Tax Advantages of Cost Segregation in Real Estate Investments

Discussion between Dr. Meetu Bhatnagar, CCIM, and Yonah Weiss, Cost Segregation Expert on tax advantages of doing Cost Segregation.

Dr. Meetu: Yonah, what is cost segregation? Will you please share this with our listener?

Yonah: I think I can do that. It’s really something that is not as complicated as it sounds. Cost segregation is a fancy way of saying a very advanced form of depreciation. And depreciation is a tax deduction that you get on your commercial or investment property. And basically, when you buy a property, the government incentivizes you by giving you a tax deduction, based on the principle that things go down in value as time goes on. That’s called depreciation, right? But your building's probably actually going up in value as time is going on.

So it’s not really depreciating. Nevertheless, they give you this tax deduction that says you can write off the entire value of your property over this long period of time 27 or 39 years. That’s called depreciation. Cost Segregation is really just segregating that cost, right, breaking down that cost into different buckets, two different categories that depreciate at faster rates. And it’s a very detailed engineering process that allows us to identify things in the building that actually depreciate faster than you would have been depreciating it meaning taking those tax deductions at that very long period of time.

Dr. Meetu: When is the best time to do this cost segregation study?

Yonah: It’s relative, usually most people get it done in the first year, they’re trying to get it done as soon as possible, because they want to set up the property tax deductions from the beginning in the right way. However, it does not need to be done in the first year. And in fact, certain times it may be more beneficial to wait. For example, if you don’t have enough income coming in, you don’t need those extra tax deductions, it may not make sense to get it right away. Also, some people may just want to wait to even out the playing field a little more. And maybe they didn’t even know about cost segregation. Another great example, people didn’t know about it. And here you are years later, you can go back retroactively, do a segregation study, meaning get those tax deductions that you missed that accelerated depreciation that you missed over the past several years, and you can get that this year.

Dr. Meetu: What kind of properties qualify for this cost segregation? Suppose I have a portfolio of 15 single family homes? Does it qualify? Or do I have a quad Plex or 100 unit apartment complex? Does that qualify for it?

Yonah: Yeah, really, any type of residential or commercial property, it doesn’t really matter what type of property is can qualify, because the qualifying is really just using the depreciation utilizing that and front loading or accelerating certain portions of that depreciation. So really any type of property besides for your personal residence, that’s the only thing your personal residence, you don’t get the tax deduction, depreciation for that. But qualifying is one thing, meaning getting that depreciation is one thing, the real question is, can you use it right? Are you going to be able to benefit from it? And how much of it can you actually use? So, we talked about accelerating depreciation, allocating certain portions of the property to these faster schedules? Typically, we’re talking about between 10 and 30% of your actual purchase price will go into that faster depreciation that you could take in the first five years of first year even. So you’re talking about which types of properties will qualify? Well, it’s going to depend a lot on what’s your purchase price? And how much of that percentage, is it going to be worth it?

Dr. Meetu: What’s the ballpark number that we should keep in mind, for the properties that are worth going for Cost-Seg? Is it 1 million or something like that?

Yonah: My rule of thumb is usually any property purchase for over a half a million dollars, even that small, is really worthwhile to look into. And we provide in most cost segregation, companies will provide an upfront free analysis, just to see if it makes sense. It’ll be kind of a feasibility analysis of sorts, where we’ll take the data from the property without actually visiting it without doing the full engineering study. But just based on our data, and the data of the property to know what you can expect, if you do a full. Is it worth it? Is it worth spending a few thousand dollars to get this full study done? What’s my outcome going to be? So, on off 10%? Even the bare minimum of a $500,000 property? You’re talking about an extra $50,000 of salary depreciation? That’s not nothing,249. honestly, something to go all in on, but it’s definitely worthwhile to look into.

Dr. Meetu: What do you think about construction projects? Suppose I am building a hotel Do you think it’s worth going for? And what is the process for the cost-segregation of new build up? Is it like something different? And what is the best approach?

Yonah: It’s very similar. In fact, you’re able to get just like you would on what we do with the engineering process is really on an acquisition, we’re reverse engineering the property, and we’re saying, okay, you buying this whole building based on this purchase price, we don’t have to see and come in and identify all the little details, he will How much is this roof, relatively to the whole property. Whereas when you’re doing a new construction, you have all of the details, you have all the invoices, you know, how much was spent. And that process is a little easier because the engineers can actually allocate all those individual items into this faster depreciation schedule. So, it can be done on a new construction. No problem.

Dr. Meetu: What do you think? How much does it cost? Any ballpark number do you have? Because it sounds like it’s quite complicated. And with that, engineering studies involved, it could be quite expensive? Please share your thoughts on it.

Yonah: Yeah, it is, can be a little bit expensive. But there’s a lot of misinformation going on out there. I’ve seen people write articles and say, Well, this only makes sense for huge commercial buildings. It costs like $50,000 to get this done. It’s not. Typically, for multifamily properties or commercial properties, we’re ranging between four to $6,000 a onetime flat fee for that type of property. Smaller single families, we actually have a flat rate we’re doing now for $1,000 a piece.

Dr. Meetu: So how much should I expect to save? Suppose I’m doing an acquisition of a $40 million portfolio? So, what should the amount that I will save if I go for this cost segregation study?

Yonah: Yeah, like I said, typically we’re looking between 10 to 30%. And multifamily properties are usually closer to 25% is pretty much the average for the reallocation. So, the first thing we need to do is we need to separate a certain amount for land because land does not depreciate. And then so from that $40 million, you may still have, let's say, take off 20% for land, you're still left with a large portion, you're still left with 36 million, something like that a large amount that you can now depreciate. You take 20% of that, 25% of that, I mean, you're looking at easily something close to $8 to $9 million of accelerated depreciation on a project that size.

Dr. Meetu: Can cost segregation be used to offset active income from other businesses? Or is it used to offset the rental income only?

Yonah: That’s a great question. And this is probably the hottest topic when it comes to cost segregation. There’s something called a real estate professional status. And this is a really important status because this is really going to determine how much of the depreciation you can use. Typically speaking, rental property income is considered passive income. Depreciation is a passive deduction; this is allowed to offset your passive income. However, if you have real estate professional status, you no longer have that passive loss limitation, which means you can use any extra depreciation, beyond your rental property income to offset your active income from any other source, you or your spouse.

Dr. Meetu: And what happens if I am not able to utilize all that negative K1 or passive loss in present year? Can I take it further into the forthcoming years?

Yonah: Yes, it carries forward. So, any extra depreciation you don’t use, that passive loss carries forward you can use in a future year.

Dr. Meetu: Suppose I bought a building in the past? Can I still do cost segregation on that?

Yonah: Yes, absolutely. You're able to do what's called catch up depreciation by changing the accounting method. You can catch up whatever depreciation you missed from previous years, and take it this year.

Dr. Meetu: One of our listeners was wondering, isn’t that our CPA is already doing cost segregation for us?

Yonah: Likely not. Cost segregation requires the engineering component to it. It’s really impossible for an accountant to properly do this without engineers in-house.

Dr. Meetu: So, while vetting a cost segregation study guy, what are the questions I should ask them to qualify them?

Yonah: Number one is that they have experience, and their studies have been tested by an IRS audit with audit protection at no extra charge.

Dr. Meetu: So, do you think like doing this cost segregation study can put me at risk of an IRS audit?

Yonah: This does not put you at a risk of an audit in any way, shape, or form, because this is literally the proper way to depreciate your property.

Disclaimer

This content is for educational purposes only and does not constitute tax, legal, or financial advice. Please consult with your CPA, tax advisor, or attorney before making any investment decisions.