Cost seg & STR loophole from a financial planners perspective

Financial Advisor · Winston Salem, NC · Member since 2016 · 195 posts · 161 votes

3y

Ouch, that hurts to read. You basically left $115k + of tax-free income on the table. Your standard deduction was $25,900 plus the negative AGI of $80k, means you could have “forced” $105k of ordinary income to your tax return(best is probably a Roth Conversion) with $0 of tax liability. Then you could have also had up to $83k of LT capital gains realized tax free inside of the 0% tax bracket for cap gains.

I’m sure it felt good to get a refund, but definitely not the most tax efficient outcome.

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Todd Goedeke

Contractor · Sheboygan, WI · Member since 2016 · 921 posts · 266 votes

3y

@Daniel Murphy do some more homework on cost segregation studies. There are companies you can reach out to online that can do a cost segregation study in as fast as a week for under $1500. It’s not rocket science .

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Michael PlaksPro Member

Tax Accountant / Enrolled Agent · Houston, TX · Member since 2014 · 5k+ posts · 6k+ votes

3y

@Daniel Murphy

You claim to dislike hype (both of us), yet inadvertently create more of it. For people with shaky understanding of taxes (and that is at least 95% of BiggerPockets users) your post sounds like:

"COST SEGREGATION IS SUPER DUPER COOL AND CREATES TONS OF TAX BENEFITS"

And this is what I call dangerous hype, since we love simple formulas like this one and do not bother to invest time in understanding.

I will address your specific technical points in a follow-up reply. Meanwhile, here is a short list of why this simplified statement is really bad:

1. An ability to take losses from cost segregation is not automatic, especially for LTRs, but even for STRs. You must have qualified, but not everybody can.

2. Refunds are utterly irrelevant in measuring your tax efficiency. And creating negative AGI is usually a very bad tax planning.

3. Cost segregation does not create deductions out of thin air. It simply "steals" your own future deductions. Sometimes it's a sensible strategy, and sometimes it is not.

4. Cost segregation savings, if available, are for one year only. From year 2 forward, cost segregation actually results in an increase of taxes.

More on the pitfalls of costs segregation is here: https://www.biggerpockets.com/forums/51/topics/1075919-five-common-myths-of-cost-segregation-and-100-bonus-depreciation

Cost seg can be an excellent strategy when it's applicable. But it is NOT ALWAYS applicable!

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Michael PlaksPro Member

Tax Accountant / Enrolled Agent · Houston, TX · Member since 2014 · 5k+ posts · 6k+ votes

3y

@Daniel Murphy

My earlier reply was for everyone, commenting on the hype of cost segregation. This one is targeted for you specifically and for other tax nerds in the room. It's much more technical and specific.

1. Your cost seg report took months.

It should not. There're some excellent providers of this service here on BP, and I doubt they take months to do the job: @Bernard Reisz, @Yonah Weiss, @Julio Gonzalez are worth reaching to next time you need it.

2. Estimated tax benefits.

You're exactly correct about the inflated tax benefits touted by some providers. I wrote about it in the past:
https://www.biggerpockets.com/forums/51/topics/831924-beware-how-cost-segregation-is-sold-to-you

3. Offsetting income with cost segregation.

You are always allowed to offset rental income down to zero, but you're not always allowed to apply the overflow losses against your other income: W2, K1, stock trading and whatnot. You did it, so you must have qualified.

If you have LTRs, you either have a very limited room (no more than $25k) if your total income is relatively low - or you need to qualify for the "Real Estate Professional" status (REPS). Qualifying for REPS is much harder than it sounds, especially for people with full-time W2 jobs.

If you have STRs, you must pass the "material participation" test which is also harder than it sounds, particularly if you use property management.

4. Reducing overall income to zero and below.

At some point, pushing your taxable income down starts to backfire, as pointed out by @Daniel Johnson. That point is different for everyone, and in your case it was definitely crossed. Often, it is wiser and more rewarding to be more patient and less greedy. There were ways to spread your tax savings over multiple years and generate significantly more savings than you harvested.

5. "The many benefits of cost segregation"

What you listed under "Financial planning opportunities" was mislabeled as cost segregation benefits. It should have been referred as tax opportunities in a year of an abnormally low taxable income. Cost segregation, as long as you qualify, is merely a tool to "manufacture" such a year.

6. Timing of a low-income year.

If you're to create a low income year, it matters when, as you yourself alluded to. Just because you can do it in the current year, does not mean it is the best/most efficient time to do so. Sometimes waiting pays off. And it's totally case-by-case.

7. Timing of cost segregation.

Many investors are under the impression that they can freely choose the timing of cost segregation. For example, they want to do it in the second year of operating the property and expect to apply it to that same year, because it is a "better" year for tax savings. Then they are shocked to find out that it is not possible, and they must apply it retroactively to the first year. Rules are complicated here and are case-by-case.

8. College financial aid.

A minor but important point. If your kid is now applying for 2023-24 school year financial aid and doing FAFSA, you will be asked for the numbers from your 2021 tax return. Not from 2022, and not from 2023. Milking FAFSA requires advance planning, and last-minute cost segregation won't work.

9. Conclusion.

As appealing as your ode to cost segregation is, remember that your mileage will vary. Sometimes your car will not even start.

4 Reply

Julio GonzalezPro Member

Specialist · West Palm Beach, FL · Member since 2008 · 4k+ posts · 1k+ votes

3y

@Michael Plaks Thanks for the mention!

