All Forum Posts by: Paul Caputo

@Matt Jones I'd be weary of a $400 computer generated report. It'll likely not stand up to audit, and on TitanEcho's website it even says their E5S modeling does not meet IRS audit requirements for cost seg. 

I think this type of thing will disappear fairly soon since the IRS Chief Counsel recently released a memorandum on the topic of penalties for aiding and abetting understatement of income tax as it relates to cost seg. Put simply the cost seg provider as well as the CPA who signed off on the report will be liable for hefty penalties for any overstatement of depreciation that results in understatement of tax liability. 

That being said the only way these low cost providers could protect themselves would be to write their programs in such a way that the benefit their work provides is so low compared to the reality of what is allowable that there isn't any chance of overstatement of depreciation, which means it would be understated and you're leaving money on the table. 

Just like everything else, with cost seg you get what you pay for, and $400 doesn't pay for much.

@Cameron Belknap Here's how it works. Depreciation is a deduction on your federal and state income tax returns that will lower your taxable income. So since you're sending less off to the IRS this will increase your cash flow on whatever timetable you're paying income taxes. 

Your rental income is put on top of your W-2 income so depreciation applies to the rental income first. If you're able to wipe out your rental income to $0 taxable after taking all other expenses and depreciation into account good for you, get more rentals and increase your income!! Since your active income is under $100k you're allowed to deduct a passive loss of up to $25,000 per year against your active income. I'm assuming your passive loss isn't going to max out the $25k, but if it does you'll have to carry forward anything beyond it. Since this takes it off the top the savings calculation should look at your combined federal and state income marginal tax rates. Since you're in Colorado with $60k active income the number you should use in the calculation is 22% federal and 4.63% state for a total of 26.43%. I think that's what you're looking for here.

As far as including FICA in your calculations I'd say no. FICA taxes are based on your earned wages less any pre-tax deductions from your employer that are exempt from FICA which is generally stuff having to do with health insurance or group life insurance. Your taxable income for income tax purposes is not the same as your earned wages to which FICA applies. A simple example is your 401(k) deductions do apply to taxable income, but don't apply to FICA. 

I'm not a CPA, so it'd be a good idea to check with yours, but I've never seen anything that has led me to believe that depreciation would impact FICA. I look at depreciation benefits everyday and we never take FICA into account. I assume that's because there's no interplay between the two since the depreciation benefit applies to taxable income, not earned wages.

It's true that you'll have to pay back the depreciation eventually in the form of recapture, but don't discount the fact that time value of money is working in your favor here. Not only can you reinvest those saved tax dollars today and get a good return on them, when you sell you're repaying the depreciation in future dollars of the same amount which will be worth less than today's dollars. Say you get $100 tax savings today and through investing it you're able to turn it into $200 over some period of time after which you sell the property. At that future date you pay back the $100, but if you look at that $100 in future dollars today it's only worth $75 in today's dollars due to inflation over that time period. And that's not even getting into partial asset dispositions and other mitigation strategies which could turn that $100 payback into a $50 payback.

It's good that you're factoring the tax implications into your calculations, you'd be surprised how many people don't do that. I hope this helps. Let me know if you have any other questions on depreciation and feel free to PM me.

@Kevin Brenner Yeah the capital gains and depreciation recapture would be significant on 25 properties purchased in the 80's and 90's so it's understandable that he doesn't want to sell and take the huge tax hit when he could just wait it out and leave everything to his heirs and pay no capital gains or depreciation recapture and then they get a stepped up basis to FMV.

Seller financing would mitigate the capital gains by spreading it out, but as @Dave Foster mentioned depreciation recapture would be due in the year of sale plus he'd still pay all the capital gains tax it'd just be over several years instead of all at once.

A 1031 would make sense if he wants to stay in the game, even though there are several options that would make it pretty hands off for him. The issue here is if he really wants to get out and use any of the proceeds from sale his hands are tied and he'd still be looking at capital gains and depreciation recapture if he ever sold without doing a 1031. 

