How to utilize Cost Segregation to your advantage

26 Replies

Hi BP Community,  

I was hoping to get some feedback on the best ways I can utilize cost segregation for my taxes this year and if anyone has recommendations for a Real Estate Accountant in the Los Angeles area that is well versed in this? I primarily invest in out of state SFH's and want to take advantage of this method. Thank you- James

Cost segregation studies are best utilized on multi-family and commercial properties. With that being said, you may benefit on your SFH's; an analysis would need to be done. Furthermore, if you are subject to the passive loss rules and not a real estate professional, your CPA should communicate to you whether you can actually utilize the tax benefits from a cost seg study.

@James R aduna - the answer depends on your current tax situation and future goals. Keep in mind a CSS only allows for an acceleration of depreciation, it's not a save on taxes per se. If you can benefit from that acceleration now, and/or how will impact your taxes in the future, only a CPA knowledgeable of your tax picture and plans can answer.

Generally speaking, a CSS is good and you can get it done for SFH - look into KBKG.com for a relatively cheap tool you can utilize to get it done. We used it for 3 of our rentals and gave us a nice boost in the tax refund.

Cost seg studies don't come cheap, and the benefit is just playing on the time value of your money. Where I am (NH) most of the cost seg studies I have seen down cost the client somewhere between $6,000 and $15,000, with a $6,000 minimum. There are a few things to keep in mind for cost segs:

1) Is there an immediate / short term tax benefit? If the property was already generating tax losses you can't use due to Passive Activity Loss Limitations, then incurring additional losses by having the cost set study done may not benefit you at all.

2) Are you planning on selling anytime soon? If you sell, you will likely end up "recapturing" a good portion of the additional depreciation taken through the cost seg, so the you really just pushed off the associated tax a few years.

3) What is your marginal tax rate? If you are in a relatively low rate, you need a significantly higher write off for it to make sense. IE you would benefit at 22%, in order to pay back the cost of a $5k study you would need to accelerate $22k in depreciation and be able to take it. 

On proposals I have seen cost seg providers show the tax benefit as if you are in the 37% bracket, and with the assumption that you can take the entire loss.  This certainly provides a rosy Outlook, but be sure to apply it to your own tax situation.

Cost Segs are all about the time value of money, and they work much better for some types of real estate than others. The general rule we tend to see is that once the building cost approaches $1m, it may be worth it to pursue. They certainly are a powerful tool, but not a great fit for all real estate applications. In your situation with SFH it seems unlikely that it would be worth the money.

@Costin I. can you expand on what type of properties, values, and costs were involved with the ones you did? I think we might be in similar situations.

We are thinking of doing it the 'low cost way' on a couple properties in our SOLO401Ks. The reason being we are wanting to convert from Traditional SOLO401K to ROTH SOLO401K and we would like to offset the tax hit of that.

We are going to be talking to our accountant soon, but our thought is this. 2 4 Plexes worth about 500K with 300K owed on them so about 200K of equity we would have to pay tax on upon converting. If we  did a Cost Segregation on them and 'accelerated' we are hoping that we could use that 'loss' to 'offset' the taxes due that would need to be paid on the ROTH Conversion.

Could any of you Pros chime in if that makes sense? @Dmitriy Fomichenko @Brian Eastman @Carl Fischer @Bernard Reisz ?

@Daniel Dietz Cost seg is a great tax tool... for the right taxpayer. Roth conversion will create income to you (not to the 401k plan), but the cost seg is being done on properties that are not part of your personal tax assets (rather the 401k plan assets).

@Yonah Weiss No cost seg discussion is complete w/o your participation :)

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@Bernard Reisz I follow what you are saying and will confirm with our accountant, but that makes sense.

With that in mind, it sounds like if I did a Cost Seg on a DIFFERENT property, one NOT in my SOLO401K account and just 'held traditionally with cash', that I *might* be able to use THAT Cost Seg that would flow to my personal taxes just like the conversion on the ROTH Conversion from my SOLO401K would?

Thanks for the response, Dan Dietz

Thank you Kory. I'm not currently looking to sell, so I would be fine in that aspect. That said, I am in the higher end of the tax bracket, so not sure how that would impact me further. I agree. I need to talk to a tax professional to get a clear outlook on my situation.

