Cost Segregation study
Investor · Carolina Beach, NC · Member since 2018 · 188 posts · 377 votes
Cost Segregation study
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Michael PlaksPro Member
Tax Accountant / Enrolled Agent · Houston, TX · Member since 2014 · 5k+ posts · 6k+ votesYou opened a can of worms :)
Thumbs up for getting into these high-end technicalities and understanding the basics. You're on the right track, but this track does not necessarily lead to the conclusion you made.
1. Your example would be close to accurate if this appliance was depreciated down to zero without cost seg. Instead, it would only depreciate at about 3% per year. So after 3 years, without cost seg, you will only have $200 of Sec 1250 recapture. With cost seg, you convert $200 of Sec 1250 recapture into $100 of Sec 1245 recapture plus $100 LT cap gain. Considering that 1250 is capped at 25%, and 1245 is not, the net effect could be zero. And even if it's positive, it's not material with these numbers. (And what if that appliance is worth $200 and not $100 at sale?)
2. I'll add another quirk. There's a possibility of rate arbitrage if you're able to deduct depreciation at an ordinary rate higher than the 25% 1250 recapture ceiling and then recapture it at 25%. But, just like your "conversion" argument, it assumes so many different factors that using this for tax planning is kind of pointless. What if your income and tax bracket changes significantly from year to year? What if all tax rates are revised by new legislation? What if your filing status changes? Etc.
3. All these deductions do not exist in vacuum. Imagine that you're doing a 1031 exchange. Imagine that you also have suspended capital losses from something else. Imagine that you had suspended passive activity losses. Any of these situations, along with another dozen of what-ifs, can totally disrupt the result happening at sale. In either direction.
Bottom line: while technically correct, your argument is not a strong argument for cost seg. Sometimes it can indeed add icing to the cake. In other situations, it can be useless or even counter-productive. Like a lot of other tax planning ideas. Tax planning is only as good as the underlying assumptions about the future.
25 Replies
- Rental Property Investor · Sioux Falls, SD · Member since 2015 · 9k+ posts · 18k+ votes6y
Originally posted by @Clint Harris:
I reached out to my accountant about doing a cost segregation study in order to utilized the accelerated depreciation, and he said that it’s usually very cost prohibitive and is hard to justify unless you have a very high income. I have a high income producing beach rental duplex that was purchased after the accelerated depreciation start date in 2017, I have a high paying W2 job in medical sales, and my wife is a real estate professional, with 1099 income, so it seems ideal to write a lot of this off. He is under the impression that a cost segregation study is extremely expensive. Does anyone have any knowledge about this or recommendations on who to use for a cost segregation study? Thanks!
They can be very expensive, but there is also software based solutions to do them for less money. I am not sure your salary has much to do with whether it is worth it. If your income is high, you can't write off passive loss from real estate (if that is what you were hoping for). It is really a question of property value and property income. Also remember with acceleration, you are not getting more expense, you are just getting it sooner, which means less write off later. I looked into doing it on some properties and the gain was marginal. I thought the deprecation needed to be figured out when the property is put in service. I didn't know you could change depreciation methods mid-stream.
- Investor · Carolina Beach, NC · Member since 2018 · 188 posts · 377 votes6y
@Joe Splitrock. Right, you just accelerate the depreciation, but once you depreciate the entire value, you can 1031 exchange into another property. It’s a Strategy used by a lot of physicians since 2017, you can write off tremendous amounts of high W2 and 1099 income. And it’s not passive, it’s no longer passive income once you have REPs status, that’s a real estate professional with more than 750 hours a year
- 6yYonah WeissPro MemberCost Segregation Expert and Investor · Lakewood, NJ · Member since 2017 · 1k+ posts · 1k+ votes
@Clint Harris you are correct about your assumptions, and you may very well have benefit since your wife is a REP. The expense of a proper cost seg study, may be minimally a few thousand dollars, so that might be what your accountant was referring too. However it's more likely that he hasn't had other clients use cost seg for a decade, if ever.
