When To Use A Cost Segregation Study?

Question

Hey everyone,

I am a new investor that closed on my first property back in June of this year (new construction) and will be closing on my second (a BRRRR property) in the middle of December. Now that tax season is around the corner, I learned that cost segregation studies will speed up the depreciation of my property, so I can pay less in taxes. I love my W2 job and don't want to leave it, so my long-term goal is making enough passive income to cover my family's monthly bills and save for more properties in the future.

So, my questions are:

What are the pros and cons of using a cost segregation study at this point in my investing career?

Will cost segregation studies positively or negatively impact my ability to finance more properties in the future?

Any advice will be much appreciated!

Ryan Reid

Sarah Waterman · Answer

Yes you have to settle when you sell.

However - The present value of those tax savings far exceeds any re-capture tax payback.

In other words it's worth it...

Basit Siddiqi · Answer

@Ryan ReidBelow are a sample of 2 instances when someone would want to perform a cost segregation study.1) They are eligible to claim real estate professional status and performing a cost segregation study would wipe out other forms of income.2) taxpayer has a lot of rentals and some are generating positive taxable income.Performing a cost segregation study on one property may wipe out the taxable income from the other properties.Best of luck.

Costin I. · Answer

@Ryan Reid

There are multiple pros and no cons (that I’m aware of) to a Cost Segregation Study (CSS) (other than the time and cost involved). It’s worth learning about it and employing it as a tool in your real estate investing toolbox, especially if you plan on adding to your investment portfolio.

While I’m not a professional in this domain, I looked a lot into the subject and I done CSS for several of my properties - I can tell you about some the gotchas and misconceptions vehiculated on the subject:

- It’s      not a way to increase depreciation on a property. It is an ACCELERATION of      depreciation (you will capture more at the beginning, in the first years      and less at the end, in the later years).

- It      has the potential to save you money from taxes – but that depends on the      rest of your tax picture, what other sources of income and deductions you      have, your goals and short term vs long term plans and tax strategies. Again,      it gives you a big depreciation in the first years (which could make a big      dent in your taxes) and less in later year (which assuming increased cash      flow, could mean less deductions, more taxes later…but that depends on      your other properties, etc.). Generally speaking, it’s a good thing from      tax perspective, and likely to help with taxes.

- While      you can do it later (or for properties acquired in previous years), it’s      more complicated and costly. Therefore, it’s better to do a CSS in the tax      year of acquisition.

- Engineer      based CSS is usually expensive for SFR’s and properties under 1Mil, and      IMO, not cost effective – but there are DIY solutions that provide solid alternative      for a fraction of the cost (look into KBKG.com – they have a good tool for      a very decent price + tutorials, once you get hang of the principle and how      to use their calculators, it takes 20min to complete a CSS report) – and that’s      the path I recommend.

- If      you’ll be able to take advantage of the big initial depreciation to shift      taxes (to count it against your W2 income) depends on several factors – if      your AGI less than 100K, and prorated up to 150K; your profession or if      you or your wife can qualify as real estate professional, your      documentation – if you maintain contemporaneous logs, etc.). More often than      not, you’ll not be able to shift deductions from passive side (rental      income) to active side of income (W2). But don’t worry, you’ll not lose      them, they accumulate and still will be able to use them to the max in      following years. The main idea is to find the right balance so that your      depreciation offsets the net rental income so you don’t pay taxes on them.

- CSS      itself has no impact on your ability to finance properties. The higher      depreciation deductions that a CSS will give you and applying that to your      taxes might have an impact on your financing (or more precise with whom      you are doing your financing) as it might show on your tax report as not      making any money or, worse from the perspective on financing qualifications,      as losing money with your rentals. That’s why you need a lender who knows      how to properly read the tax report, how the depreciation is applied and      what is the real rental income (or how to consider the rental income in      the calculation of DTI).

If you need more details on this stuff, you can PM and we can chat.

Danielle Jackson · Answer

All great advice here. Another way to look at it...

Dan Moberly · Answer

This is what I was thinking... I make lower w-2 income right now, I only have 3 rentals now, and I'm not a REP right now. I'm planning to hold long term but things might change. I'll be making good w-2 income in a few years, may become a REP at some point and plan on purchasing more rentals but the savings don't seem like the cost/time would be worth it.

Paul Moore · Answer

Hi @Ryan Reid. I think you are on the right track. From what I understand, there are at least three levels of cost aggregation studies. The highest priced engineering study at over $10,000 typically is usually for commercial properties. There is a mid priced study in the $5000 range from what I understand, and some property owners use the study. Though I have no experience with this third level, I also understand there is a sort of do it yourself type study that you can do for under $1000. I don’t know how well this will hold up in an IRS audit so be careful, but it seems like this level would be most appropriate for a residential property. Happy Investing!

Bill B. · Answer

If you plan to be making less money in the future (when future depreciation would help m than today.) and your taxable income is well over $100k (otherwise you’re turning a 12-15% tax bracket in to a 25% tax bracket.) and your qualified as a real estate professional so you can deduct the expenses against your regular income (you spend more time in real estate than at any w-2 job with a minimum of 750 hours) and you can get it done for a $1,000 give or take and you plan to hold it for at least 10 years (or do a 1031 exchange) it’s probably not a horrible idea. But that’s such a small market.

Oh ps. You saw the savings above (although wrongly stating you wouldn’t get any depreciation for the first 39 years) were substantial at $5M. I assume your property is probably smaller.

Lane Kawaoka · Answer

It does not always make sense to spend 10K on a cost seg to get losses especially if you are doing smaller properties (under 100 units) and based on the time value of money, if we are looking for a early exit it does not make sense - should we be doing an exceptional job going through the unit upgrades. As you know when you sell an asset all the depreciation and bonus depreciation needs to be recaptured or given back.Most investors are not Real Estate professionals and therefore cost segs and bonus depreciation is overkill beyond (normal bonus depreciation) as it will knock out the passive gains in the first few years of the project in most cases. In other words, even with normal depreciation you are offsetting most of your capital gains. If you are a REP and therefore interested in this subject, there is a high likelihood we will be doing a cost segregation but always reserve the rights as managers to make the call in the end in the best interests of all investors.Assuming an LP is not a "real estate professional" what is the advantage to the cost segregation to that investor?  I understand it's certainly not a bad thing, but what's the advantage?In most cases normal depreciation will more than offset gains in the first few years of a value add project. The "excess" suspended losses will pile up on your books and can be used to offset passive gains. Passive gains could be coming from other passive investments especially coming from sale of other assets (which are overripe - you should have sold earlier so you don't have such a large capital gain and depreciation recapture in the first place).In summary Passive Losses cannot offset Ordinary Income (401k withdrawals) unless you are implementing REP status

Buddy Holmes · Answer

@Sarah Waterman

My Bad. Sarah is absolutely correct.  It was a Sr moment thinking your BRRRR was a fix and flip not the fix-hold and refi!

Buddy Holmes · Answer

@Ryan Reid

The cost segregation study is a very good way to increase the depreciation on a property you own.

However, you must understand what the tax code requires when you sell that property.

Added depreciation is only useful if you hold the property long term, or only plan to use a 1031 exchange of the property.

When you sell the property otherwise you must settle with the IRS on the depreciation recapture.

Your description of doing BRRR's, suggest that this added depreciation method would do nothing for you.

Cheers,

Buddy

When To Use A Cost Segregation Study?

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