All Forum Posts by: Melanie Baldridge

Did you know that Limited partners or real estate investors can absolutely benefit from depreciation?

RE Pro Status supercharges this.

If you or your spouse are an RE Pro, your LP investments can lead to depreciation offsetting both passive and active income.

If you are not an RE Pro, the losses due to depreciation can only be used to offset passive income—such as income from other rental properties or other passive investments.

Someone I know bought a ranch to use as a short term rental property in 2021 for $1.7 million.

Engineers did a virtual site visit, they were able to assign a value of $347,000 to either 5-7-15 year assets that were eligible for depreciation.

In 2021, the bonus depreciation amount that you could take was 100%.

This means that the owner could immediately deduct the full amount of eligible property in the year it was placed in service, rather than depreciating it over time.

With that in mind, he took the full $347K deduction in his FIRST YEAR of ownership to offset taxable income from rentals.

This was roughly ~20% of his purchase price.

It was a big win for him.

In 2024, the bonus depreciation rate is 60% so the calculation would be different.

That said, you can still save and defer a ton.

Quote from @Sean Graham:

Quote from @Melanie Baldridge:

A question that we get:

"Does the IRS require site visits for cost segregation studies?"

While the IRS does not mandate a physical site visit, the IRS cost segregation audit technique guide (ATG) does suggest conducting “field inspections.”

It’s important to note that the ATG is not an official IRS document.

It serves as a guide and cannot be used, cited, or relied upon as an authoritative source.

However, the recommendations in the ATG are worth considering.

According to the guide:

“A field inspection is recommended to document the physical details of the building, type of construction, materials used for construction, the assets contained in the building, the size and types of building systems, and any land improvements that were included in the purchase of the property and the condition of that property at the time of purchase.”

So while the IRS does not require a site visit for cost segregation studies, following the guidance from the cost segregation audit technique guide can be beneficial.

@Melanie Baldridge good post. When/how does your team decide on doing a physical site visit vs. a virtual site visit? 

We offer physical site visits for properties above $2.5/3M or if it's required by the client.

Around 95% of our studies are done virtually but if you need boots on the ground and it makes sense for your property or portfolio, we'd be happy to help.

Quote from @Janet Behm:

Melanie, 

You are being prolific!

I just started following you,

Janet

 Appreciate it! 

I recommend that you learn the tax code and take ownership over your strategy.

Not having some foundational knowledge and an opinion on how to approach taxes as a business owner is a huge mistake.

In my experience, every single business owner who says "I just let my CPA worry about it and I focus on my business" is doing a suboptimal job at tax planning.

They are likely missing out on 10s or hundreds of thousands in saved dollars every year.

Stop making excuses and get to work.

Just a few months of part-time learning about taxes will pay you for the rest of your career.

Quote from @Kevin S.:

@Melanie Baldridge

What is the tax implication if I swap one property for another that is valued at lesser amount.  Say sell property for 2M and buy another (within the required time frame) for 1.5M?

Does the swap has to be one for one property?  Can I sell one property for 2M and buy 2 properties for 1M each?

In a 1031 exchange, if you sell a property for $2 million and purchase a replacement property for $1.5 million, the $500,000 difference is considered "boot" and is subject to capital gains tax.

To fully defer capital gains taxes, the replacement property must be of equal or greater value than the relinquished property, and all proceeds from the sale must be reinvested.

Cost segs unlock these savings, but the losses won't offset your ordinary income from your job unless you are an RE Pro.

Here's how to think about RE Pro status to make the best case with your CPA and the IRS:

RE Pro Status starts with the IRS definition of a Real Estate Professional (IRS Pub 925).

It is not as simple as getting a real estate license or working for a firm that provides real estate services.

Ask yourself these questions to see if you qualify:

Q1: Are you in the right business? A real estate pro is spending their time in real property business. Builders, house flippers, brokers, etc.

Unfortunately, banking and finance services and certain architect and engineering services don't qualify. This includes cost seg pros.

Q2: Are you an equity owner? This trips a lot of people up. You must own at least 5% equity in the qualifying business.