A friend of mine wrote a blog post all about cost seg. What was most interesting to me was he also stated in the article, that the can be very expensive and he wrote "$10,000-$25,000", I called him out on it saying that it hasn't cost that much for over a decade in the industry, and asked where he got his data from (since a few months prior I sat down with him and answered all of his questions about cost seg). He pointed me to a Journal of Accountancy article written in 2006 😂
- 6yYonah WeissPro MemberCost Segregation Expert and Investor · Lakewood, NJ · Member since 2017 · 1k+ posts · 1k+ votes
Originally posted by @Joe Splitrock:
Depreciation does need to be figured out when you place the property in service, but you can change that at any point in the future by filing a form 3115 (change of accounting method), which will allow you to also make an adjustment, and 'catch-up' any accelerated depreciation that was missed in previous years.
- 6yBernard ReiszPro MemberCPA delivering RE Tax Tools: 1031 Exchange, SDIRA, 401(k), Cost Seg · New York City, NY · Member since 2017 · 581 posts · 563 votes
Kudos to @Clint Harris for using a well-thought-out strategy! The only iimpediment to executing your strategy appears to be misinformation supplied by a service-provider - and, now that @Yonah Weiss has chimed in, you can connect directly with the highest-quality cost seg resource available!
- 6yYonah WeissPro MemberCost Segregation Expert and Investor · Lakewood, NJ · Member since 2017 · 1k+ posts · 1k+ votes
Originally posted by @Bernard Reisz:
Kudos to @Clint Harris for using a well-thought-out strategy! The only iimpediment to executing your strategy appears to be misinformation supplied by a service-provider - and, now that @Yonah Weiss has chimed in, you can connect directly with the highest-quality cost seg resource available!
Appreciate the kind words Bernard!
- 6yDaniel HymanBusiness MemberCPA · Milwaukee, WI · Member since 2016 · 2k+ posts · 1k+ votes
I agree that cost seg studies can be a significant investment of funds. Sometimes, the benefit of that investment is minimal. At other times, the benefits can be huge. This is not a "one size fits all" strategy.
@Yonah Weiss is one of the nation's experts in cost seg. It would be a good use of your time to see if he can help you out directly.
My Online Accountant572 Reviews - Rental Property Investor · Sioux Falls, SD · Member since 2015 · 9k+ posts · 18k+ votes6y
Originally posted by @Clint Harris:
@Joe Splitrock. Right, you just accelerate the depreciation, but once you depreciate the entire value, you can 1031 exchange into another property. It’s a Strategy used by a lot of physicians since 2017, you can write off tremendous amounts of high W2 and 1099 income. And it’s not passive, it’s no longer passive income once you have REPs status, that’s a real estate professional with more than 750 hours a year
Keep in mind that when you do a 1031 exchange, you transfer the "used depreciation". Assuming the new property has higher value, you can depreciate the difference. You need to keep buying more expensive properties and each time you have less and less depreciation to offset income. It is not as great as you think it is.
Sorry I didn't catch the part that your wife is a real estate professional. Keep in mind the 750 hours a year is only half the test, you also need the majority of your activities to be real estate. In other words over half your time must be spent on real estate activities.
- 6yMichael PlaksPro MemberTax Accountant / Enrolled Agent · Houston, TX · Member since 2014 · 5k+ posts · 6k+ votes
It could be worth it for a beach duplex, and with your wife qualifying as RE Pro (per your statement, and I hope she does qualify). Get a quote from @Yonah Weiss and then a second opinion on feasibility and on RE Pro from someone who specializes in real estate.
- Investor · Carolina Beach, NC · Member since 2018 · 188 posts · 377 votes6y
Really appreciate your input Yonah, once I’ve educated myself a little bit on the subject, you are exactly who I was hoping to speak with, you beat me to it! Love the new FB group and Weiss Advice was my next stop after BP. Thanks!
