IRS finalizes Cost Segregation Rules (and timeline)
Specialist · Scottsdale, AZ · Member since 2020 · 9 posts · 36 votes
The treasury dept and IRS just released the final set of regulations for the popular 100% bonus depreciation schedule.
And great news for the Real Estate pros trying to avoid taxes... the “placed in service” date was extended to January 1st 2027 (2028 for certain longer production property)
So... you can keep up this new winning strategy... and avoid paying taxes for the next several years.
The Tax Cuts and Jobs Act of 2017 increased the first year Bonus Depreciation deduction percentage from 50% to 100%.
That means... taking advantage of a Cost Seg Study... you can buy a building, front-load 20%-40% of the total depreciation to the first year. Then, you can use all that tax liability you just avoided, to go buy another building. Hit repeat. And, avoid a ton of taxes every year while building a massive real estate portfolio.
Good news on the bonus extension for sure.
But I would be more careful hyping up cost segregation as universal tax avoidance. It's a great strategy in some situations, not all.
I wrote about it before if you want so see my position: https://www.biggerpockets.com/...
Good news on the bonus extension for sure.
But I would be more careful hyping up cost segregation as universal tax avoidance. It's a great strategy in some situations, not all.
I wrote about it before if you want so see my position: https://www.biggerpockets.com/...
As previously indicated Cost Segregation is appropriate in certain situations, but certainly not all. Just so folks don't misinterpret this, I initiated Cost Seg consulting projects for a professional firm I worked with many moons ago now (long before it became a chic topic), so I have no axe to grind. However, often missed is that Cost Seg has its own costs and is primarily only a timing benefit, a benefit that can be meaningful for some, but again not necessarily all.
Small investors are probably better served by focusing on sound project economics first. Get the economics right and the tax benefits will typically follow. So sure take advantage of all the tax benefits you can that goes without saying. However, don't make them the focal point of your investment strategy.
@Michael Plaks
Thanks Michael for commenting.
I read your article and feel bad about how your client was treated. I obviously can’t justify the work of a company like that. I hate when companies take the tax write off and times it by 37% (the highest tax bracket) to show how much they can save.
And of course I don’t think Cost Seg is the only tax strategy. But it’s a great one.
A couple things to consider for Paul: (I think that was the clients name in that article)
1) If he is trying to eliminate 100k in tax liability owed to the IRS, he should have picked a Cost Seg that would have worked with you (the CPA) to figure out exactly how many houses were needed to Cost Seg to counter that number. Then hit repeat each year. There was overkill in that example you gave. Take that away and the situation gets a lot better.
2) You mentioned that Bonus Depreciation is just depreciation that you would get anyway over 27.5-39 years. Of course that’s true. However, there is a real benefit to front-loading that depreciation.
As a real estate professional who just avoided paying the IRS 100k, Paul can take that cash and buy more property to generate more income and avoid more taxes.
If you consider the future value of a lump sum... avoiding 15k in tax liability today vs 27 years later means that $15,000 today is worth more than $61,000 twenty-seven years from now at 5.25% interest.
If done correctly, Paul could avoid paying that 100k this year and for the next several years. Along with increasing the size of his portfolio and generating more income in the future.
Let’s say he avoids 100k or more for the next 5 years. That’s half a million bucks. Sounds pretty awesome to me.
Agreed on your points, except on your belief that my client could have erased $100k this year. He could only do it partially, even despite qualifying as a RE Professional, using cost seg and otherwise being in a favorable position.
My beef with your cost seg peers is this unmitigated optimism that your strategy (which I love and recommend when applicable) magically wipes taxes for everyone. Maybe not a belief, but a notion that drives your marketing.
I honestly prefer someone saying: "I have a great tool. Let's see IF it can help you" instead of "I have a great tool that will deliver the humanity from taxes, hop onboard." I mean it in a friendly way.
@Michael Plaks
I love it! Great insight.
Out of curiosity, why couldn’t he attack that remaining tax liability with Cost Seg?
Out of curiosity, why couldn’t he attack that remaining tax liability with Cost Seg?
Because he would need to have $300k-$500k worth of accelerated depreciation which he did not have room for and because, even if we could generate it, it was not compatible with his overall long-term strategy. Reducing taxes is great but it's only a part of a business plan.
Good discussion! @Michael Plaks I also read your other thread you shared.... some very good things to be aware of and make sure of what is being 'sold to you'.
I am wondering in VERY general terms if doing a CSS would be beneficial in the way I am thinking for a situation I have in mind.iIf I have a Traditional SOLO401K that owns a property worth say 400K that I owe 300K, so 100K of equity in and I want to convert it to a ROTH SOLO401K.