Working a W-2 job at construction company =/= RE PRO
Owning a construction company == possibly an RE Pro

Q3: Are you meeting time thresholds? This is a bright line issue, and unfortunately this is where people lose.

RE Pros spend each of the following:

More than 750 hours of service during the year
AND
More than 50 percent of his/her time working in real property businesses

Additionally, I talk a lot about the benefits of the RE Pro spouse. If you are pursing that path then one spouse alone must meet both tests.

Qualifying hours for the 750 include time spent working on the business activities mentioned above.

Again, more than 50% of your time means this is way more than a hobby. It is typically your primary job.

The 40 hr/week W-2 worker is going to have a hard time convincing an IRS agent they are meeting this threshold.

STR loophole is a better path for my friends in this category.

Once you finally cross the pro hurdle, you're not done! You must also materially participate in your RE activities.

If you materially participate in each RE activity, losses are fully deductible. If not, even though you are a re pro, losses are passive & deductions are limited.

There are 7 scenarios that will qualify as material, and you only need to meet one:

*500 hours
*Substantially all participation
*> 100 hrs and at least 1/2
*Significant participation
*5/10 years
*Personal service activity w participation in last 3 years
*Continuous participation

To materially participate, you must be involved in the operations of the activity on a regular, continuous, and substantial basis.

Once you pass the pro test, the material participation often comes along for the ride.

You can elect to aggregate all rental real estate for purposes of measuring material participation under Sec. 1.469-9(g).

Your time spent on all your rental properties (STRs don't qualify) counts as one activity, making it easier to materially participate.

In order to make a strong case with your CPA and the IRS you need to document your hours.

Best practice is an hours log where you are as specific as possible. If you are audited the IRS will want to see supporting docs (e.g. calendar, CC statements, etc).

If you've reached the end of this thread and your NGMI on RE pro there are a few more options:

1. Buy RE for your business to operate out of
2. Generate lots of passive income that you need to offset
3. STR Loophole

If RE Pro status is in your future, congrats!

As always:

1. Talk with your CPA before making any decisions
2. Be mindful of Excess Business Loss rules
3. Taking bonus depreciation early is a tax deferral, not a tax savings.

Recapture is real and debt must be repaid!

Newton's law of tax:

What goes down must come up.

Everyone enjoys the sweet benefits of bonus depreciation, but what happens when you sell?

A post on recapture:

People are concerned about recapture when they cost segregate their improvements and for good reason.

Recapture is real, and those deferred taxes will need to be paid.

But fear not! If you think ahead, you can minimize recapture with the right tax planning.

So... What is recapture?

Basically, there's no free lunch when it comes to taxes.

Depreciating property lowers your tax basis. When you go to sell, you're subject to tax on the amount of profit between your adjusted basis and sale price, not your purchase vs sale price.

Recapture is NOT repaying the depreciation. It's a tax on the gain.

How is this calculated?

To set the scene: A cost seg study breaks your property into two important categories:

1250 "real" property aka the building, foundation and other long life assets.

&

1245 property aka anything that can be accelerated such as 5, 7, or 15 year property like carpets, cabinets, or other site improvements. This is most of the depreciation you are taking year one.

You can calculate your depreciation recapture by taking the sale price of the asset and subtracting the adjusted cost basis.

The adjusted cost basis is what you paid for the asset plus any improvements you made along the way minus the depreciation you took along the way.

The profit above this original cost is taxed as a capital gain, but the part linked to depreciation is taxed at a maximum rate of 25% under the unrecaptured gains of section 1250.

To recap the tax rates are:

- Sec. 1250 real property: 25%

- Sec. 1245 property and 15 year 1250 property: Ordinary Tax Rates

There are ways to minimize depreciation recapture especially if you know how to work smart with your CPA.

1) Asset Valuation at Time of Sale - Sellers can minimize recapture by reallocating the price of the assets on sale. Your old carpet did not become more valuable over the seven years you owned the property, even if you are selling for a gain. Work with your CPA to allocate more value to land and structure. For larger properties, some of our clients run another cost segregation study at the time of sale.

2) Partial Dispositions - Taxpayers can carve out and dispose of components removed or demolished from a building. By making partial dispositions, you can also avoid subsequent recapture on these items when you go to sell. Note this election MUST be made in the year of the dispositions.

