Hypothetical: A Single Rental With Usable Deductions

This walk-through shows the shape of the analysis for one rental. The goal is not the specific numbers but the steps you can copy with your own figures.

The setup

An owner buys a residential rental for $600,000 in a hypothetical year. Land is assumed to be $120,000, so the building and other depreciable basis is $480,000. The owner is assumed to be able to use additional deductions against other income in the year, for example by qualifying as a real estate professional. The study is assumed to cost $5,000. The combined federal and state tax rate on the income offset is assumed to be 35 percent. Bonus depreciation is assumed for illustration to be available at 100 percent on qualifying assets. Verify the real rules. See Bonus Depreciation: Rules as Currently Understood (Verify).

Step 1: baseline depreciation without a study

The $480,000 is depreciated over 27.5 years straight line. A full year is about $17,450. In year one, with a mid-month convention and an assumed mid-year purchase, perhaps around $8,000 to $9,000. Over the first five years, the total might be around $80,000.

Step 2: hypothetical study result

Assume the study places $72,000 in 5 and 7 year property and $30,000 in 15 year land improvements, leaving $378,000 in the building. The 15 percent and 6 percent shares are simply assumptions for the example. Real shares vary and may be higher or lower.

Step 3: first-year depreciation with the study

Assuming 100 percent bonus applies, the $102,000 in short-lived property could be deducted in year one. The $378,000 building remains on 27.5 years, about $13,750 a year in full years, and perhaps $6,500 in the first partial year. Total year-one depreciation is roughly $108,500, compared with about $8,500 without the study. The extra is roughly $100,000.

Step 4: tax value in year one

At an assumed 35 percent, $100,000 of extra deductions would reduce tax by about $35,000 in year one, if fully usable. This is the number that often headlines discussions. It is not the whole story.

Step 5: what is given up later

The $102,000 would otherwise have been depreciated over 27.5 years, which is about $3,700 a year. So the deductions in later years are lower by roughly that amount each year. Over five years, the study version has about $18,000 less of ordinary building depreciation on that portion than the baseline. The total depreciation over the property's life is unchanged. The benefit is timing.

Step 6: costs

The fee is $5,000 and additional preparation fees might be $1,500. Together, $6,500.

Step 7: the sale side

Suppose the owner sells in year ten for a price that allocates $20,000 to the personal property components and land improvements, though the depreciation taken on them was $102,000. That could produce recapture as ordinary income of up to the lesser of gain and depreciation. Details vary. See Hypothetical: Sale and Recapture After a Study. If the owner never sells, or exchanges, the recapture may never arise. See Section 1031 Exchanges and Depreciation Recapture.

Step 8: putting it together in three cases

The table deliberately avoids precise figures because the aim is to show the reasoning.

What this example shows

• The year-one deduction is much larger than the baseline, but total depreciation is the same.
• The value depends on using the deduction. See Hypothetical: Passive Limits and Suspended Losses for a case where it cannot be used.
• The fee is small compared to the potential timing benefit in this scenario, but a smaller building could change that. See Hypothetical: When a Study Is Not Worth It.

Variations to try

Change the study cost to a higher figure and see how the picture changes. Change the tax rate to 24 percent and see how the value falls. Assume the owner cannot use the deduction, and see how the analysis collapses, which leads to Hypothetical: Passive Limits and Suspended Losses. Assume the property is sold in year three, which leads to Hypothetical: Sale and Recapture After a Study. Assume the shift is half of what was assumed. Assume bonus is not available and the assets are depreciated on regular schedules. Each variation teaches which assumptions matter.

What the example leaves out

It ignores state taxes, the time value of money, other limits on deductions, and the possibility of different classification of some items. It also ignores the effect on other parts of the return, such as income-based thresholds. A real analysis would include them.

A caution about generalizing

Do not assume your property will resemble the example. The shares are assumptions, and real outcomes can be quite different. The example is a tool for learning the structure of the analysis.

Your turn

Replace each figure with your own and run the three cases. Then work through the Cost Segregation Decision Checklist.