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. ๐

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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.

Related: The 6 Basic Principles (& 3 Common Myths) of Investing For Retirement

## 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 thatย 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:ย 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.

1. The above mentioned \$235,000 ordinary income
2. Total tax liability from the sale of both properties: \$55,000 (Cap gains/depreciation recapture taxes)
3. Total personal income taxes saved via unused depreciation brought forward in year of sale: \$55,950
4. 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 โ 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. ๐ 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.

Or…

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. ๐

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?

Licensed since 1969, broker/owner since 1977. Extensively trained and experienced in tax deferred exchanges, and long term retirement planning.

1. Okay, you lost me here! You got a lot going on here in the “simple” example!!

How much did they pay for the two properties, and did they appreciate over the 5 years, normally you don’t assume that, right?

What kind of transaction costs getting in and out of the properties in just 5 years, has to affect yield in such a short term hold if they are sold?

Throwing the extra equity in every month has to be lowering the interest expense paid quickly, so there must be a lot more income to shelter concurrently with the excess depreciation to cover current year taxes, how does that balance out in terms of how much accumulated depreciation is left over after 5 years to use to shelter for “gains” and depreciation recapture?

is the depreciation recapture just on the portion used to cover net income from the property in years 1-4? Using the excess depreciation at the point of sale, I assume that does not trigger a recapture of that amount as well–is there some advantage to using and recapturing it in the same year?

I respect your strategies and know you have them nailed down tight, but I got to say trying to keep up is a bit like drinking from a fire hose!

Especially when you start adding the force multipliers that supercharge a comfortable retirement to one of rare abundance for most high income professionals and business owners!

thanks Jeff,

j

• Jeff, cash flow doesn’t go up a penny due to a quickly decreasing balance. It rises immediately once debt is eliminated. Or maybe I misunderstood that part of your comment.

On the other hand, less interest paid is actually less shelter, right?

I didn’t go into mammoth detail in order to keep the post from War and Peace status. ๐

Recapture tax is maybe one of the most mischaracterized taxes around. It’s 25%, and applied to depreciation which exceeds that of ‘straight line’. All unused depreciation on the sidelines at point of sale are used against ordinary income at sale. Your point is well taken though, as it’s far more complex/detailed than can be put into a post. The bottom line takeaway is that the investor ends up with so much tax free or after tax dollars at sale directly as a result of employing this approach.

• Both Jeffs – it seems some clarification is needed here. The example, while good, wasn’t clearly explained and will lead to confusion. Additionally, it seems there is misunderstanding with depreciation recapture. I think this article should be amended to provide clarity to readers.

There are two classifications of Section 1231 (capital) assets. They are Section 1245 and Section 1250.

Section 1245 assets can be thought of as personal property.

Section 1250 assets can be thought of as buildings and structural components.

When you buy a property, it is considered Secrion 1250 property. A cost segregation study is used to break out components into Section 1245 property. There Re two primary reasons for this:

1. Section 1250 property has a long depreciation period (15 years for land improvements, 27.5 years for residential structures, 39 years for commercial structures) whereas Section 1245 property has lives of 5 and 7 years giving you a larger depreciation write-off; and

2. There will generally be less depreciation recapture in the year of sale on Section 1255 property.

What was not adequately explained was ironically the foundation of the post: depreciation recapture.

On Section 1250 property, you will ALWAYS pay a 25% recapture rate on depreciation taken or allowable. You will pay a recapture rate equal to your ordinary rate ONLY if there is excess depreciation over straight line. This rarely happens with Section 1250 property, so just remember that you will generally always pay a 25% rate on ALL depreciation you’ve taken…

… Unless you have a cost segregation study performed and have classified some assets as Section 1245. Depreciation recapture on Section 1245 assets is taxed at your ordinary rate only if there is depreciation in excess of straight line.

If you have Section 1245 assets with a five year life and you get a cost segregation study done in year six, you get to take all Section 1245 depreciation you could have taken for the past five years, in year six when you do the cost seg study. Because the asset was technically worthless in year five, when you sell in year six you don’t have any “depreciation in excess of straight line” and therefore you don’t have recapture taxes. This is what Jeff was trying to explain.

Example: you have a building with \$100k. This is a Section 1250 asset and depreciated over 27.5 years. In year six of ownership, you perform a cost segregation study and realize that \$20k of the \$100k is actually Section 1245 property (things like carpet, appliances, shelving, cabinets, etc).

Since five years have passed, we have taken depreciation of \$18,182 (\$100k/27.5 x 5). But, assuming the Section 1245 assets our cost seg study identified were considered 5-year property, and now it’s year six, our entire \$20k worth of Section 1245 assets should have been fully depreciated (\$20k worth of depreciation. Additionally, the remaining \$80k of the building depreciated over five years results in \$14,545 worth of depreciation. \$14,545 plus \$20,000 results in \$34,545 worth of depreciation that we SHOULD HAVE taken up to this point – but we have only taken \$18,182. So our cost seg study allows us to write off the difference of \$16,363 (\$34,545 – \$18,182) in the current year since that’s what we technically should have taken over the past five years but we didn’t because we were depreciating the entire Section 1250 asset over 27.5 years rather than depreciating some of it over five years.