I also have some 'cash properties' that I bought for say 500K that I have 400K of basis in that if I did a CSS on I could accelerate 100K of depreciation.
I am thinking that the 100K of accelerated depreciation would 'offset' the 100K of Net Equity in the SOLO401K that would be taxable if converted to a ROTH.
In VERY general terms, would that be a logical use of a CSS? Income is WELL under 150K if any losses are created and in the low end of 22% bracket. One other reason I am considering this is that I am working on buying another 600K of rentals in the SOLO401K, and I would like to convert it BEFORE I make that purcase.
Thoughts? Thanks, Dan Dietz
@Michael Plaks
Yeah, poor guy. He got Cost Seg studies on 20 houses and couldn’t generate 300k in depreciation?!?
If the houses were worth an average of 200k each... he should of generated around 1.2 million in Bonus Depreciation. (Meaning, he should have only needed 4-6 cost Seg studies each year... increasing as he generates more wealth from the more property he buys with the 100’s of thousands of dollars in taxes he is avoiding)
That sucks, I feel awful for him.
I do not intend to continue this back-n-forth. The reason for me to exit this discussion is the fundamental difference in how we look at things. You're a cost seg salesman, and you're appropriately promoting its potential benefits. I'm a tax accountant, and I take a holistic approach to my clients' taxes and finances, so I balance a lot more considerations than you. I extract applicable benefits from cost seg, and it's case-by-case, not general like in your presentations.
Potential v. applicable is where we diverge. We do agree though that cost seg is very powerful when used correctly.
Before withdrawing, I will point out several things that make your simplistic take on cost seg inapplicable for the specific client we are looking at and maybe for others.
1. His average basis is $100k. Using your 20%-40% ballpark (even though 40% on an old SFH is a stretch, in my opinion), we get about $30k per house. It would take him 10 houses to hit $300k of depreciation.
2. You're making the same crucial misrepresentation as the cost seg company my client hired: The benefit of cost seg is not the depreciation available, but depreciation available over and above what can be taken without cost seg. His $100k tax bill was after significant depreciation has already been taken. So he would need $300k extra depreciation from cost seg - i.e. more than 10 properties.
3. Date in service matters. Some of his houses were placed in service before the 2018 reform, when 100% bonus was not available. Other houses have not been placed in service until the following year, so their cost seg benefits are on hold.
4. Maximizing depreciation is usually a worthwhile goal to pursue. Usually, but not always.
5. Often, passive activity loss rules eliminate the benefits of cost seg. My client qualified as a Real Estate Professional, so he did not have this problem, but many investors do.
6. I object to your strategy of doing partial rolling cost seg, as in 4-6 properties per year. I believe it to be in violation of the concept of accounting method change, in other words prohibited. If you buy 4-6 new properties each year - sure. But I don't think you can own 30 existing properties and gradually cost seg them over several years in groups of 5. I may be wrong on this one, and I welcome the input from my colleagues on this specific issue. @Yonah Weiss - what say ya?
I wish you and your company success, Tyler. In case it's not clear: I'm generally IN FAVOR of cost seg, and I recommend it to my clients. But only after a thorough in-depth analysis, because one size doesn't fit all. Heck, after this quarantine, nothing fits anymore.
I am wondering in VERY general terms if doing a CSS would be beneficial in the way I am thinking for a situation I have in mind...
...I am thinking that the 100K of accelerated depreciation would 'offset' the 100K of Net Equity in the SOLO401K that would be taxable if converted to a ROTH...
...In VERY general terms, would that be a logical use of a CSS? Income is WELL under 150K...
Thanks for the compliment, Daniel. I'll start with a cliché: we cannot productively discuss taxes "in very general terms." I wish. Everything is case-by-case.
I'll point out two flaws in your thinking. One is that you must add the Roth conversion income first, before calculating allowable deductions. For example, if your income is currently $100k which allows you $25k of rental losses, you start by adding $100k of Roth conversion income. Now you have $200k income, above $150k, so you can take NONE of the rental losses, with or without cost seg. (If you qualify for RE Pro - a different story.)
The second mistake is that even if you stay under $150k, your potential loss is limited: no more than $25k until income hits $100k and then gradually phased out to zero between $100k and $150k. You can never take an extra $100k from cost seg, unless you're a RE Pro or you sold some properties for a gain or some other special situation applies.