The option that no one ever mentions is a bit fancy and complicated, but might be the best option here. I'm talking about a charitable remainder trust. Putting the properties in such a trust (before sale) would allow him to sell everything to you and significantly reduce and potentially completely eliminate capital gains and depreciation recapture. When he dies or the trust is terminated it does need to pay at least 10% (the remainder) to the charity of his choice. Like I said it's complicated so you need to have it all setup properly by people with experience in doing these, but I see this as a great option for everyone to get what they want. He gets out of the game and avoids the huge tax hit, and you're his hero and get all the properties. Sounds like a win-win to me!

This is a great strategy, but setting it all up properly is fairly complex. Make sure whoever sets it up knows what they're doing. You could potentially keep the same trust and revolve several properties through it over a longer period of time if you want. It's a good idea to pair this with some life insurance for the charity if you plan to continue it until death which is what most do as far as I know. 

The tax benefits from doing this should help reduce or even eliminate capital gains and depreciation recapture upon sale, but again you need competent advisors to set everything up to get the optimal benefits from this strategy. 

Feel free to PM me.

The changes in the new tax law allow for 100% bonus depreciation on assets with class life of 20 years or less in newly constructed property as well as used property acquisitions. Don't think that would do anything for him selling a duplex, but could be good for the new owner. 

If they can push through a tax cut 2.0 there may be other changes to depreciation, but I haven't heard anything about that. 

Depreciation recapture tax is based on the allowed or allowable depreciation in relation to the depreciable cost basis from the original purchase price (purchase price less non-depreciable land value) and the amount of time it's been held. There hasn't been any change to that. 

So there have been changes, but not that would effect him so not sure what he's talking about.

@David Hildebrandt

1. Since you have 50/50 ownership it's simple, you get 50% of the depreciation, he gets 50% of the depreciation.

2. As far as I know you can't deduct the full mortgage payments, only the interest so your taxable income is going to be significantly higher than what we were previously thinking. This makes cost seg more important for you and your partner to lower the taxable income.

3. With a long hold period cost seg makes even more sense since there's a lot of time for the time-value of money to work. Your dollars are worth significantly more today than they will be in 20 years. With cost seg you're effectively front loading the depreciation so yes you're getting a large benefit early on and in turn getting a little less benefit in the future, but again the money is worth more now than it will be in the future. 

You need to take depreciation for as long as it's a rental property. Recapture on sale is based on allowable depreciation and will be figured on that. So if you don't take the half year, the recapture will still be the same as if you did. Even though it's recaptured right away you need to take it so it's a wash, if you don't take it you'll be overpaying taxes.

@Eric Fernando Congrats on the new property! You could definitely look into it, but being totally honest there may not be that much benefit in a property that size. It really depends on what the allocation between land value and improvement value is on the property. Feel free to PM me.

@David Hildebrandt congrats on the property! A few things to add. First off with your partner being a dentist, I'd be more interested in the cost seg on the dental office than on the 8 unit and SFR. Dental offices are some of the best properties out there for cost seg since there's a lot of specialized plumbing and electrical systems not to mention all the FF&E. Depending on the specifics of the office there could be a lot of value for him hiding in there. Now since he's a dentist I'm assuming the passive loss limitation will come into play (unless he happens to be married to a RE professional) If he makes over $150k passive losses are disallowed and would carry forward.

From my calculation the basis in the buildings should be about $239,540 ($325k purchase price and about 73.7% improvement value - $185k improvement/251k total) so depending on the details you could see $24,000-$72,000 reallocated as @Yonah Weiss noted. With that basis you're looking at $8,710 depreciation per year with the regular straight-line method. ($239,540/27.5 years = $8,710) 

I'm assuming the $2,000 to $2,400 per month is your NOI after taking out all expenses other than depreciation and debt service leaving you with $24k-$28.8k annual income. The straight-line will bring that down to $15,290-$20,090 taxable income per year. Since this property was acquired in February 2018 100% bonus depreciation applies, you can elect to do 50% or not use it but that's a question for your CPA. Generally you'd want to take as much as possible so you'd do the 100% bonus depreciation.

