Cost segregation questions - help needed!

19 Replies

Tax season is upon us, I'm in need of some advice regarding cost segregation for next years planning.  My husband and I are real estate investors in MN with 70+ units that are long term buy and hold properties.  We are looking to buy a small apartment building next year, 20-40 units (or larger if we find the right property).

Question - Can cost segregation deprecation be used to offset active income from his insurance business?  Or is it only able to off-set rental income? We've talked to a few tax accountants, and have yet to get a clear answer.  Any input would be extremely helpful.

Thanks!  Karen

@Karen Higgins Short answer: If you OR your husband are not a 'real estate professional' then unfortunately there is a limit to how much of the passive losses created by depreciation (accelerated or not) can be used to offset your 'active' income.

A 'real estate professional' as deemed by the IRS is someone who works 750 hours per year in real estate, AND it is at least 50% of your total working hours.

@Yonah Weiss I do qualify as a real estate professional.  

Hypothetical numbers... if we had $50,000 of "extra" depreciation after accounting for all profits in our real estate, could we then use that $50,000 against $150,000 of income from our insurance business?   

@Karen Higgins If you qualify then you're in!!! you can use your extra depreciation against your active income to lower your income tax liability. 

Answer: YES! 

@Yonah Weiss Thanks!!  Another questions...  We just purchased 14 units for $600,000 last month, built in 2007.  In your opinion, would that be worth a cost segregation study?

Hi Karen,

As I understand it from your posts on here you and your husband likely qualify as real estate professionals. If you decide to accelerate depreciation via a cost seg it would first offset income from your other properties and if you have a net loss it will help offset other income on your return. if you insurance business is being reported on Schedule C (not in a S-Corp or LLC) this will not however reduce the self-employment taxes you have to pay on the insurance income.

A Cost seg is really a play on the time value of money, depending on your goals with the property it may or may not make sense.  Our firm completes cost segregation studies however a $600k apartment building doesn't typically justify the cost of completing a study.  That doesn't mean you can't break out certain items upon purchase to accelerate depreciation, it just means it doesn't make sense to complete a study.  For example, instead of calling everything 27.5 year property we break out appliances and other items that are easily identifiable.  This doesn't take much time at all and allows clients to write off the basis in their property quicker.

There was a change under the "Trump plan" that affects your ability to complete a 1031 exchange (like-kind exchange) after completing a cost seg so if that is part of  your strategy it would be something to consider as well.

There isn't a hard set line on when it makes sense to complete a study but with the information posted I don't think it would make a lot of sense on this property.  It would be easy to do a "mini" cost seg though and take the low hanging fruit.  It is always easier to do this in the year of purchase because there is a little more red tape involved by breaking out assets after the year of purchase.

@Karen Higgins We have completed studies of properties worth similar to your 14 unit. Most firms will prepare a complimentary estimate (feasibility analysis), for you to see the numbers, of how much it would cost, and how much benefit you could expect. Make sure to get one, and see the numbers for yourself, and decide whether it makes sense or not based on your situation. Obviously the more the property is worth the more benefit you will obtain.

If you are planning on continuously buying properties in the years to come, then it is much more than the "time value of money" it actually allows you to continuously lower your overall income tax by using the maximized accelerated depreciation on your new properties.

The 100% (or 50%) option of of bonus depreciation, allows you to deduct all (or 50%) of that accelerated depreciation in year one, instead of spreading it over 5 years. 

@John Woodrich Thanks for the input.  Do you have a contact here in MN that does the cost segregation "mini study" you mentioned?  Or does your company do this? This property is located up north in Bovey, MN.  What is the typical cost of the "mini study".  I'm assuming it is not as expensive as doing the full cost seg study.

@Karen Higgins I sent you a message but have to run - will send you a separate one related to these questions in a bit.

"We've talked to a few tax accountants, and have yet to get a clear answer."