Originally posted by @Yonah Weiss:Originally posted by @Joe Splitrock:
Depreciation does need to be figured out when you place the property in service, but you can change that at any point in the future by filing a form 3115 (change of accounting method), which will allow you to also make an adjustment, and 'catch-up' any accelerated depreciation that was missed in previous years.
- Investor · Carolina Beach, NC · Member since 2018 · 188 posts · 377 votes6y
Yep, good points, I’m sure it could be a slippery slope that catches up eventually if not used for the right assets. Wife is a full time realtor, we are investors with 5 owned STR units, 4 in arbitrage, and 18 under management, so shouldn’t have an issues with REPs, believe that should more than meet the qualifications.
Originally posted by @Joe Splitrock:Originally posted by @Clint Harris:
@Joe Splitrock. Right, you just accelerate the depreciation, but once you depreciate the entire value, you can 1031 exchange into another property. It’s a Strategy used by a lot of physicians since 2017, you can write off tremendous amounts of high W2 and 1099 income. And it’s not passive, it’s no longer passive income once you have REPs status, that’s a real estate professional with more than 750 hours a year
Keep in mind that when you do a 1031 exchange, you transfer the "used depreciation". Assuming the new property has higher value, you can depreciate the difference. You need to keep buying more expensive properties and each time you have less and less depreciation to offset income. It is not as great as you think it is.
Sorry I didn't catch the part that your wife is a real estate professional. Keep in mind the 750 hours a year is only half the test, you also need the majority of your activities to be real estate. In other words over half your time must be spent on real estate activities.
- 6yYonah WeissPro MemberCost Segregation Expert and Investor · Lakewood, NJ · Member since 2017 · 1k+ posts · 1k+ votesNo problem Clint. Happy to answer any questions you may have. You know where to find me :)
Originally posted by @Clint Harris:
- 6yBernard ReiszPro MemberCPA delivering RE Tax Tools: 1031 Exchange, SDIRA, 401(k), Cost Seg · New York City, NY · Member since 2017 · 581 posts · 563 votes
@Raj Kapur Loaded question!
Short answer: Cost seg deductions from real estate rental assets are subject to Passive Activity Loss Limitations. Must you be a Real Estate Professional (for tax purposes) to benefit? Not necessarily, but very likely that you do; if your income is between 100k-150k and you "actively participate," you may be able to deduct up to 25k.
- 6yMichael PlaksPro MemberTax Accountant / Enrolled Agent · Houston, TX · Member since 2014 · 5k+ posts · 6k+ votes
Look at this thread if not already https://www.biggerpockets.com/...
As to your question - you do not need to be RE Pro for cost segregation. All cost segregation does is increasing your depreciation deduction. Whether or not you can benefit from a higher depreciation deduction is a matter of your overall numbers: total income and total rental losses. But if you're already limited in taking rental losses, then the extra depreciation obtained thru cost segregation will not help unless you're a RE Pro.
- Investor · Clarksville, MD · Member since 2020 · 9 posts · 6 votes6y
@Bernard Reisz thank you for the clarification. @Michael Plaks thank you for the link to the thread - it clarified the cost segregation scenarios really well!
- Investor · USA · Member since 2015 · 168 posts · 243 votes5y
Hi @Michael Plaks, You said " All cost segregation does is increasing your depreciation deduction". I think that is only partial true, right? Cost segregation not just increases the depreciation deduction, also converts partial or all " Section 1250 Gain" to long term capital gain.
For example, an appliance costs $2000, if it is depreciated together with the building at 27.5 year, then the depreciation recapture will be " Section 1250 Gain", taxed at maximum of 25%.
However, if it is depreciated separately as personal property, though the deprecation recapture will be " Section 1245 Gain" and be treated as ordinary income, but because personal property like appliance will only have minimal value when we sell it, let say it worth $100, so we only need to recapture the $100 as ordinary income, the other $1900 is effectively converted to long term capital gain.
