Cost Segregation Discussion

7 Replies | Houston, Texas

Hello all,

I am currently looking to network with commercial real estate investors in the Houston, Tx area. I want to hear opinions on cost segregation and advantages/disadvantages of the process. I enjoy having these conversations as it helps me obtain a broader perspective on the subject. I am also looking to join RICH and it seems like a quality group based upon the reviews on here.

Happy Monday!

Originally posted by @Steven Hume :

Hello all,

I am currently looking to network with commercial real estate investors in the Houston, Tx area. I want to hear opinions on cost segregation and advantages/disadvantages of the process. I enjoy having these conversations as it helps me obtain a broader perspective on the subject. I am also looking to join RICH and it seems like a quality group based upon the reviews on here.

Happy Monday!

Hi Steven,

I'm not from Houston, but I would be more than happy to discuss the advantages and disadvantages of cost segregation. Feel free to PM me. You also have a great accountant out in Houston @Michael Plaks who could help you with that as well. 

Thank you for the mention, @Yonah Weiss .

@Steven Hume - will be glad to share some pointers about Houston networking. RICH is one of the organizations, and there're several others.

As to cost segregation - I'm a big supporter of the concept when commercial properties are involved. Your best source of specific information are BP resident experts: Yonah Weiss and @Paul Caputo .

Thanks for the shoutout @Michael Plaks  

I'd be happy to chat sometime about cost segregation  @Steven Hume , our HQ is outside of Dallas. Michael should be able to point you in the right direction as far as Houston goes, He's been there specializing in real estate taxation there since the 90's! 

There are a lot of advantages to cost seg, the biggest being that you keep more of your money in your pocket instead of sending it to the IRS. In most jurisdictions property taxes are lower on personal property than real property so there's a reduction in property taxes as long as you set that up properly. Another advantage is that with properly done cost seg you're in compliance with the tax code, without cost seg you're not compliant since you haven't properly applied MACRS depreciation. After-tax debt service coverage ratio is significantly increased when applying cost seg, so financing should be easier. 

Only disadvantage I can think of is that there's depreciation recapture upon sale of the property. You're going to have recapture whether you've taken depreciation or not. With cost seg since you've taken more depreciation you'll have more recapture, but there are ways to mitigate this. 

@Paul Caputo

Paul, thanks for the information. My biggest confusion at the moment is how cost segregation affects passive investors and active investors and if it's beneficial for passive investors to purchase a cost segregation study. 

Doing minimal reading, it seems like passive investors don't have anything to gain through this strategy. 

@Steven Hume That all depends on the individual investor. First off a passive investor shouldn't be the one purchasing the cost segregation study. That should be done by the sponsor or whoever is taking the lead on the project. It's really up to them and how the deal is put together if they would bear the cost or somehow pro rate it among the investors. 

If the investor is active for tax purposes or a real estate professional for tax purposes (making anything in real estate that would normally be considered passive an active activity for tax purposes) there's no need for discussion they'd get the full benefit based on their ownership of the deal. Any losses can be taken against other income. No-brainer here.

If the investor is passive and does not qualify as a real estate professional it gets a bit more complicated. If their income is under $100k there's a $25,000 passive loss limitation that fully phases out at $150k income, so its a 2:1 phase out. Anything beyond those limits can be carried forward indefinitely and anything remaining would be fully realized upon sale of the property. 

If a passive investor is in a deal that shows no taxable passive income and has no other passive income then they would see no benefit from cost segregation since the additional depreciation benefit would just carry forward. This situation is rarely the case since a deal has to have income to make sense. I wouldn't invest in a deal that wasn't going to make any money, and I'm sure you wouldn't either. In some cases straight-line depreciation is enough to offset all income to bring taxable income down to zero, but that would be a pretty bad deal since you're looking at about 3.6% straight-line depreciation per year on rentals and about 2.5% straight-line depreciation per year on commercial, which doesn't include land value so the numbers on the whole property are lower. 

Oftentimes passive investors have several passive investments, so losses on one can offset income on the others. So if one investment is really cranking out some good income you can offset it with another investment. The thing people overlook here is that depreciation lowers taxable income. So say you're a passive investor in a property and the passive income is $10k/year, take straight-line depreciation and other deductible expenses to make that $5k/year taxable passive income. With cost segregation you may be looking at a taxable loss of $1k/year for the first 5 years, which carries forward since your total income is over $150k. In the sixth year you can use that built up loss to be at $0 taxable passive income for year six. So without cost segregation you've paid taxes on $30k passive income over those six years. With cost segregation you've paid taxes on $0 over those six years. This is an oversimplified example, but illustrates that it's better to pay taxes on $0 and have losses carry forward to offset future income than to have taxable income in those early years. 

Every property and every deal is going to be different so it needs to be looked at on the individual level, but cost seg will generally benefit everyone involved.

@Paul Caputo  @Yonah Weiss would you recommend investigating a cost segregation report be completed on a new construction small multi-family property? I am in the process of building a duplex - construction costs will be about $230,000 basis in the lot is $20,000. Estimated project completion is first of Sept. I do qualify as a real estate professional. I have good expense/cost data on the building and have been thinking about Cost Seg. I've been told its best to complete the study as early in the process of ownership to achieve maximum benefit. Would an asset of this size typically be worth going through the process? For what it's worth I plan to build an identical duplex on the adjoining lot but it will probably be 6-8 months until I start on that one. 

@Kevin Wattenbarger I usually advise doing a cost segregation when the basis is at least $1M. That being said, there can still be benefit even on a $230K duplex, albeit minimal. With the new tax law and 100% bonus depreciation, you can write off all of the 5 and 15 year assets in year #1. So, if you need the extra deductions to offset other income, it may make sense for you to spend a $2-3K to get a study done. Good luck with the completion!