter-lived assets, leading to higher depreciation expenses in the early years and reducing your tax liability.

 Other Considerations When Using Segmented Depreciation

When an income property is sold, the seller is required to recapture all depreciation at a rate of 25 percent. This means the IRS effectively assumes the owner took depreciation deductions and charges accordingly, so failure to take the deductions actually leads to a loss if the property is sold. Thus, it's in your best interest to maximize your depreciation deductions.

If you want to start  using MACRS to your advantage, talk to a tax professional. Better yet, consider bringing a professional property manager on board to help you handle your rental accounting and get the most profit out of your property. You can find the best options in your area using our free search tool.