Bill S. Thank you for your feedback. I'll look into DIYcostseg.com. I'll reach out to Brandon. Can anyone else on this thread suggest a CPA to discuss this further in the Los Angeles area? Thanks 

@Daniel Dietz

I'm not a tax expert but I don't see how cost segregation can help you reduce your tax liability (directly anyway) on a Roth conversion. You would have to get independent third party appraisal on the asset you are converting minus debt and that would determine the taxable amount. Be sure to discuss the specifics with your CPA. 

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@Daniel Dietz & @James R aduna - we done it for 3 SFR, 2 acquired in 2017 and 1 in 2018. All were 3/2 SFRs with an approximate FMV of 200K (I think the tool works best with SFR between 100K and 500K). Each report cost us $400 and, once I got the handle of the online tool, it took me about 15-20min for each. It's easy, you'll need a couple inputs from the CPA (like your tax bracket to give you an estimate on tax savings) and to be clear on the property depreciation basis, the rest is property details the CPA will not know anyway and you'll have to provide (like the length of the fence and material, or the type of flooring).

We kept it simple and did not complicate ourselves with older acquisitions (only the ones in that tax year) as that require a change in the way taxes are calculated, going back and amending returns, etc., extra stuff on the CPA side that he will charge you for. Without that, you just give the report output to the CPA to add it to the tax return.

Last year, for example, we also got a depreciation bonus and accelerated 20K+ with the CSS that got us a serious boost in the tax refund. Keep in mind, that is an acceleration of depreciation, not a save. Still, $400 for 7K+ extra in tax refund, not a bad deal.

Normally, if you end up with losses because of the depreciation and CSS, and your adjusted gross income (AGI) is 100K or less, I think you can move 25K of the losses to the active side of income and reduce your tax footprint. If you have more than 100K, it gets prorated up to 150K AGI. The rest gets stored and you can get it next years (you don't lose it, just gets delayed). OR If you qualify as a real estate professional (not that difficult, if you participate actively in your property management and meet the hours requirement, easy if you have non working spouse that is doing that) than you can deduct more than 25K in one year. A CPA can explain better than me, according to your situation specifics.

How any of this applies to properties in an IRA, converted to a SOLO401K, beats me. You need advice from a CPA here.

Costin, Thanks for the feedback. Just wanted your feedback based on your comments above. So currently, I have 6 properties ranging $70k to $110K. They were purchased in (4 properties) 2018 & (3) 2019. It seems you suggest to only do properties above $100k and submit current tax year? Based on your experience you suggest to only do the CSS on 3 properties in 2019 that were worth over $100k. Correct? 

@James R aduna

You're ignoring the warning raised in multiple answers to your question: the starting point is to determine whether you can benefit from it at all. 

For example, if you're single and have a full-time W2 job making $150k, and your properties already have a net (after expenses) loss without cost segregation - then cost segregation is useless to you. This was just an example, and we would need to evaluate your entire tax situation and numbers on the properties to determine if CSS is of any benefit to you.

Then, there're other issues that should be considered: cost v. benefit and the exit strategies. Invest couple hundred dollars in talking to a good accountant before investing thousands into CSS. 

The DIY online option mentioned by @Costin I. has one potential caveat: there is no guarantee that the IRS will accept such numbers upon an audit, since they are based on a statistical approach instead of an inspection of the actual property. So there's some risk. 

@Michael Plaks

DIY cost seg allows you to buy audit protection. If you get audited on a algorithm based study you just have to pay for an engineered one. With the audit protection they cover this. The founder Randy told me that only a few have ever come back from the IRS needing an engineered one (I think it might have been 4 out of several thousand) and once his team did an engineered one the IRS accepted. So less than 1% chance that you need an engineered study to back in up and if you do need that you’ll be fine with an engineered one. The risk of an engineered one can be bought with audit protection for $195. So I don’t think this is as big of a risk as people make it out to be!

