I am a new investor that closed on my first property back in June of this year (new construction) and will be closing on my second (a BRRRR property) in the middle of December. Now that tax season is around the corner, I learned that cost segregation studies will speed up the depreciation of my property, so I can pay less in taxes. I love my W2 job and don't want to leave it, so my long-term goal is making enough passive income to cover my family's monthly bills and save for more properties in the future.
So, my questions are:
What are the pros and cons of using a cost segregation study at this point in my investing career?
Will cost segregation studies positively or negatively impact my ability to finance more properties in the future?
Any advice will be much appreciated!
The cost segregation study is a very good way to increase the depreciation on a property you own.
However, you must understand what the tax code requires when you sell that property.
Added depreciation is only useful if you hold the property long term, or only plan to use a 1031 exchange of the property.
When you sell the property otherwise you must settle with the IRS on the depreciation recapture.
Your description of doing BRRR's, suggest that this added depreciation method would do nothing for you.
Yes you have to settle when you sell.
However - The present value of those tax savings far exceeds any re-capture tax payback.
In other words it's worth it...
This is great information! I was on the fence about doing it, because I didn’t have a complete picture of what cost segregation is. Now I feel confident moving forward.
Thank you both!
My Bad. Sarah is absolutely correct. It was a Sr moment thinking your BRRRR was a fix and flip not the fix-hold and refi!
Hi @Ryan Reid. I think you are on the right track. From what I understand, there are at least three levels of cost aggregation studies. The highest priced engineering study at over $10,000 typically is usually for commercial properties. There is a mid priced study in the $5000 range from what I understand, and some property owners use the study. Though I have no experience with this third level, I also understand there is a sort of do it yourself type study that you can do for under $1000. I don’t know how well this will hold up in an IRS audit so be careful, but it seems like this level would be most appropriate for a residential property. Happy Investing!
All great advice here. Another way to look at it...
I am a retired Professional Engineer, and used that certification to do 4 Cost Segregation Studies on my SFR's.
I was audited by the IRS for another issue,and the studies were never an issue.
I used a simple MS Word report format, broke the items up systematically with photos and costs for each with referenced source for costs.
ON a new construction if you can get a copy of the bills, should be a simple DIY task.
There are multiple pros and no cons (that I’m aware of) to a Cost Segregation Study (CSS) (other than the time and cost involved). It’s worth learning about it and employing it as a tool in your real estate investing toolbox, especially if you plan on adding to your investment portfolio.
While I’m not a professional in this domain, I looked a lot into the subject and I done CSS for several of my properties - I can tell you about some the gotchas and misconceptions vehiculated on the subject:
- It’s not a way to increase depreciation on a property. It is an ACCELERATION of depreciation (you will capture more at the beginning, in the first years and less at the end, in the later years).
- It has the potential to save you money from taxes – but that depends on the rest of your tax picture, what other sources of income and deductions you have, your goals and short term vs long term plans and tax strategies. Again, it gives you a big depreciation in the first years (which could make a big dent in your taxes) and less in later year (which assuming increased cash flow, could mean less deductions, more taxes later…but that depends on your other properties, etc.). Generally speaking, it’s a good thing from tax perspective, and likely to help with taxes.
- While you can do it later (or for properties acquired in previous years), it’s more complicated and costly. Therefore, it’s better to do a CSS in the tax year of acquisition.
- Engineer based CSS is usually expensive for SFR's and properties under 1Mil, and IMO, not cost effective – but there are DIY solutions that provide solid alternative for a fraction of the cost (look into KBKG.com – they have a good tool for a very decent price + tutorials, once you get hang of the principle and how to use their calculators, it takes 20min to complete a CSS report) – and that's the path I recommend.
- If you’ll be able to take advantage of the big initial depreciation to shift taxes (to count it against your W2 income) depends on several factors – if your AGI less than 100K, and prorated up to 150K; your profession or if you or your wife can qualify as real estate professional, your documentation – if you maintain contemporaneous logs, etc.). More often than not, you’ll not be able to shift deductions from passive side (rental income) to active side of income (W2). But don’t worry, you’ll not lose them, they accumulate and still will be able to use them to the max in following years. The main idea is to find the right balance so that your depreciation offsets the net rental income so you don’t pay taxes on them.
