Five common MYTHS of cost segregation and 100% bonus depreciation

[Michael Plaks]

Cost segregation is the 2022 version of "bro, are you on keto?" If you're not posting about your cost seg results in 2022 - are you even lifting, err, investing? 

So let this decidedly uncool boomer spoil this lit party by shooting down, in no particular order, five (out of many more) myths:

Myth 1. Cost seg is some secret magic voodoo that creates tax deductions out of thin air.

It does not. Every property you buy comes with a reserve of depreciation deduction, roughly equal to the property's full purchase price minus the value of land. Normally, you spend this reserve slowly and steadily: take about 3% of it every year. What cost segregation gives you is an ability to take more like 30% of your total depreciation in the first year instead of 3%. 

Isn't 30% better than 3%? Sure it is. But now you have less depreciation left for the future. You basically eat all your burgers and chili dogs during the first quarter and then have to survive the rest of the game on chips and pretzels. You do not "create" more food out of your game stash. You simply eat all the best food early.

In the tax world, it means that taking cost seg in the first year can actually increase your taxes in later years.

How do you solve the snack shortage problem? Well, you order more pizza. Similarly, you can ignore this cost segregation side effect if you keep buying more properties - never a bad idea, even in today's market. 

Myth 2. Cost seg is a brilliant solution to cut those insane taxes I'm paying on my regular job salary.

In most cases, it is not. Cost segregation's goal is to create large tax losses. Unfortunately, you cannot take those tax losses against your W2 income. There're harsh limits, often $0, called PAL (passive activity losses) rules. These rules do not let you use your tax losses and instead force you to sit on them until some special situation arises in the future, such as selling one of your properties.

Since most investors with W2 or 1099 jobs are under these PAL rules, they max out on the available tax deductions without cost segregation. Cost segregation does not reduce taxes if you're limited by PAL.

You cannot cash out your Frequent Flyer miles and use it to pay your mortgage or your CPA. You can only use it to get free tickets and upgrades. What if you're not flying in the near future? What good does it do you to load up on bonus miles promotions today? Can't cash them. You will simply have a bigger reserve in your account for whenever in the future you might need it. Not today. Today it's basically useless. Just like cost segregation for PAL-restricted investors.

But I heard on this podcast that I can elect to be a "Real estate professional" which gets me around these PAL rules and allows as much losses as I want! True, except you cannot elect this REP status. You have to qualify for it, and it is intended for people who basically are full-time in real estate. If either you or your spouse are a full-time Realtor or a wholesaler/flipper - great, you're in! If both of you have conventional 40-hrs W2 jobs, you cannot qualify, even if you get a Realtor license. You will be stuck with PAL rules.

Important exception: the rules are different for STRs (short-term rentals) and may give you a much welcome opening. However, these rules are also tricky, so make sure to learn them from an experienced accountant and not from YouTube. It's a not an automatic loophole, you need to qualify/plan for it, and it's not always possible.

Myth 3. If I have room for more depreciation deductions, cost segregation is a must.

It is certainly an attractive opportunity to evaluate, but not an automatic no-brainer. 

- Depreciation is a loan, not a freebie. You have to repay this loan when you sell the property. The (somewhat inaccurate) technical term is "depreciation recapture." If you're planning to sell this property in the near future, all depreciation, including bonus depreciation from cost segregation, will become taxed thanks to depreciation recapture. In this case, cost segregation may be pointless. Good news: there're tax deferral strategies like 1031 exchanges that remove this concern about depreciation recapture. As you correctly guessed, the rules are quite complex.

- If you have multiple properties, you don't have to do cost segregation on all of them. Sometimes, it is better to use cost seg on only a portion of your portfolio.

- Cost v benefit should always be considered. The most thorough and reliable results come from full-scale cost segregation studies when an engineer visits your property and produces a detailed custom report. These studies are not cheap. A cheap alternative is DIY software-based cost segregation reports, however they are only as good as the data you enter into them and are more likely to be challenged by the IRS.

- Even if you can increase your tax loss on your current taxes, it is not always the best long-term move, depending on your overall tax situation today and in the future. This is something that needs to be evaluated by a tax strategist specializing in real estate investing. You can find many of us on this BiggerPockets forum.

Myth 4. The sooner I do cost segregation, the better. There is nothing to lose.

Timing does matter. This post is written in November of 2022. Let's say you are buying your first STR before the end of this year, in time for the holiday booking spike. As guru podcasters taught you, you immediately order cost segregation study, in anticipation of a sweet tax relief. When it comes to tax time in the spring, your CPA informs you that you did not pass some weird "material participation" test, whatever it means, and you cannot take losses from cost segregation. Shoot.

But - you can pass this material participation test in 2023, so you can apply cost segregation to your 2023 taxes, right? Wrong. You will have to apply it to 2022, even if your cost segregation is done in 2023. But wait, if I had PAL-limited cost segregation losses in 2022, and I'm no longer limited by PAL in 2023, I simply roll over my 2022 losses into 2023 and use them in 2023, right? Wrong again. Your 2022 losses will stay locked even in 2023, despite you now passing that stupid material participation. Why? Ask Congress, they are making the tax laws. 

As strange as it sounds, in this particular example, you possibly would have been better off waiting with cost segregation until 2024. Does not make sense, I agree.

Yes, extremely frustrating, but everyone's tax situation is different, and the only way to optimize your taxes is by working with a competent tax professional. Or becoming one yourself if you're that much of a tax geek.

Myth 5: Since 100% bonus depreciation disappears after 2022, hurry up!

It does not disappear. It is becoming an 80% bonus in 2023. You don't get to eat the whole pizza, but you are not going hungry. You still get to eat 80% of it.

What about the other 20% - do we lose it? No, we don't. See #1 and #2 above. Bonus depreciation does not create extra deductions, it merely allows you to take the same depreciation sooner. You still get to take the remaining 20% depreciation later on or adjust your taxable gain when you sell the property. Not as good as taking 100% all at once, but still a pretty good deal.

If your situation does warrant cost segregation for your 2022 taxes, you still do not have to rush and complete it in December. Cost segregation must be done before you do your 2022 taxes, not before the end of 2022. This means you still have a few months. An added benefit is that you will have your complete 2022 picture when the year is over, and your tax accountant will be able to give you a well-informed advice on whether cost seg is of benefit to you for 2022.

One potential reason to complete your cost seg in December: you might be able to deduct the cost of the study itself on your 2022 taxes.

Myth 6 (Yes, I promised 5, this is a 100% bonus): party-pooper accountants just don't understand the power of cost segregation

We do. We love the concept, teach it, and recommend it to many clients. But just like keto diet, any other diet or any tax strategy - it's not for everyone, and it's not magic. I know, your heard differently from TikTok influencers. Bless their hearts, as they say here in the South.