So I think one benefit of the cost segregation is that it can convert " Section 1250 Gain" to long term capital gain, which is still a big benefit.
Am I right? Not a CPA, just an ordinary investor, not sure whether I understand it correctly or not. Please correct me if I am wrong.
Thanks!
- 5yMichael PlaksPro MemberTax Accountant / Enrolled Agent · Houston, TX · Member since 2014 · 5k+ posts · 6k+ votes
You opened a can of worms :)
Thumbs up for getting into these high-end technicalities and understanding the basics. You're on the right track, but this track does not necessarily lead to the conclusion you made.
1. Your example would be close to accurate if this appliance was depreciated down to zero without cost seg. Instead, it would only depreciate at about 3% per year. So after 3 years, without cost seg, you will only have $200 of Sec 1250 recapture. With cost seg, you convert $200 of Sec 1250 recapture into $100 of Sec 1245 recapture plus $100 LT cap gain. Considering that 1250 is capped at 25%, and 1245 is not, the net effect could be zero. And even if it's positive, it's not material with these numbers. (And what if that appliance is worth $200 and not $100 at sale?)
2. I'll add another quirk. There's a possibility of rate arbitrage if you're able to deduct depreciation at an ordinary rate higher than the 25% 1250 recapture ceiling and then recapture it at 25%. But, just like your "conversion" argument, it assumes so many different factors that using this for tax planning is kind of pointless. What if your income and tax bracket changes significantly from year to year? What if all tax rates are revised by new legislation? What if your filing status changes? Etc.
3. All these deductions do not exist in vacuum. Imagine that you're doing a 1031 exchange. Imagine that you also have suspended capital losses from something else. Imagine that you had suspended passive activity losses. Any of these situations, along with another dozen of what-ifs, can totally disrupt the result happening at sale. In either direction.
Bottom line: while technically correct, your argument is not a strong argument for cost seg. Sometimes it can indeed add icing to the cake. In other situations, it can be useless or even counter-productive. Like a lot of other tax planning ideas. Tax planning is only as good as the underlying assumptions about the future.
- Investor · USA · Member since 2015 · 168 posts · 243 votes5y
Originally posted by @Michael Plaks:
You opened a can of worms :)
Thumbs up for getting into these high-end technicalities and understanding the basics. You're on the right track, but this track does not necessarily lead to the conclusion you made.
1. Your example would be close to accurate if this appliance was depreciated down to zero without cost seg. Instead, it would only depreciate at about 3% per year. So after 3 years, without cost seg, you will only have $200 of Sec 1250 recapture. With cost seg, you convert $200 of Sec 1250 recapture into $100 of Sec 1245 recapture plus $100 LT cap gain. Considering that 1250 is capped at 25%, and 1245 is not, the net effect could be zero. And even if it's positive, it's not material with these numbers. (And what if that appliance is worth $200 and not $100 at sale?)
2. I'll add another quirk. There's a possibility of rate arbitrage if you're able to deduct depreciation at an ordinary rate higher than the 25% 1250 recapture ceiling and then recapture it at 25%. But, just like your "conversion" argument, it assumes so many different factors that using this for tax planning is kind of pointless. What if your income and tax bracket changes significantly from year to year? What if all tax rates are revised by new legislation? What if your filing status changes? Etc.
3. All these deductions do not exist in vacuum. Imagine that you're doing a 1031 exchange. Imagine that you also have suspended capital losses from something else. Imagine that you had suspended passive activity losses. Any of these situations, along with another dozen of what-ifs, can totally disrupt the result happening at sale. In either direction.
Bottom line: while technically correct, your argument is not a strong argument for cost seg. Sometimes it can indeed add icing to the cake. In other situations, it can be useless or even counter-productive. Like a lot of other tax planning ideas. Tax planning is only as good as the underlying assumptions about the future.