Hi Karen,

Clearly you and your husband are real estate investors and kudos to you for the properties that you own. My biggest concern is your statement that you couldn't get a clear answer from your tax team. As real estate investors, you need a tax professional who is on it and knows all about the tax laws surrounding real estate. That's going to be a critical piece for you. It would be great if that person was in Minnesota, but it isn't necessary. With Sharefile, you can hire someone who specializes in real estate remotely. I'd be sure to get several recommendations and then interview at least three. Quick google search came up with a few things. Hope they help. Good luck!

https://www.biggerpockets.com/forums/51/topics/166...

http://www.dcschluter.com/real-estate-accounting-s...

http://www.hgkcpa.com/industries/real-estate/

https://fa-cpa.com/industries-we-serve/minneapolis...

Karen,

My expert contact in this space corrected me saying anything at $500K and above could work.  Also noting this change in tax law that has been a boon for his business is:

Any buildings purchased new or already built from October 2017 to today qualifies for 100% Bonus Depreciation in the first year. This dramatically increases the economic benefit for the investor. 

@Karen Higgins With a $600K property you should see a good benefit, but the bigger the better with cost seg. If you have 20% land value on that property you've got $480K depreciable cost basis. If it makes sense for you depends on your situation. If you want to lower or eliminate your current tax liability it makes sense to take a look and see what's possible. Since you're a real estate professional doing long term buy and hold and have over 70 units it's likely you'll see a huge benefit from cost segregation.

The reason it's been difficult to get clear answers from the accountants you've spoken with is that cost segregation is not their area of expertise. Accountants generally do not have construction knowledge. To be done properly cost segregation should be done by a construction engineer or architect with knowledge of the relevant tax code. That's the first principal element of a quality cost segregation study. 

https://www.irs.gov/businesses/cost-segregation-audit-technique-guide-chapter-4-principal-elements-of-a-quality-cost-segregation-study-and-report

A "mini" cost seg is basically a residual estimation, which is cautioned against by the IRS because it is generally inaccurate. They don't require any particular method, but they do require it to be accurate. Unless you built the property yourself and have all the invoices it's quite difficult to segregate costs since everything must be reconciled to the total cost. The only way to really be accurate is a detailed engineered cost segregation study. 

I agree with what Paul says, most accountants don't have the knowledge to advise on even the most basic approaches.  Here is the the IRS audit guide which explains the different methods - what I am calling a "mini" cost seg study is defined here as the "residual estimation approach": 

https://www.irs.gov/businesses/cost-segregation-au...

The detailed engineering approach is definitely better than a residual estimation approach but the costs of completing them are also quite different.  The cost of a detailed engineered study is better absorbed by commercial buildings and hotels, it can be hard to justify the approach at times on smaller residential buildings but it varies based on particular circumstances.

Originally posted by @John Woodrich :

I agree with what Paul says, most accountants don't have the knowledge to advise on even the most basic approaches.  Here is the the IRS audit guide which explains the different methods - what I am calling a "mini" cost seg study is defined here as the "residual estimation approach": 

https://www.irs.gov/businesses/cost-segregation-au...

The detailed engineering approach is definitely better than a residual estimation approach but the costs of completing them are also quite different.  The cost of a detailed engineered study is better absorbed by commercial buildings and hotels, it can be hard to justify the approach at times on smaller residential buildings but it varies based on particular circumstances.

 Thanks for clarifying the difference based on the IRS's definition. However we have seen MANY accountant who attempt to guesstimate, without giving proper sourcing. Although it might fly so long as one isn't audited...but it also often misses out a significant portion that an engineer based study would find. We've seen up to 30% missed out.

As far as pricing goes several other qualified national firms specializing in cost seg, are able to keep the costs down, by streamlining the process, and not out-sourcing any of the work.

Bottom line, like @David Thompson said above, any property worth at least $500,000 should do themselves a favor and get free estimate, which most qualified firms provide. You'll see the numbers clearly, what it will cost, and what benefit is projected, and make an educated decision yourself (with the counsel of your CPA) and stop giving money to the IRS, that they allow you to keep!

@Karen Higgins ,

Great replies from other members above, but please factor in the limitation on the NOL starting this year. TCJA limits the NOL deduction to 80% of taxable income.  So extra depreciation might not produce the same results as you hoped for. 

Since you mentioned that you have an insurance company, the 80%-of-taxable-income limit doesn't apply to NOLs of property and casualty insurance companies. 

You might need to talk to a good CPA to navigate this. Good luck. 

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