- CSS itself has no impact on your ability to finance properties. The higher depreciation deductions that a CSS will give you and applying that to your taxes might have an impact on your financing (or more precise with whom you are doing your financing) as it might show on your tax report as not making any money or, worse from the perspective on financing qualifications, as losing money with your rentals. That's why you need a lender who knows how to properly read the tax report, how the depreciation is applied and what is the real rental income (or how to consider the rental income in the calculation of DTI).
If you need more details on this stuff, you can PM and we can chat.
It does not always make sense to spend 10K on a cost seg to get losses especially if you are doing smaller properties (under 100 units) and based on the time value of money, if we are looking for a early exit it does not make sense - should we be doing an exceptional job going through the unit upgrades. As you know when you sell an asset all the depreciation and bonus depreciation needs to be recaptured or given back.
Most investors are not Real Estate professionals and therefore cost segs and bonus depreciation is overkill beyond (normal bonus depreciation) as it will knock out the passive gains in the first few years of the project in most cases. In other words, even with normal depreciation you are offsetting most of your capital gains. If you are a REP and therefore interested in this subject, there is a high likelihood we will be doing a cost segregation but always reserve the rights as managers to make the call in the end in the best interests of all investors.
Assuming an LP is not a "real estate professional" what is the advantage to the cost segregation to that investor? I understand it's certainly not a bad thing, but what's the advantage?
In most cases normal depreciation will more than offset gains in the first few years of a value add project. The "excess" suspended losses will pile up on your books and can be used to offset passive gains. Passive gains could be coming from other passive investments especially coming from sale of other assets (which are overripe - you should have sold earlier so you don't have such a large capital gain and depreciation recapture in the first place).
In summary Passive Losses cannot offset Ordinary Income (401k withdrawals) unless you are implementing REP status
If you plan to be making less money in the future (when future depreciation would help m than today.) and your taxable income is well over $100k (otherwise you’re turning a 12-15% tax bracket in to a 25% tax bracket.) and your qualified as a real estate professional so you can deduct the expenses against your regular income (you spend more time in real estate than at any w-2 job with a minimum of 750 hours) and you can get it done for a $1,000 give or take and you plan to hold it for at least 10 years (or do a 1031 exchange) it’s probably not a horrible idea. But that’s such a small market.
Oh ps. You saw the savings above (although wrongly stating you wouldn’t get any depreciation for the first 39 years) were substantial at $5M. I assume your property is probably smaller.
1. More tax deduction in early years and less in later years. That means higher taxable income in future years because you have less deductions. That could be a good strategy if you expect to be in a lower tax bracket in future years or it could leave you with a heavy tax burden in the future. Tax rates are only likely to increase in the future, so you could be deferring taxes into future years where you are going to pay an even higher rate.
2. When you sell a property you recapture depreciation and pay taxes. If you accelerate, it means more recapture and more taxes. Two strategies are to hold the property long term or like-kind exchange into a new property. Just be aware that an exchange transfers basis, which means all that "used" deprecation gets transferred to the new property. That means less deductions on the new property. Of course you can accelerate depreciation on the new property, but that only gives you short term relief. If you keep exchanging, it is like a tax snowball rolling down hill.
This can be a big surprise to people who are used to real estate generating a loss to offset income. I actually had enough income that the IRS charged me interest for unpaid quarterly taxes. I guess a good problem to have, but sending big checks to the IRS is a tough pill to swallow after taking losses for years.
The IRS acknowledges that cost segregation had been increasing due to bonus depreciation from the TCJA. They also acknowledge that tax law and cases in this area are murky, making it harder to audit. I think this area will receive increased scrutiny as the government is looking to increase tax revenue (by increasing audits). Not a problem if what you are doing is legitimate, but accelerating beyond reasonable amounts could be a problem. I would use a professional company to perform the study under direction of your tax professional. Make sure the strategy makes sense long term and you are not just creating a bigger tax burden in the future.
Below are a sample of 2 instances when someone would want to perform a cost segregation study.
1) They are eligible to claim real estate professional status and performing a cost segregation study would wipe out other forms of income.
2) taxpayer has a lot of rentals and some are generating positive taxable income.
Performing a cost segregation study on one property may wipe out the taxable income from the other properties.
Best of luck.
A Cost Segregation study is simply a straightforward way of Accelerating Depreciation on ANY commercial or residential rental portfolio.
Yes there are instances where it doesn't make sense and the ROI is not there...