Hi Mike, thank you very much for your detailed analysis and all three pointes are great and I can understand them.
Here is my own situation. My current marginal tax rate is just 12%, and my future family W2 income will be even lower because we plan to retire in a few years. I do have a sizable rental portfolio currently does not have much cash flow, but once I stop cash out refinancing and expanding, I expect cash flow will get better.
I bought a property last year with depreciable basis a little bit of over $500k. If I do a cost segregation it probably can separate about $120k as personal property, which can lower my tax by $10k(plus some loss carry forward) for 2020. Though I am not a real estate professional but I sold a property last year with about $60k long term capital gain and $20k Section 1250 Uncaptured deprecation.
Eventually I will sell the property.
If I hold the property long enough to 28 years and all deprecations are used up, that case obviously favors the cost segregation because:
- Without cost segregation will got $120k Section 1250 Gain
- With cost segregation will got $120k LT capital gain.
However, realistically I probably will hold only half that long, probably 15 years. Let’s say I will hold 14 years and only half of the deprecations are used up for building, in that case:
- Without cost segregation, depreciated $60k for 14 years, will get $60k Section 1250 Gain
- With cost segregation, depreciated $120k for 1~14 years, will get $120k LT capital gain
That’s the choice I need to make, and still hesitating whether worth the trade...
Again, thanks!
- 5yMichael PlaksPro MemberTax Accountant / Enrolled Agent · Houston, TX · Member since 2014 · 5k+ posts · 6k+ votes
You acknowledged being in agreement with my points. Well, one of them specifically objected to the word "obviously" you used in your reply to me, and the other questioned the value of a 15-yr plan during the times when we can only plan the next hour, if that far. :) Tell me what rates we will have in 15 years, for starters.
The way I might evaluate your decision is this: it saves me $10k today minus the cost of the cost seg study itself. Even if I have to repay the entire $10k 15 yrs later, the time value of money plus inflation should be more than worth cost seg today.
Of course, this is not tax advice, because you're not my client, and I do not know nearly enough about your situation to issue a responsible recommendation.
- Investor · USA · Member since 2015 · 168 posts · 243 votes5y
@Michael Plaks, thank you very much!
- 5yJulio GonzalezPro MemberSpecialist · West Palm Beach, FL · Member since 2008 · 4k+ posts · 1k+ votes
Clint .. based on your circumstances, a cost segregation would be a great value and investment. Costs are reasonable and tax deductible as well. I'm happy to give you a quote!
- Member since 2022 · 1 post · 1 vote3y
We do offer an upfront no charge Cost Segregation Benefit Analysis so that our clients have a good understanding of the additional cashflows and accelerated depreciation the study would provide. For houses and condos our fees range from $950-1900 depending on the size of the residence and site improvements. Note, these are fully engineered studies meaning we breakout all 5, 15 and 27.5 year components specific to the property. Some firms only breakout the 5 & 15 year components or generalize the 27.5 year items. This is important for longterm benefit and disposition purposes. Ie. retiring replaced roof systems, ac units, carpet, lighting etc.
Our goal is to carve out between 32-36% of a property's depreciable basis for accelerated depreciation.
Example of Cost Segregation benefit: Purchase 220,000- Land 44,000, Basis of improvements 176,00 X 32% average to carve out for accelerated depreciation= 56,320 X your estimated tax rate 28%= 15,769 cash value created by Cost Segregation study
We complete studies for every income producing property type. From condos, houses, office/ warehouses, medical to $400MM mixed-use communities. We have completed thousands of studies over 14 years.
- 3yBasit SiddiqiBusiness MemberAccountant · New York, NY · Member since 2015 · 8k+ posts · 3k+ votes
There are a lot of DIY cost segregation companies that can be very affordable.
When you pick an accountant, you want that accountant to have great references such as cost segregation companies.
Basit Siddiqi CPA4.979 Reviews
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