561-253-6640

1 Reply

Todd Goedeke

Contractor · Sheboygan, WI · Member since 2016 · 921 posts · 266 votes

3y

@Michael Plaks You did not mention that with regards to STVRs material participation includes being involved with co managing : construction, decorating, landscaping, of new construction. In addition management of marketing,vendors and service providers also counts as participation.

For high 6 figure or 7 figure income earners there is no reason not to immediately use bonus depreciation via cost segregation to offset other income. If a property owner chooses to use self management or participates in construction management the year bonus depreciation is used, that does not mean the property owner can t switch to passive investor status in subsequent years.

Using Section 179 expensing and cost segregation remains as one of the best tax reduction strategies involving RE and STVRs in particular.

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Michael PlaksPro Member

Tax Accountant / Enrolled Agent · Houston, TX · Member since 2014 · 5k+ posts · 6k+ votes

3y

@Todd Goedeke

The situation described by @Daniel Murphy is not "high 6 figure or 7 figure income earners." The way he utilized cost segregation was not optimal.

Many of the "high 6 figure or 7 figure income earners" do not have the time and ability to pass the material participation test. But, if they do, combining STRs with cost segregation certainly is an excellent strategy.

I never spoke against cost segregation. I spoke against its misapplication and misunderstanding.

2 Reply

Eric Williams

Accountant · Houston, TX · Member since 2023 · 148 posts · 41 votes

2y

Quote from @Daniel Murphy:

Hey all, I did a cost seg study on my short term rental for the 2022 tax year. I'm a financial planner by profession & really wanted to understand the nuances behind this topic more. I love comparing the hype vs real world. I apologize if this is a bit long, but here's a random list of thoughts after digging into this and actually doing a study...

Before Cost Seg

- $400k property purchased in Jan of 2022. I reached out to get a cost seg estimate & came back with these estimates:

$352k building cost ($400k minus estimated land costs)

~$77k in estimated bonus depreciation

= $28k in estimated tax benefits ($77k in estimated bonus deprecation * 37% tax rate)

Note - the above is my main point of contention with these cost seg estimates. These estimates always tend to show the max amount of bonus deprecation multiplied by the HIGHEST tax rate = your estimated tax benefit.
1) Most of us are not in the highest tax rates and:

2) Tax rates step both up and down, so you can't simply take the bonus depreciation multiplied by a tax rate. It doesn't work like that... IE - don't expect the estimated tax savings on your inital report to be your actual tax benefit.

During

- the report actually took me much longer than anticipated to receive. I had to follow up with the company multiple times and seemingly provide the same info to them multiple times.

I would definitely recommend starting this early rather than later as the report takes months to complete.

Actual numbers post report:

5 year property = $42k

15 year property = $120k

total building cost = $204k

Actual Tax Return

~Married Filing Jointly

~$82k in W2 income

~$150k in self employed income netting $52k in K1 income

~$11k in capital gains from stock market investments

~$60k in rental income from Schedule E and $215k in depreciation expenses ($162k from cost seg bonus deprecation & the rest from first year costs / capital expenses)

We ended up with an AGI of -$80k

Nuances & Thoughts
- Most frequently, Cost segs are focused on high income investors. I don't believe I'm considered "high income".

- Some will say doing a cost seg on a $400k property is not worth it but in this case, we absolutely found it worth it.

- I ended up with a fed & state tax refund total of around $18k

plus, I still have a significant loss carry forward that I should be able to use in future years.

We also had ~$30k in charitable deductions that we could NOT use in 2022 due to AGI limits. These will be carried forward to future years to offset future taxes.

For the first time in years, we qualified for a property tax refund. This was a little over $3,000

One thing to note, when your AGI & tax liability gets near zero, child tax credits are only refundable up to $1,500. Meaning, you do not get the full value of the $2,000 child tax credit if you have a low AGI, you may only get a max credit of $1,500 per child.

In my case, I ended up with around $20k in tax benefits in year one and should get nearly that much in a year two carry forward. (complete guesstimate)

Financial Planning Opportunities

This is the area that really interests me. As I've talked with my clients & other investors, here are some areas I can think of to maximize the benefits of a cost seg. (all as a result of an abnormally low AGI for the year)

- If you have any inherited / beneficial IRA assets, you could potentially do large withdrawals with little to no tax effect.

- If you're applying for financial aid for college or other institutions, you may potentially qualify for additional aid based on a low AGI.

- If you have large capital gains, you may be able to realize them & qualify for the 0% tax rate.

- You could potentially convert a portion of your 401k/IRA into a Roth 401k/IRA virtually tax free. After a 5 year holding period, you may be able to withdraw your basis from the Roth tax free to purchase more real estate (note, I need to verify this as I don't know this to be 100% accurate)

- You could potentially offset taxes from a year where you anticipate large gambling income, cancellation of debt or more likely, stock option awards or other employee stock incentives.

This was not meant to be an exhaustive list. Moreso, I've been thinking of this a lot recently & just wanted to share some deeper thoughts. When most people talk about the benefits of doing a cost segmentation study, they talk about tax savings. I find the real beauty of this strategy in the other supplamental benefits that are not often considered.

I hope this helps give another perspective on the cost seg / STR Loophole topic...

Thank you.

They also fail the mention the type of entity.

So amounts passed through need to be calculated along unique taxpayer characteristics.

Cost segs honestly need to be used on active trades or businesses where the excess depreciation is nonpassive and can offset other ordinary income. A good example was a 7 practice dental office that seg'd after the acquisition to gain the advantage of hindsight.

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Cost seg & STR loophole from a financial planners perspective

Cost seg & STR loophole from a financial planners perspective

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