  • @James R aduna @Daniel Dietz  
  • I’m not affiliated in any way with KBKG. I just used them repeatedly and things worked good for me – which doesn’t guarantee in any way you’ll have the same experience. I’m sharing all this because I looked extensively into CSS for my SFRs and hit a block of ignorance and/or the prohibitive cost of engineer conducted studies (at 2K+ a pop of course they will denigrate a solution that cost only $400 and threatens directly their livelihood, but that’s the cost of technological advances).
  • To do CSS for properties acquired in previous years you need to 481(a) adjustment calculations [and I don't know if that calculator is included in the $400 CSS report or it's extra]. Then the CPA will have to go and change the “accounting method” and ammend your previous tax returns - additional cha-ching. For that reason, for me it didn't make sense and I only do it for property acquired in the current tax year for which I did not submit yet the tax return. In your case, use the estimator and talk with your CPA to see if the additional costs justify doing the CSS for the 2018 ones.
  • You pay the same $400 for the 70K property as for the 200K property. The “savings” will be better for the 200K so the value you get for the $400 is better the higher the depreciation tax basis of the property you CSS. But the benefits depend on your overall tax picture, or you might get depreciation bonus that would make sense to do it for all of them – your CPA needs to give you an idea how things change.
  • It also depends on your plans and investing strategy. CSS gives you an acceleration of depreciation – that might be a benefit to your current year cash flow, but might also impact your future cash flow. If you sell, depreciation will need recaptured. When you sell, in the next 3 years, vs after 20 years, vs never can also have a different impact. Only you and your CPA can define those parameters and decide best course of action.
  • Based on the information I glean from you, I would do the 2019 acquisitions and go from there.
  • Like @Michael Plaks  said, if you end up with net rental losses, adding to them the extra CSS depreciation is not going to help you that year (!) [unless you or your wife can qualify as RE professional]. It’s not useless, as you’ll be able to bank those losses for next year (or for the year when you’ll generate income…and if you are not generating it any time soon you might want to reevaluate your investing strategy). If you end up with net positive rental income, CSS might help offset the taxes on that. Again, you need to be pretty good at evaluating your tax situation OR have a good CPA.
  • Keep in mind: If I’m not mistaken, depreciation is also dependent on the date the property was placed in service. For the first year you’ll get a prorated portion. Which means, for example, that if the rental was acquired in October, and advertised for renting as of Nov 1st, you’ll only get 2 months of prorated depreciation. So a CSS might move the bulk of benefit next year, not the taxes for this year. [same theme repeats – involve a knowledgeable CPA, too many variables to juggle if you are not used to do it]
  • KBKG have estimators – a Residential Cost Segregator Preview Calculator - that you can use to see how it will impact your taxes.
  • They also offer webinars where you can learn how to use the tools and get your questions answered. Plus a FAQ section @ kbkg.com/costsegregation/faq
  • As for IRS [this was one of my major concerns with this solution and it was explained to my satisfaction], they offer a “KBKG Audit Guarantee - We stand behind our reports. In the event of an IRS audit, KBKG will provide free audit support time at no additional charge for issues directly related to our report.”@ kbkg.com/residential-costsegregator. [……but as with anything, is there truly any guarantee 10 years down the road?]
  • Additionally “Will the company be available if I get audited by the IRS? Any company can give you a Cost Segregation report with results that save you a lot of money; the real question is whether it will stand up to IRS scrutiny. The true value of the fee you pay is how easy (or painful) the audit process goes. Every Cost Segregation company will say they stand behind their work, but how can you really know what will happen when the IRS audits the report? Using a larger company that has been in business many years should give you comfort that they can successfully defend your study against an IRS audit. Look at their client profile. Bigger, well-known clients have a higher probability of being audited by the IRS. A company without high profile clients probably doesn’t have a great deal of experience dealing with the IRS. Some companies mislead consumers by stating they’ve done work for companies like Walgreens, McDonald's, or Holiday Inn when in fact they have only worked with smaller franchisee’s or landlords that lease their buildings to such companies.”
  • So, here is what I would do: 
  •   1.Go read their section about the Residential Cost Segregator, watch the video, checkout the sample report, sign up for the free webinar. 
  •   2. Study the FAQ and gather your still unanswered questions to send to them to see if they get answered to your satisfaction. 
  •   3. Use the “preview calculator” to get a feel on how things might work for you. 
  •   4. Talk with your CPA and see how all this fits in your current and future tax situation and investing strategy. 
  •   5. Run a trial with one report for one of the houses, analyze the impact with your CPA and extrapolate for the other houses. 
  •   6. If all good, do the others [prior to finalizing the tax return].
  •   7. Good luck!

"Ignorance is bliss. Knowledge is power, but also a burden, leading to analysis paralysis. The cure to both - the 4 ions: education, action, progress(ion), not perfection".

@Daniel Dietz Cost seg does not require an appraisal, as it's based on cost basis (that's why it's called cost seg) - not on fair market value. 

Similarity, debt on the asset impacts your equity - not your cost basis. 

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