2) 1031 - There's usually no tax on gains or losses when swapping property for similar property. However, even in an equal exchange, recapture tax might apply. But, if a cost-seg study is done on the old property, you can manage Sec. 1245 recapture tax by doing a study on the new property to confirm it has as much or more Sec. 1245 property.

You cannot swap a fully depreciated gas station for a raw piece of land and avoid recapture - you must replace all the 1245 and 1250 property.

3) OZ - Sure you can defer your capital gains for a few years into an OZ fund, but the magic of OZ investments is the ability to achieve tax-exempt growth after a 10-year holding period. Cost seg depreciation is not subject to recapture here! The compliance on these can be tricky, tread carefully or work with experienced funds.

4) Death - Nothing is certain but death and taxes. For RE owners, death allows you to pass assets to your heirs and step up in basis, effectively eliminating recapture. We generally advise our clients to go ahead and pay the recapture rates if death is the alternative.

The good news about recapture - the deductions are a deferred tax liability to you, and an interest free loan from the government. You will never pay more tax in recapture than what you originally deferred, assuming your personal tax rate stays the same. Borrow the money interest free and compound on

As always DYOR and talk with your CPA.

Here's a framework that you should know for tax planning:

The further you can push your taxes out, the smaller they become.

The time value of money shows us that a dollar is worth more today than 20 years from now.

Planning is used to kick the can down the road, and make sure there will be available cash to pay the tax!

The #1 way real estate investors defer taxes to later dates is with a system called depreciation and bonus depreciation.

Depreciation is the act of slowly, over time, deducting the initial expense of an asset against your taxable income.

Generally over a 27.5 (residential) or 39 (commercial) yr time frame.

So each year you can write off a few percent of the purchase price against your income. & different parts of the asset can be depreciated on different schedules.

To find out the useful lifespan of each component, you do a cost segregation study to analyze all of the parts.

The raw land can't be depreciated so you start by giving that a value first.

But other items can be depreciated on a quicker timeline.

A roof, road, sidewalk, fencing, walls, gates, doors, latches, flooring, air conditioners, pavers, curbing, landscaping, etc.

The IRS has a depreciation schedule for each type.

Some parts are 5 yrs. Others 15 yrs, etc.

So we depreciate a portion of the asset costs faster.

We do the study and get dollar amounts assigned to different parts and different schedules to front-load depreciation.

Now you can get 5 or 6% of the value as a deduction in the early years...

But wait... there's more.

Bonus depreciation allows you to deduct a certain percentage of cost in the first year an asset is put into service.

Anything that is on a schedule of 15 years or less...

So the doors, sidewalks, HVAC, walls, latches, curbs, security, gates, etc

A % of this stuff goes in Yr 1.

For years 2015 through 2017, first-year bonus depreciation for these items was set at 50%.

It was scheduled to go down to 40% in 2018 and 30% in 2019, 0% in 2020.

But then the Tax Cuts and Jobs act moved this percentage to 100% from 2017 to 2022 and 80% in 2023 and 60% in 2024.

Its not uncommon to allocate 30% of an asset cost to items that can be depreciated on a 15 year or faster time frame.

So now 60% of that 30% of your asset's cost can be depreciated in the first year, excluding land.

Pretty great.

This is how real estate owners, investors, and operators make millions and pay very little in taxes compared to W2 employees.

They pay even less and can offset other types of income if they are an RE Pro.

A question that we get:

"Does the IRS require site visits for cost segregation studies?"

While the IRS does not mandate a physical site visit, the IRS cost segregation audit technique guide (ATG) does suggest conducting “field inspections.”

It’s important to note that the ATG is not an official IRS document.

It serves as a guide and cannot be used, cited, or relied upon as an authoritative source.

However, the recommendations in the ATG are worth considering.

According to the guide:

“A field inspection is recommended to document the physical details of the building, type of construction, materials used for construction, the assets contained in the building, the size and types of building systems, and any land improvements that were included in the purchase of the property and the condition of that property at the time of purchase.”

So while the IRS does not require a site visit for cost segregation studies, following the guidance from the cost segregation audit technique guide can be beneficial.