And due to the unlimited number of possible what-ifs, questions like yours cannot be correctly resolved with a quick online post. This calls not just for a tax accountant but for a tax strategist to figure out the best way to move forward in your situation. And if you need one - you know who is who on this forum. :)
@Michael Plaks
No need to continue the back-and-forth
I thought we were simply having a discussion. I’m sorry if I offended you. I was honestly just curious about this situation.
And let me be very clear, my company always treats each client on a case by case situation. We love turning away potential customers who wouldn’t actually be able to take advantage of a Cost Seg. (I did it today for a woman in California, who didn’t understand passive vs active income)
The only reason I am speaking in “general” or “simplistic” terms here (as you described them) is because I don’t know all the information. But, I was asking about it because I truly was interested. I wanted to know more. I enjoy learning about various situations in our industry.
1-2) I had no idea he was trying to cost seg 20 100k dollar houses... that’s not something we’ve ever done.
3) Of course date in service maters, but this forum was about the 2017 tax law, and assumed we were talking about the benefits of Bonus Depreciation.
6) You can absolutely put a plan together to gradually cost seg properties as needed (rather than carry forward the depreciation) and rather than trying to buy multiple residentials in the future, you could also look at multifamily or other commercial options as the portfolio grows.
Thanks for the kind words. I wish you success as well. And I hope you continue to recommend Cost Seg Studies as a small weapon in your arsenal to help your clients.
I also hope your clients never hire a cost seg company like that one from your example, and from here on out they deal with companies that treat every client as a case by case specific customer.
Goodie. Cost segs make 1031 exchanges obsolete for syndication investors.
Thanks for the tag @Michael Plaks! First of all, this thread looks like a marketing piece.
Nothing really changed from the proposed regs that we have all been working with since the TCJA at the end of 2017 until now...they just became finalized. Big news?
To answer your question about the SFHs:
6. I object to your strategy of doing partial rolling cost seg, as in 4-6 properties per year. I believe it to be in violation of the concept of accounting method change, in other words prohibited. If you buy 4-6 new properties each year - sure. But I don't think you can own 30 existing properties and gradually cost seg them over several years in groups of 5. I may be wrong on this one, and I welcome the input from my colleagues on this specific issue. @Yonah Weiss - what say ya?
I agree with @Tyler Baldwin on this, I don't see a reason that someone cannot choose to depreciate some properties without cost segregation, and then file 3115 in future years to capture the depreciation then. I would love to hear any insight anyone else may have on this subject.
@Michael Plaks
I read your article and would like to weigh in on a few items.
First, I am 100% with you on a CSS reporting a “tax savings.” A CSS and cost segregation company does not have all the appropriate information to report a “tax savings.” This is especially true for multiple year projections.
Second, you have a great handle of accelerated depreciation as a tax concept, but some misunderstanding of their practical uses in advanced corporate finance. Let me explain.
Acceleration of depreciation is not “robbing” from future years. For your academic exercise to work, there are two variables you must hold constant.
1. A constant tax rate
2. A single purchase
When you relax these, laboratory style variables, you find that tax timing is intensely important. For example, a business owner has 5 years to retirement and makes $350k per year. Accelerating depreciation for those 5 years would defer high tax income years. The depreciation would fall off after the 5th year, but so would the tax bill. This is not “robbing” from future years.
Second, even if the tax rate stayed constant, repeating the purchase of property every few years would defer taxes as long as the purchases continue. This is a higher level of corporate finance, and a very effective tool. For example a property purchase gives accelerated depreciation deduction of $30k per year for 5 years. At the five year mark, the owner makes a second purchase of the same amount receiving another $30k per year for another 5 years. Then at the 10yr mark you make a third purchase and so on. This gives you an ongoing deferral of taxes.
Finally, I take exception to your categorization that @TylerBaldwin is “just a salesman” and you are some wholistic truth teller. Especially when you ask another “salesman” to weigh in. Unless you are running a non-profit, you are as much of a sale-person as anyone else. And just because we “sell a product” does not me that we don’t look out for the best interest of our clients or that we don’t a strong grasp of the concepts to which we speak. I believe you owe him an apology.
Goodie. Cost segs make 1031 exchanges obsolete for syndication investors.
Hi Lane, this sounds very interesting. As I consider you a syndicator that has my respect and admiration, I was hoping you could provide some more details? I've looked a lot of syndication deals the past few years and I always thought the vast majority of syndicators do not utilize 1031 anyway? The only syndicator that comes to mind that actually does 1031 from one deal to another is a prominent syndicator located in San Diego, but that is only viable because their waiting list is a mile long and they have enough repeat heavy hitters to justify the additional work required.
