Cost Segregation study

[Clint Harris]

I reached out to my accountant about doing a cost segregation study in order to utilized the accelerated depreciation, and he said that it’s usually very cost prohibitive and is hard to justify unless you have a very high income. I have a high income producing beach rental duplex that was purchased after the accelerated depreciation start date in 2017, I have a high paying W2 job in medical sales, and my wife is a real estate professional, with 1099 income, so it seems ideal to write a lot of this off. He is under the impression that a cost segregation study is extremely expensive. Does anyone have any knowledge about this or recommendations on who to use for a cost segregation study? Thanks!

[Michael Plaks]

@Jenning Y.

You opened a can of worms :)  

Thumbs up for getting into these high-end technicalities and understanding the basics. You're on the right track, but this track does not necessarily lead to the conclusion you made.

1. Your example would be close to accurate if this appliance was depreciated down to zero without cost seg. Instead, it would only depreciate at about 3% per year. So after 3 years, without cost seg, you will only have $200 of Sec 1250 recapture. With cost seg, you convert $200 of Sec 1250 recapture into $100 of Sec 1245 recapture plus $100 LT cap gain. Considering that 1250 is capped at 25%, and 1245 is not, the net effect could be zero. And even if it's positive, it's not material with these numbers. (And what if that appliance is worth $200 and not $100 at sale?)

2. I'll add another quirk. There's a possibility of rate arbitrage if you're able to deduct depreciation at an ordinary rate higher than the 25% 1250 recapture ceiling and then recapture it at 25%. But, just like your "conversion" argument, it assumes so many different factors that using this for tax planning is kind of pointless. What if your income and tax bracket changes significantly from year to year? What if all tax rates are revised by new legislation? What if your filing status changes? Etc.

3. All these deductions do not exist in vacuum. Imagine that you're doing a 1031 exchange. Imagine that you also have suspended capital losses from something else. Imagine that you had suspended passive activity losses. Any of these situations, along with another dozen of what-ifs, can totally disrupt the result happening at sale. In either direction.

Bottom line: while technically correct, your argument is not a strong argument for cost seg. Sometimes it can indeed add icing to the cake. In other situations, it can be useless or even counter-productive. Like a lot of other tax planning ideas. Tax planning is only as good as the underlying assumptions about the future.