By Erika Albert, Broker, E-Rae Realty
Short answer: A cost segregation study breaks a property's purchase price into components with shorter useful lives, so more depreciation can be taken earlier. Because land doesn't depreciate, homes with a high building value relative to land value, often newer construction, tend to be stronger candidates. A CPA and a cost segregation provider decide the actual numbers, so it’s not a bad idea to talk to both before you choose a property.
When a buyer tells me they're buying for tax reasons, cost segregation is usually the next thing they bring up. It's a real tool, and it's also one of the most misunderstood. I'm a broker, so this post covers what I look for on the property side. The tax math belongs to your CPA.
What does a cost segregation study actually do?
When you buy an investment property, the price isn't one thing. Part of it is land, part is the structure, and part is everything inside and around it: appliances, cabinetry, flooring, fixtures, fencing, landscaping, a pool. A cost segregation study, performed by a specialist, assigns values to those pieces. Some of them can be depreciated faster than the building itself. Your CPA then decides how to use the study on your return.
I'm deliberately not quoting depreciation schedules, percentages or dollar outcomes here. Those depend on current tax law as well as the property, and they change.
The quality of the study matters too. The IRS's Cost Segregation Audit Techniques Guide spends a full chapter on what makes a quality study and recommends a field inspection for all quality studies. A cheap, thin report might cost less upfront, but it's the report you'd be relying on if anyone ever asks questions.
Why does land value matter so much in Austin?
Land can't be depreciated, so the share of the price that is land is the share a study can't help with. In a lot of Austin neighborhoods, the land is worth a lot and the house proportionally isn't. A dated bungalow on a valuable central lot can be a fine investment, but it's often a weaker cost segregation candidate than the price suggests.
A quick first screen I use: look at the county appraisal district's split between land value and improvement value for the property. It isn't what a cost segregation provider will use, but it gives you a rough sense of the ratio before you spend money on a study.
Here's a hypothetical with made-up round numbers. Two houses each cost $700,000. On one, the appraisal district attributes 80% of the value to the improvements. On the other, 50%. Before any study begins, the first house starts with $560,000 of potentially depreciable basis and the second with $350,000. That's a $210,000 difference in the starting point. The appraisal district's split is a quick screen, not the answer, and your CPA and cost segregation provider will determine the actual allocation. It's also why my Tax-Play Portal shows each property's improvement percentage next to its gross yield.
Which Austin STRs tend to be stronger candidates?
In my experience, these come up again and again:
Newer construction, where the building is a larger share of the value.
Homes with a high improvement-to-land ratio on the appraisal district record.
Properties with significant site improvements and contents, like a pool, outdoor living areas, and a full furniture package.
A price point that fits your CPA's plan. Your CPA can help you think about what range makes sense for you.
None of these makes a property a good investment on its own. It still has to earn enough to carry itself, and it has to be legal to operate as an STR where it sits.
If a full furniture package is part of your plan, I wrote about how to furnish an Austin short-term rental.
When should I talk to a CPA about cost segregation?
In an ideal world, it is great to have one before you write an offer. If your CPA and a provider can look at a property's general profile while you're still choosing, you avoid buying a home whose value is mostly dirt. It's also worth asking how the timing of your purchase and the date the property starts renting affect what you're hoping to do in a given tax year.
Think about the exit at the same time. Depreciation reduces your basis, and when you sell, part of your gain can be taxed as ordinary income from depreciation recapture (IRS Publication 544). That doesn't make cost segregation a bad idea. It means the benefit is partly a timing benefit, so your hold period and eventual sale belong in the plan from the start.
Frequently asked questions about cost segregation
What is a cost segregation study?
A cost segregation study breaks a property's purchase price into components with shorter useful lives, such as appliances, flooring, fixtures, fencing, landscaping and a pool, so more depreciation can be taken earlier. It is usually done by an engineering-based provider. Your CPA then decides how to use the study on your return, so bring them in early.
Why does land value matter for cost segregation in Austin?
Land cannot be depreciated, so the share of the price that is land is the share a study cannot help with. In a lot of Austin neighborhoods the land is worth a lot and the house proportionally is not, so a dated home on a valuable central lot is often a weaker candidate than its price suggests.
Which Austin short-term rentals are the best cost segregation candidates?
Stronger candidates tend to be newer construction, homes with a high improvement-to-land ratio on the appraisal district record, and properties with significant site improvements and contents, such as a pool, outdoor living areas and a full furniture package. None of these makes a property a good investment on its own. It still has to earn enough.
Do I need a cost segregation study to buy an STR?
No. A cost segregation study is optional, and your CPA may or may not recommend one for your situation. Some owners skip it entirely. If you do want one, it is usually done by a specialized cost segregation firm working with your CPA, and the conversation should happen before you write an offer on a property.
Does cost segregation affect what I owe when I sell my STR?
It can. Depreciation reduces your basis, and when you sell, part of your gain can be taxed as ordinary income from depreciation recapture, according to IRS Publication 544. That does not make cost segregation a bad idea. It means the benefit is partly a timing benefit, so plan your hold period and eventual sale with your CPA from the start.
Who does the study?
Usually a specialized cost segregation firm, working with your CPA. I keep a list of cost segregation specialists.
Do condos make good candidates?
That's a CPA question, but on the STR side, condos are not a common STR option in Austin, because only a very limited number of condo buildings allow short-term rentals. That being said, condos have zero land value, so it's worth discussing with your CPA or cost segregation specialist.
Does the furniture count?
Ask your CPA how furnishings are treated. It's one reason some tax-motivated buyers prefer a turnkey property that's already furnished and booking.
Related: Can buying an Austin short-term rental lower my income taxes?
Related reading
Talk it through
If you want help finding properties with a strong building-to-land ratio that also work as short-term rentals, book a call with me.
I'm not a CPA, and this post is general information, not tax, legal or financial advice. Buyers should consult their own CPA. Need one? See my list of STR accountants.
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