Also, while I agree that cost segs provide a front-loaded benefit to syndicators, won't most of that benefit be paid back when the investment goes full cycle? I'm having trouble seeing how that will make 1031 exchanges obsolete? Thanks.
@Yonah Weiss @Michael Plaks Regarding the "rolling CSS w/ 3115's", I have done this. It is of particular value when a property sponsor may have an equity partner that does not see value in depreciation (perhaps they have built up NOLs, will be in the property short term, or are tax exempt). Maybe this equity partner is in on 5 properties, and you obtain CSS in the first year of ownership, but buy out the partner over 0-5 years. Why would you implement the CSS while still in the partnership? A lot of that depreciation would just go to waste. And while I bet this could be remediated by putting in a special allocation provision to the partnership, doing so would be painful to explain and probably not meet economic substance standards.
Another reason to "delay" implementing CSS: NOLs are currently limited (well, not for the moment b/c of CARES Act). There is no reason to "stockpile" NOLs - you can otherwise pull those levers (the levers of CSS and bonus) only when you need it. If not, excess NOLs will be subject to the limitation, and not be monetized to their full potential.
Is there a negative to front loading depreciation and using that money to buy another property? Let's say you do that for a few years. Then you are left with a bunch of income producing properties and you lost half of your biggest deduction - depreciation. It is fine if you budget for the taxes, but this isn't a free ride or tax avoidance. I like to maximize deductions, but I have looked into using cost segregation on my $200K houses and I couldn't see the huge advantage. Not for the cost of the study and the realistic percentage I could accelerate. I see cost segregation as a better strategy for larger multifamily.
I would say talk to your tax accountant and make sure this is the best strategy for you. Anyone selling cost segregation services should identify as such in the discussion. Debating strategies is great, but understanding where everyone fits in helps put things in context too.
Finally, I take exception to your categorization that @TylerBaldwin is “just a salesman” and you are some wholistic truth teller. Especially when you ask another “salesman” to weigh in. Unless you are running a non-profit, you are as much of a sale-person as anyone else. And just because we “sell a product” does not me that we don’t look out for the best interest of our clients or that we don’t a strong grasp of the concepts to which we speak. I believe you owe him an apology.
Seriously? A celebrity TV host and business professional like Tyler needs his big brother (or coworker, whatever) to defend himself? We had a mutually respectful discussion with him just fine. I don't owe anybody anything, but if Tyler feels offended for some reason - I suppose he could request an apology without a proxy.
I did not call Tyler "JUST a salesman", I called him a salesman and complimented him to boot. I find nothing offensive in this word. As you correctly pointed out, I am a salesman myself, and so are you. If you're so sensitive about this word, maybe it's not the best career choice.
Yes, I tagged another cost seg professional in the context of a very specific technical question, hoping to get helpful input on something I was not sure myself. If seeing a competitor on an online thread threatens you so much, again, maybe it's time to reconsider your career.
Speaking of an apology, maybe you owe me one, considering your condescending tone? But please don't bother. This forum is not for personal dustups, particularly completely made-up ones. I had nothing against your friend Tyler and did not see anything personal from him, likewise. Peace.
@Yonah Weiss @Michael Plaks Regarding the "rolling CSS w/ 3115's", I have done this. It is of particular value when...
Gentlemen, I did not question the usefulness of this strategy. I questioned its legality. Just because you have done it, does not automatically mean that it is allowed. And let's be clear - I do not know. Maybe it is legal, and maybe not. You have not answered this so far, either. You assume it is, but I'm not sure.
Here is my thinking, and it could be wrong. When you file 3115, you're requesting the IRS to grant an (automatic) permission to change your accounting method with respect to depreciation. If you have 30 properties, and you're applying cost seg to only 5 of them, you're requesting a permission to adopt a new accounting method for 5 of your properties but keep the old one for the other 25. I'm already slightly uncomfortable with this, but it probably does not violate the letter or the spirit of the law. I said probably, as I have not researched it.
But now next year you're requesting a similar permission again, this time to apply it to another set of properties. It feels like the first time it was requested in bad faith. You requested a new method but applied it selectively. Repeating myself: I am not sure, and I currently do not have time to research it. I just refuse to simply assume that it is OK without legal support for this position.
Finally, if these groups of properties were split between multiple entities - then sign me up. I see no issue with changing an accounting method for one entity but not for the other(s).
Whoever is the first to research this, you, me or someone else - please chime in. Especially if you already know the answer.
@Michael Plaks
There is nothing to suggest that grouping activities would prevent a change of accounting, automatic or otherwise. The IRS is clear that they allow different types of accounting for different types of inventory. A company can use LIFO for one product and FIFO for another. In fact, the preferred method is actual costs.
