All Forum Posts by: 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. 

@Karen Chenaille There are definitely people out there who will try the DIY approach with cost seg. The thing is you need to cross your fingers and hope you don't get audited. If the IRS actually looks at a DIY cost seg they'll immediately throw it out without any further review. Thing is reviewing depreciation is about at the bottom of the IRS priorities, so improper cost seg generally flies under the radar. 

The IRS Chief Counsel released a memo stating that to perform cost segregation properly one must have knowledge of construction, construction techniques, design, auditing and estimation procedures. That means generally the only people truly qualified to do cost segregation are construction engineers or architects who have been trained in cost segregation and the pertinent tax code. That's why the first element in a quality study is preparation by an individual with expertise and experience. So a DIY method is not recommended unless you're actually qualified. 

On the surface cost seg can seem simple enough to DIY. Say you remodeled a rental condo and have all the invoices for the rehab. It makes sense that you'd just need to figure out what qualifies for 5, 7 or 15 year depreciation from the rehab, keep the rest of the property on a 27.5 year schedule, setup a depreciation schedule and call it a day right? The problem with that is two-fold: first there are likely existing assets that are not replaced that qualify for shorter asset lives so you're leaving money on the table, and second you have no cost basis for the removed assets replaced in the remodel as they're intertwined with the initial building cost basis so you'd technically still be depreciating retired assets which is tax fraud. 

It's also quite a bit more complicated than "this qualifies for 5 year and this doesn't qualify" since there isn't really a "list of every possible asset and it's depreciation life" most assets that qualify for 5 year fall under asset class 57.0 assets used in distributive trades and services. There are 6 tests called the WhiteCo factors (named after a tax court case on the subject) designed to figure out the permanence of individual assets to see if they qualify for short life treatment. You can even have the exact same asset and in one case it qualifies for 5 year and in another case it doesn't. A simple example is baseboards: if they're considered permanently attached to the wall like being glued on they're treated as a long life asset, it would damage the wall to remove it so it's like part of the wall; on the other hand if it's easily removable like being tacked or nailed onto the wall it qualifies for 5 year. That's just one out of a thousand different nuances that makes cost seg so complex. 

Even among professional cost segregation firms there are huge differences in methodology and accuracy. The IRS describes 6 different methods with varying levels of accuracy. Many cost seg firms use a statistical sampling or computer generated modeling approach which is a bit cheaper since it's less work, but it's inherently inaccurate so it generally leaves money on the table or worse overstates qualifying assets. If that's what you're looking for it may be better to save the money and do it yourself since your guess may be as good as theirs. Accuracy is important so the detailed engineering from actual cost records and detailed engineering using cost estimation methods are the preferred approaches. 

So you can DIY and realistically chances are quite low that you'd have any issues, but if the IRS reviews it the fines and penalties will significantly outweigh saving some money by not having it done professionally plus you're either gonna leave a lot on the table or overstate which is a surefire way to get audited. Having it done right gives you peace of mind on the audit front, you're not leaving money on the table, and the benefits will significantly outweigh the costs usually at least 3 to 1 but oftentimes it's 5 to 1 or 10 to 1 depending on the property. 

@Todd Dexheimer

I'm not a syndicator, but I am a cost segregation expert. 

1. Cost seg should absolutely save money over the hold period. Taxes are decreased significantly which increases cash flow significantly. Without cost seg these tax benefits are often never realized due to short life assets being improperly classified as long life assets. An added benefit is the lower amount of long life real property assets means a smaller property tax bill in most jurisdictions.

2. There are passive loss limitation rules that can affect such investors if their active income is over $100k, unless the qualify as a real estate professionals for tax purposes. If an investor does not qualify as a real estate professional and makes over $150k in W2 income any passive losses are carried forward, so they'd pay no tax on the investment income and have a carry forward to be used in future years as long as the depreciation is sufficient to wipe out investment income. If under $100k active income there's a $25,000 limit on passive losses. That limit phases out from $100k-$150k at a 2:1 ratio. Paper losses from depreciation can also be used to offset other passive income.

3. The downside at sale is depreciation recapture, but profit and capital return at sale will more than cover any recapture in the majority of cases. Recapture will be higher with cost segregation than traditional depreciation, but there will be some level of recapture either way. Partial asset dispositions can significantly mitigate recapture since there's no recapture for retired assets, and if a 1031 exchange is used to exit capital gains and recapture are further deferred until sale without a 1031 exchange. 

Hope that helps! For the vast majority of commercial properties cost segregation is a home run that provides significant benefits to all investor partners.

Natalie Kolodij is right. if you’re just trying to fix depreciation you don’t need to amend your returns, you need to file form 3115. It allows you to catch up on any missed depreciation by using the section 481(a) adjustment. You can only amend the past 3 years, but you can go back much farther with form 3115 to correct depreciation. If the assets are worth enough it would make sense to do a cost segregation study to maximize the depreciation. Most firms will include form 3115 with the cost segregation study.

