Cost segregation is merely a different flavor of real estate depreciation. Depreciation is in essence a paper loss. That is, you don’t really experience a loss of real money outta your Levis. It’s there to account for the physical deterioration of the property and the components making up that property. “Normal” depreciation, also often called straight-line, is a relatively simple arithmetic problem most fifth graders can do. Here’s an example:
You pay $125,000 for a rental home. The first rule is that land can’t be depreciated. Duh, right? Let’s say the value of the land under this home is $25,000. That leaves $100,000 of depreciable property. Since it’s residential the tax code says we will used a 27.5-year schedule. We simply divide the $100,000 by 27.5 years, which gives us $3,636.36 in annual depreciation.
In my experience, that’s what the vast majority of real estate investors do. Furthermore, it’s likely the way to go for them, generally speaking.
Remember, the property’s depreciation is a “loss.” But we can’t offset whatever income we like with it. The tax code says the property’s cash flow must be “sheltered” first. Since the cash flow is around $2,600/year, this leaves a bit over $1,000. As long as you don’t make over $100,000/yr at your job(s), that $1,000 can be used to offset an equal amount of job (read: ordinary) income. Whatever the tax savings are, it’s more cash flow in your pocket directly due to investment real estate. From $100,000 to $150,000, the amount of leftover depreciation you’re allowed to take against ordinary income begins to be taken away. In any case we’re all limited to a maximum of $25,000 used against ordinary income in a year. The rest must be put on the sidelines for another year, or for some, ’til the day they sell.
But if you made $125,000, you’d be restricted to a maximum of $12,500 depreciation against ordinary income that year. Once you reach $150,000, you’re barred by the tax code from applying any leftover depreciation (after sheltering all property cash flow) against ordinary income. Many folks seem to find out about this limitation only after they reach that income. It’s not a happy surprise. 🙂
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What is Cost Segregation?
Applying “CS” as a strategy is pretty simple — on paper. However, it requires expert attention. A report does a breakdown of the property’s various components, and each get their own separate “lifespan” assigned. The majority of these items have depreciable lives of 5-7 years. You’ll need this report, most of which are executed by engineers specializing in them. They’re not required to be from engineers, but if you use a tax expert, make dang sure they’re not rookies. This is NOT something with which you wanna play games. The only times I’ve been ok with a tax expert experienced with CS is when the property(s) in question are new and the builder agrees to hand over any and all blueprints.
Depending upon the kind of investment property, CS usually results in an annual dollar increase in depreciation of 2-5 times. A fully equipped medical building with many built-in high tech instruments can zoom the amount of depreciation off the chart. In my experience, though, 1-4 unit residential rentals typically double annual depreciation dollars. It’s not the rule, but seems to be what happens. This is a result of giving 5-7 year “lives” to many things like stoves/ovens, dishwashers, and the like. Then there’s the plumbing, electrical, heating, air conditioning, and all the rest. Foundations even get into the act, as they should.
What’s a CS “Strategy”?
First and foremost, it assumes the investor(s) makes over $150,000/year in ordinary income. This assures they’ll be blocked from using any excess depreciation against ordinary income. There’s one exception that I usually recommend against: declaring “professional investor” status with the IRS. That’s a different post altogether, but suffice it to say, I’ve qualified for it in every way possible and eschewed it my whole career. Different strokes though, I get it. Meanwhile, back at CS Ranch…
Best case scenario is to pay off all loans over a five-year period. Not 4.5 years, or 5.5 years. Five years. This is relatively important, as the highly increased annual depreciation tends to fall of a cliff beginning the sixth year. This reduced amount usually continues ’til the end of the 15th year, at which time the party’s pretty much over, and you’re more or less naked.
Note: Another reason why the closing of the property’s sale should very closely coincide with becoming free ‘n clear: The cash flow in this example would quadruple the first month sans loan payment. You would then be forced to begin dipping into the aforementioned unused depreciation on the “sidelines” to shelter it. This would then reduce the depreciation you really wanted to use to offset capital gains and depreciation recapture tax liability from the property’s sale. As in much of life, timing is important to say the least.