On top of that, if we sell the building in year six, we pay no depreciation recapture tax on our five year Section 1245 assets because straight line depreciation has made the asset worthless (we only pay recapture on excess depreciation, but if the asset’s life is five years and it’s been five years, we can’t have excess depreciation since the asset is now worthless).

But we DO pay depreciation recapture tax at a 25% rate on the depreciation taken related to our Section 1250 asset, which after the cost segregation study, we determined was \$14,545.

So, we absolutely will have to pay depreciation recapture, but if you can accelerate depreciation of Section 1245 assets in the year of the sale, this method may result in solid savings for you.

• Excuse typos. Typing on phone ๐

2. There will generally be less depreciation recapture in the year of sale on Section 1255 property.

2. There will generally be less depreciation recapture in the year of sale on Section 1245 property.

• If you sell a property, will you pay long term capital gains tax on 1245 assets once they are fully depreciated?

2. Jeff,

Great article. Love the synergy of the purposeful planning!

Best,
Dave

3. Does this involve 1031 transfers at the end of 5 years? Don’t you have to recapture the depreciation on the sale without it? ?

• This approach is specifically designed for the purpose of avoiding the need for a 1031, Jerry. The depreciation that remain ‘unused’ for the life of the investment are simultaneously applied in full to the formula for computing adjusted basis AND the investor’s ordinary income in the year of sale. Recapture tax of 25% is applied to all depreciation taken above straight line.

• Hey Jerry – see my post for clarification above.

4. Jeff,
I have not read enough about you to know this yet, so forgive me if its obviously stated in your many insightful blogs, but are you an accountant? If not, whom can you recommend; if so, are you taking on any new clients? I’m in my early 50’s and getting restarted in real estate and could sure benefit from the knowledge you’ve been sharing!!

• Lord NO! I’m not an accountant, but do know some incredibly knowledgeable people who are. I take new clients all the time, depending upon their goals. Send me an email and we’ll set up a chat.

5. You’ve got me thinking, Jeff. Never thought of this strategy in this way before. Thank you for sharing.

You didn’t go into the professional investor issue, and I understand it’s a longer post.

But assuming I could qualify for professional investor status (which I do), couldn’t I then shelter an extra \$10,000/year and save ordinary income NOW instead of waiting? We are talking time value of money. I can go ahead and invest those tax savings with debt paydown, notes, new rentals, etc.

If I’m a high-earning professional investor, it seems like sheltering other high-bracket income now (37.3%) and then paying capital gains at 20% or so is a win. And even 25% on the the 1250 recapture could be below my ordinary income tax bracket.

My point is, in that situation wouldn’t you be better off as a professional investor? Or am I missing something?

• Hey Chad โ Super question. I’m also a ‘poster boy’ for professional investor, and have avoided it like the plague. ‘Course, when I began acquiring real estate and notes, there were no limits on depreciation taken regardless of the investor’s ordinary income. ๐ It’s not that you’re missing something, Chad, you’re just doing what many do, which is to give far too much value to tax savings over time.

Here’s my reasoning. Through the CS strategy I can amass more money by a factor of 2-10 than the professional investor can with his itty bitty extra tax savings invested each year. Let’s do a quick, down ‘n dirty example.

If you had a \$300k duplex that would give you \$20k/yr CS depreciation your tax savings at 37.3% would be \$7,460/yr for 5 short years. Your depreciation at that point would drop off a cliff. On the other hand, by forgoing that write-off for the same 5 years, I was able to bank at least \$300k with little or no net tax liability due to my use of the CS strategy. For you to even equal that amount BEFORE tax you’d need your tax savings to earn just under 117% yearly.

And yes, I realize if you put the tax savings against the debt, your duplex would also be debt free. Thing is, if you sold yours the tax liability, using your 20% cap gains rate, then adding 3.8% from ObamaCare, plus the 25% recapture tax on \$50k of depreciation over straight-line, you’d net far less than in my example. Furthermore, with my tax free booty in the bank, I can replace my one duplex with two, and still have enough money left over to acquire over \$100k in discounted notes if I wish.

Am I making sense?

• Allow me to address a math error, Chad. I made the mistake of answering before finishing my first caffein injection. ๐ Your duplex wouldn’t be even within shouting distance of being debt free in 5 years using your tax savings to pay down the loan. At today’s rates, plus assuming you’d be putting the cash flow against the loan also, in 5 years you’d still owe around \$120k. I’d be free ‘n clear, as I directed more monthly income from my portfolio to ensure a 5 year payoff. Also remember that when you do sell, say in the same 5 years, you’d have \$100k in depreciation deducted from your original cost basis WITHOUT having the same amount to use against your ordinary income the year of sale.

6. Hey Matt โ If your 1245 property is completely depreciated to \$0 and you’re selling, you’ll pay taxes on them IF you word the sales contract the most brokers/agents do. You must have a paragraph specifically stating the personal property comes with the property at no extra cost. You’ll also, though not always, arrange for a bill of sale showing no consideration was received for said named personal property. Make sense?