So let's work out what that'll do for you and your partner. Let's say you're right in the middle of the 10%-30% range at 20% reclassified for about $48k of 5 year and 15 year assets with $192k remaining 27.5 year assets. On the remaining $192k you're getting about $7k depreciation per year for the full 27.5 years. In year one you're getting $55k total depreciation ($48k+$7k). If passive losses are disallowed and you're carrying it forward you'd zero out taxable income for several years before seeing a positive taxable income again. Year one: $24k income -$55k depreciation = $31k loss, zero taxable loss carries forward. Year two: $24k income - $7k depreciation - $31k carry forward = $14k loss, zero taxable loss carries forward. Year three: $24k income -$7k depreciation -$14k carry forward = $3k taxable income. Year four and after: $24k income -$7k depreciation = $17k taxable. So with this carry forward you're paying no tax first 2 years, a little tax 3rd year when the carry forward runs out, and then back up to a little higher than where you were with straight-line in year 4 and after. If the limitation doesn't apply then you could get a refund if the loss zeros out the rest of your income and the benefit would be a one and done type of deal for the current year. 

The benefits aren't huge on a property of this size, but they're definitely there either way. Just up to you and your partner if it makes sense to spend $2k-$3k to save $7k-$10k on taxes over the next few years. And thanks for the tag @Michael Plaks!

@Steven Hume That all depends on the individual investor. First off a passive investor shouldn't be the one purchasing the cost segregation study. That should be done by the sponsor or whoever is taking the lead on the project. It's really up to them and how the deal is put together if they would bear the cost or somehow pro rate it among the investors. 

If the investor is active for tax purposes or a real estate professional for tax purposes (making anything in real estate that would normally be considered passive an active activity for tax purposes) there's no need for discussion they'd get the full benefit based on their ownership of the deal. Any losses can be taken against other income. No-brainer here.

If the investor is passive and does not qualify as a real estate professional it gets a bit more complicated. If their income is under $100k there's a $25,000 passive loss limitation that fully phases out at $150k income, so its a 2:1 phase out. Anything beyond those limits can be carried forward indefinitely and anything remaining would be fully realized upon sale of the property. 

If a passive investor is in a deal that shows no taxable passive income and has no other passive income then they would see no benefit from cost segregation since the additional depreciation benefit would just carry forward. This situation is rarely the case since a deal has to have income to make sense. I wouldn't invest in a deal that wasn't going to make any money, and I'm sure you wouldn't either. In some cases straight-line depreciation is enough to offset all income to bring taxable income down to zero, but that would be a pretty bad deal since you're looking at about 3.6% straight-line depreciation per year on rentals and about 2.5% straight-line depreciation per year on commercial, which doesn't include land value so the numbers on the whole property are lower. 

Oftentimes passive investors have several passive investments, so losses on one can offset income on the others. So if one investment is really cranking out some good income you can offset it with another investment. The thing people overlook here is that depreciation lowers taxable income. So say you're a passive investor in a property and the passive income is $10k/year, take straight-line depreciation and other deductible expenses to make that $5k/year taxable passive income. With cost segregation you may be looking at a taxable loss of $1k/year for the first 5 years, which carries forward since your total income is over $150k. In the sixth year you can use that built up loss to be at $0 taxable passive income for year six. So without cost segregation you've paid taxes on $30k passive income over those six years. With cost segregation you've paid taxes on $0 over those six years. This is an oversimplified example, but illustrates that it's better to pay taxes on $0 and have losses carry forward to offset future income than to have taxable income in those early years. 

Every property and every deal is going to be different so it needs to be looked at on the individual level, but cost seg will generally benefit everyone involved.