Cost seg & STR loophole from a financial planners perspective

[Daniel Murphy]

Hey all, I did a cost seg study on my short term rental for the 2022 tax year. I'm a financial planner by profession & really wanted to understand the nuances behind this topic more. I love comparing the hype vs real world.  I apologize if this is a bit long, but here's a random list of thoughts after digging into this and actually doing a study... 

Before Cost Seg

- $400k property purchased in Jan of 2022.  I reached out to get a cost seg estimate & came back with these estimates:

$352k building cost ($400k minus estimated land costs)

~$77k in estimated bonus depreciation

= $28k in estimated tax benefits ($77k in estimated bonus deprecation * 37% tax rate)

Note - the above is my main point of contention with these cost seg estimates.  These estimates always tend to show the max amount of bonus deprecation multiplied by the HIGHEST tax rate = your estimated tax benefit.  
1) Most of us are not in the highest tax rates and:

2) Tax rates step both up and down, so you can't simply take the bonus depreciation multiplied by a tax rate.  It doesn't work like that... IE - don't expect the estimated tax savings on your inital report to be your actual tax benefit. 

During

- the report actually took me much longer than anticipated to receive.  I had to follow up with the company multiple times and seemingly provide the same info to them multiple times.  

I would definitely recommend starting this early rather than later as the report takes months to complete.  

Actual numbers post report:

5 year property = $42k

15 year property = $120k

total building cost = $204k

Actual Tax Return 

~Married Filing Jointly

~$82k in W2 income

~$150k in self employed income netting $52k in K1 income

~$11k in capital gains from stock market investments

~$60k in rental income from Schedule E and $215k in depreciation expenses ($162k from cost seg bonus deprecation & the rest from first year costs / capital expenses)

We ended up with an AGI of -$80k

Nuances & Thoughts 
- Most frequently, Cost segs are focused on high income investors.  I don't believe I'm considered "high income".  

- Some will say doing a cost seg on a $400k property is not worth it but in this case, we absolutely found it worth it. 

- I ended up with a fed & state tax refund total of around $18k 

plus, I still have a significant loss carry forward that I should be able to use in future years. 

We also had ~$30k in charitable deductions that we could NOT use in 2022 due to AGI limits.  These will be carried forward to future years to offset future taxes. 

For the first time in years, we qualified for a property tax refund.  This was a little over $3,000

One thing to note, when your AGI & tax liability gets near zero, child tax credits are only refundable up to $1,500.  Meaning, you do not get the full value of the $2,000 child tax credit if you have a low AGI, you may only get a max credit of $1,500 per child. 

In my case, I ended up with around $20k in tax benefits in year one and should get nearly that much in a  year two carry forward. (complete guesstimate)

Financial Planning Opportunities

This is the area that really interests me.  As I've talked with my clients & other investors, here are some areas I can think of to maximize the benefits of a cost seg. (all as a result of an abnormally low AGI for the year)

- If you have any inherited / beneficial IRA assets, you could potentially do large withdrawals with little to no tax effect.

- If you're applying for financial aid for college or other institutions, you may potentially qualify for additional aid based on a low AGI. 

- If you have large capital gains, you may be able to realize them & qualify for the 0% tax rate. 

- You could potentially convert a portion of your 401k/IRA into a Roth 401k/IRA virtually tax free. After a 5 year holding period, you may be able to withdraw your basis from the Roth tax free to purchase more real estate (note, I need to verify this as I don't know this to be 100% accurate)

- You could potentially offset taxes from a year where you anticipate large gambling income, cancellation of debt or more likely, stock option awards or other employee stock incentives. 

This was not meant to be an exhaustive list. Moreso, I've been thinking of this a lot recently & just wanted to share some deeper thoughts.  When most people talk about the benefits of doing a cost segmentation study, they talk about tax savings.  I find the real beauty of this strategy in the other supplamental benefits that are not often considered.  

I hope this helps give another perspective on the cost seg / STR Loophole topic...

[Daniel Johnson]

Ouch, that hurts to read. You basically left $115k + of tax-free income on the table. Your standard deduction was $25,900 plus the negative AGI of $80k, means you could have “forced” $105k of ordinary income to your tax return(best is probably a Roth Conversion) with $0 of tax liability. Then you could have also had up to $83k of LT capital gains realized tax free inside of the 0% tax bracket for cap gains. 

I’m sure it felt good to get a refund, but definitely not the most tax efficient outcome.