BEWARE: How Cost Segregation is sold to you

[Michael Plaks]

My client, let's call him Paul, was not happy to owe the IRS $100k - the tax penalty of having a successful flipping/wholesaling operation. So, based on his buddy's advice (sounds familiar?), he ordered a cost segregation study on his 20 rental SFHs. Paul was pretty upset with me when I informed him that he still owed the IRS. He expected to erase all of his taxes, because, according to the cost segregation firm he hired, they created "$600k in cost seg tax savings" for him!

Indeed, their report shows an average savings of $30k per property. Times 20 properties - yep, $600k protected from the evil Uncle Sam and back in the investor's pocket! Don't know about you, but I would LOVE to save $600k on taxes. 

Now, shall we look a little closer? Here is one page from the cost seg report, for one of Paul's houses.

1. Yes, the number circled in red is $30,740, and it was sold to Paul as his savings. But what that number represents is the lifetime sum of the annual savings - i.e. the total of the last column! This is what Paul would receive over 28 years of depreciation. What can he claim now, on his 2019 tax return? Only the current year savings $2,868, plus we can retroactively claim the two past years, 2017 and 2018. Together, this is less than $9k in savings - a far cry from the $30k.

2. But let's look at this $2,868 "tax savings" for 2019. How was it figured out? I'll tell you how. It's 40% of $7,171. First, what is 40%? I could sort of understand this rate if the property was in CA with its insane state tax. But this property is in FL, with no state income tax! Paul's tax bracket is 24%, reducing his alleged 40% tax savings almost in half!

3. The most troubling part, if you have not noticed it yet, is that the 40% is applied to $7,171. $7,171 is the total depreciation for the year. It is NOT the cost segregation savings - which is $3,317, less than half! Without cost segregation, Paul still had $3,855 in depreciation, per the 3rd column. Cost segregation increased it by $3,317 - and that is the number that should count!

4. The real number of Paul's savings for 2019 for this property is $3,317 x 24% = $796.  Yes, only $796, as opposed to $2,868.

5. I'm afraid you still do not appreciate the extent of deception on this report. Let me show you. Look at the red numbers circled by my blue pen. This is what they mean: starting from year 6, cost segregation creates negative tax effect - i.e. you pay MORE taxes than you would've paid without cost segregation! 

In case you're wondering WTH - it is exactly how cost segregation is supposed to work! They tell you it "creates" more depreciation, right? They lie. All you do is you accelerate depreciation! You do take a whole lot more depreciation in the first 5 years, as the table correctly shows - but you have to rob your future years in order to do so.
Cost segregation does not magically create additional depreciation deductions. It merely lets you take depreciation earlier.

And now look at what the last column of the table shows. It assures you that you continue to generate over $1,000 in "savings" every year! Not at all! This is simply $2,737 of remaining depreciation per year, times the inflated 40% rate. Without cost segregation, the remaining depreciation per year would've been $3,855.

6. This particular property was placed in service in 2017. Some of Paul's 20 properties were placed in service in 2018 and 2019, giving him just 1 or 2 years of savings today. And some properties were not in service until 2020 - meaning no immediate tax impact at all.

To recap, here is the cost segregation sales pitch:

• You will get over $600k in "tax savings" from our report!

And here is the reality:

• $600k is the total depreciation over the 28-yr lifetime of Paul's properties, times the inflated 40% tax rate
• this total depreciation would've been taken over 28 years either way, with or without cost segregation; cost segregation only shifts more of it towards the first 5 years
• the actual tax savings for Paul were $35k for this year, with another $55k coming over the next 3 years (your mileage will vary)
• if he sells his properties, as opposed to 1031 exchange, he will have to return all these savings to the IRS at the time of sale

So, am I just anti-cost-segregation, you would ask? Absolutely not. Cost segregation is an excellent tax strategy when applied correctly. For Paul it was still pretty helpful, since he qualified as a real estate professional. For other investors, it could've been a waste of money and effort. Consult your tax accountant before doing it.

My problem is not with cost segregation. My problem is with selling Paul on $600k "tax savings" when in reality he only received $35k.