A Real Life Example
Let’s use one of my real life/real time clients as an example. They own many small income properties, two of which they’re using to execute this approach. To keep things brief, I’ll spare you some of the boring details, opting for the bottom line results.
They live in California and make about $235,000/yr combined. The straight-line depreciation for each of the subject properties is around $10,000 annually. Using CS has doubled this almost to the dollar to just over $20,000. Here are the factors/numbers involved in their situation.
- The above mentioned $235,000 ordinary income
- Total tax liability from the sale of both properties: $55,000 (Cap gains/depreciation recapture taxes)
- Total personal income taxes saved via unused depreciation brought forward in year of sale: $55,950
- Net taxes paid due to sale of properties: $Zip
Note: Savings on personal taxes based on known marginal rates are 28% fed/9.3% state — 37.3%
In this case the amount needed for debt elimination was around $2,850 per loan, per month. This couple’s been with me for about four years, give or take, which means their plan has had time to gain some serious traction. This is especially true as it relates to the overall cash flow currently produced by their portfolio as a whole.
Their real estate gives ’em a tad over $4,000 monthly, all sheltered of course. Then their personal discounted note portfolio, though still in its infancy, adds another $2,000 or so. This easily allows them to execute the CS strategy on a couple of their Texas properties. All the money is coming not from their own earnings, but from other people’s money. This is a good thing. 🙂 Most clients though end up adding some of their own family money into the pot when paying off the debt early.
When the Dust Clears, What’s the Bottom Line?
Where to begin, right? This wasn’t done in a vacuum, so let’s first compare it to some of the other options available.
- First, if they’d merely applied each property’s cash flow to the loan payment, those loans woulda been paid in full in just over 17 years anyway. They’d still be in their 50s, so not a timing problem. In fact, that applies to all their properties, which would all be free ‘n clear before they turned 60. Still good, but not nearly as cool as having several hundred thousand tax free dollars in the bank over a decade sooner. Time. Value. Money.
- Second, they could still accomplish this in five years without using CS. The two props would still be free ‘n clear. They could then use the cash flow for other investments, or refi them for $200,000 each, also tax-free. They could then add to their real estate and/or their note portfolio without selling. Ok. But it yields at least $160,000 less cash. Wonder how much that would mean over the next 20-40 years?
- Third, they simply allow their overall investment portfolio to mature ’til retirement. The properties pay themselves off in plenty of time, maybe with a gentle push at the end. Their note portfolio grows more or less organically, feeding on its own income of random early payoffs. This is what most investors do, though the vast majority sans a note portfolio. Vastly inferior results re: retirement income.
Using the CS strategy, they bank roughly $560,000 tax-free dollars in just five years. They take a paltry $225,000 of that and replace the two sold duplexes. The balance is added to group note investments, which gives access to profits from both performing and non-performing notes and land contracts. This earns them 13-18% annually. They then immediately begin repeating the CS strategy with THREE duplexes this time out. They’ll have the required monthly income due to their newly beefed up note portfolio. 🙂
That’s exactly what they’re gonna do, which will result in over $1 million in the bank in five more years. They still won’t be 50 years old. They’re combining the principles of the time value of money with strategic synergism. When used prudently and with a purposeful plan, that combo has proven to be productive to say the least. In just three rounds of consecutive uses of the CS strategy, they will have accomplished the following, which is NOT a complete list:
- Produce after tax dollars in the bank totaling $2.5-3 million dollars.
- Replace all real estate at a 1:1 to 1:2 ratio.
- Massively increase their ultimate note income in retirement.
- Seriously increase the free ‘n clear equity in their real estate portfolio at retirement, not to mention cash flow.
- Increase the years of depreciation remaining on investment properties held at retirement considerably.
- Allowed themselves the option at any time to “quick fund” an EIUL, producing decades of tax-free retirement income.
The first key to any investment plan designed to maximize retirement income is to first understand what your options are. Most investors don’t know they’re working on half a page of their five page options menu. The second key is to acquiesce to the reality that not only do they need an expert, they need a team of experts to accomplish a truly magnificently abundant retirement. The CS strategy is merely one of those options.
Investors: Do you use the cost segregation strategy to maximize your investment plan? Any questions?
Leave your comments below!