As for real estate inventory, there is nothing that specifically suggests real estate grouped for economic purposes is excluded. The intention of the grouping activities is to identify the PAL. Activities, both passive and active, do not forfeit their rights to change accounting methods.
Furthermore, grouping activities doesn’t aggregate the real estate portfolio on the IRS form 4562. Each property still holds their own depreciation schedule, regardless of grouping activities.
The lack of an exclusion of real estate in the regulation and the presence individual depreciation schedules, even for grouped activities, strongly suggests the is no merit to your concern.
Thank you for sharing your opinion. Unfortunately it is just an opinion, and so is mine. I'm not sure in mine, and I'm not sure in yours. Possibly you are correct, in fact I hope that you are correct, as this would be beneficial to some clients.
When I have time, I will try to find an authoritative answer if it exists. If I find it, I will share. Please do likewise if you happen to find a published IRS guidance or a court case that validates your opinion.
I'll be holding my breath...
Is there a negative to front loading depreciation and using that money to buy another property? Let's say you do that for a few years. Then you are left with a bunch of income producing properties and you lost half of your biggest deduction - depreciation. It is fine if you budget for the taxes, but this isn't a free ride or tax avoidance. I like to maximize deductions, but I have looked into using cost segregation on my $200K houses and I couldn't see the huge advantage. Not for the cost of the study and the realistic percentage I could accelerate. I see cost segregation as a better strategy for larger multifamily.
To your point of whether there is a negative to front-loading depreciation and using the savings to grow your portfolio. This is not much different from any other form of leveraging. After all, this is basically a leveraging strategy. Subject to multiple possible "but"s, it could be very effective. Of course, everyone's situation and business goals are different, so it may not be a good move for some investors.
As to the cost effectiveness for inexpensive SFH - generally a full-service CSS is not, unless it's done for a portfolio, reducing the per property cost. However, there're affordable DIY alternatives that use generalized computer models in lieu of traditional on-site studies. Here're two such options to consider:
https://www.kbkg.com/residential-costsegregator
https://diycostseg.com/
@Michael Plaks
Again you are misguided in your understanding of how cost segregation works. Using your example, you paint a negative that this investor was able to acquire multiple properties that are high income paying because he had excess cash from cost segregation? In what world is that a bad thing? Also, how many 7 year cycles does a person have to complete before retirement? 2 or 3, if they are lucky to be young enough. It is tax reduction if you depreciate in high income years and lose that depreciation in low.
Cost segregation is not at all like leverage. Leverage is borrowing money to purchase more than you can purchase on your own. Changing how you account for property you own is not leverage. The timing of depreciation is a strategy used by virtually every corporation on the planet and we believe regular investors should be able to use this technique as well.
And let’s be clear, when the IRS comes knocking because a tax payer used a “diy” strategy, you will not be there to help them, free of charge of course. But I’m sure your IRS agent will allow you to just change your numbers after you receive the audit notice. “Hold on, before the audit, I’m really going to do the cost segregation now.” See how that goes over.
Cost segregation is a strategy. It is complex, but highly beneficial. The work that goes into them is worth far more that anyone charges. It’s not a magic bullet, but it is highly effective.
The second mistake is that even if you stay under $150k, your potential loss is limited: no more than $25k until income hits $100k and then gradually phased out to zero between $100k and $150k. You can never take an extra $100k from cost seg, unless you're a RE Pro or you sold some properties for a gain or some other special situation applies.
And due to the unlimited number of possible what-ifs, questions like yours cannot be correctly resolved with a quick online post. This calls not just for a tax accountant but for a tax strategist to figure out the best way to move forward in your situation. And if you need one - you know who is who on this forum. :-)
@Michael Plaks, thanks for the response. I am pretty sure I understand what you are saying about the 'income' from the ROTH conversion has to be added BEFORE the CSS 'deduction' gets applied to determine what the AGI is to determine IF I would be eligible to take up to that 25K loss.
With that said, I *think* I would still be in a good spot. Even when adding my regular income/AGI AND my ROTH Conversion (40K) I would still be under the 100K limit where the phase out starts, probably around 80-90K. THEN I would deduct the first year accelerated depreciation deduction of say 40K and be back to where my AGI was at the beginning.
A lot to think about! I guess I could just pay the tax on the conversion and say the depreciation for down the road too, as I plan to hold these long term. One of the main reasons I want to get the SOLO401K converted is that I am working on 2 different Seller Financing deals that I want to buy with this account, and I would prefer to do that FIRST as their is going to be some nice equity in them.
Thanks again, Dan Dietz