This is an extremely interesting new wrinkle in the tax code. The forthcoming guidance on this will be very helpful, and by first glance it looks like a huge benefit for savvy investors. Using cost segregation and 100% bonus depreciation in tandem with the OZ seems like a no brainer, but the opportunity for using cost seg’s “little brother” an abandonment study would be perfect for this. An Abandonment study is basically the same as a cost segregation study, but it’s done on a property that will be torn down. You get all the benefits you’d normally get from cost seg, but there’s no recapture since the assets are immediately retired through demolition. Then you build the new property and do cost seg on the new assets as you’d normally do. Done right it’d be a windfall tax benefit and you’re doing your part to revitalize the area! The more I learn about the new tax law, the better it gets for real estate investors.

If he wants to totally divest his US properties there’s another option that doesn’t get much attention here: putting all the assets into a charitable remainder trust. Then he can sell it all to you and virtually eliminate capital gains tax and depreciation recapture. This is tricky to setup, but if done correctly you get the property and he gets the cash tax free over several years with at least 10% going to the charity of his choice. It’s complicated but seems like it might make sense here. I’m not an expert on this, but I know people who are.

@Josh Wallace The depreciation schedule (usually called a Tax Asset Detail, Fixed Asset Schedule or Federal Asset Report) is just the document that shows your depreciation deductions. You don't have a choice about taking depreciation, but you can choose to either take it straight line or use accelerated depreciation. 

Upon sale of a property depreciation recapture applies to the amount allowed or allowable meaning if you didn't take depreciation you will still have to pay the recapture on what you could've taken. 

Here's how the numbers would look. Say you bought a property for $500k and over a number of years took $100k in depreciation. If you're at 35% tax rate that depreciation was worth $35k in tax benefits. Then you sell for $600k. That $100k depreciation is recaptured at 25% so you have to pay back $25k in recapture tax. Then you have a capital gain of $100k as well taxed at capital gains rate of 15% for $15k of capital gains tax. So you have a tax hit of $40k on that sale, but over the years you've gotten $35K in tax benefits from the property and $100k gain. If you didn't take the depreciation those numbers would be the same except no $35k in depreciation benefits. 

If you think about this it makes sense. You get the depreciation deduction because you own the property. When you no longer own it you're no longer entitled to those tax benefits you took when you did own it. Also the time value of money is at play here. Since a dollar today is worth more than a dollar tomorrow the tax hit on sale is worth less in today's dollars and the tax benefits today are worth more in future dollars. 

The practical way to look at depreciation is that without it your current tax bill will be higher, and with depreciation your current tax bill will be lower.

Short answer: it’s unlikely you’ll have any issues since it gets automatic consent form the IRS. Long answer: Cost seg can be done on buildings placed in service since January 1st 1987. So as long as it was purchased or constructed since then there will be no issue. Even if it was built in the 1800’s as long as it was acquired since 1/1/1987 it qualifies. With the cost segregation study and form 3115 you’re all set. The IRS has 30 days to credit the taxpayer account after they’ve received form 3115. You can file it at any point in the year and the adjustment will go against future taxes, sometimes eliminating the next few quarterly payments or more. If you file it with your return you can get a refund check from the IRS, sometimes a pretty big one. It’s very important for it to be filled out correctly so make sure whoever is doing it has experience with the form. Most cost segregation firms complete 100’s of these per year as do some CPAs.

Form 3115 is your best (and only allowable) option here. You’ll get a significant tax benefit from the catch-up depreciation from $0 to the allowable amount. If you filed an extension you still have the opportunity to file it with your return and lower your tax bill or even get a refund. If you file the 3115 at any other time the tax benefits are credited against future taxes which would likely lower or eliminate the next few quarterly tax payments. Another benefit would be that in addition to the 2 units you sold in 2017 you’ll be able to catchup on the remaining units as well. As Michael Plaks said there are several CPAs on BP that can help you with this, but make sure they have experience with the form and real estate knowledge. Their fees will be money well spent in tax savings.

@Account Closed A bit more clarification on cost segregation for this property.

1. Cost segregation is based on the actual cost basis. If the assessed land value is $1.5mm and the building value is $350K your building value ratio is approximately 18.9% of total value ($350K /$1.85mm) A $3mm purchase price raises your building cost basis up from $350K assessed to $567,567 actual. Even though the land value is extremely high, there should be enough assets in $567K to make the cost segregation more than worth your while.

2. As shown above you use a ratio between the assessed values and the purchase price to figure the actual cost basis. Your CPA will generally put together a depreciation schedule showing this prior to filing taxes for the year of acquisition. Cost segregation results in a very detailed depreciation schedule with every asset in the building identified and properly classified. 

Another thing to consider is that the additional cash flow from cost segregation will increase your DSCR (after tax of course) which will make it easier to secure funding.

Since the assessed values are so out of line with the norm It may make sense to challenge the assessed values. Errors from the assessors office are more common than you'd think and are often revised favorably when challenged.

If you have any other questions on the topic please feel free to PM me!