#15: When Should I do a Cost Segregation Study?

Or it can lead to them, making a terrible choice that can end up costing them an insane amount of money. So when you go to a tax professional, And do you ask them? Should I consider doing a cost segregation study on my single family house. And their immediate response. Is no. Absolutely not. They're not worth it. Cost segregation studies are only for commercial properties or cost segregation studies. Only ever make sense on a house that costs this amount or more.

Or no one should do these unless they're a real estate professional, et cetera. That should give you a little bit of reason to guess. And if you are. A tax professional who approaches cost segregation studies. With such a black and white viewpoint, then hopefully this episode will open up your mind to a little more consideration around

them. a cost segregation study. It's something that a real estate investor can have done to a piece of investment property. Where instead of just depreciating an overall building has one asset. The study has an engineer go through and allocate out. Various components of this building. So instead of having one building that gets depreciated across 39 years or 27 and a half years. Now we have other assets like flooring windows. Appliances fencing, et cetera.

And because we have values for all of those items. We can now depreciate them separately. And some of those have shorter lives. Meaning that we can now write off the cost value of the fence. Across its correct. 15 year life instead of the presumed overall purchase of a property 39 year life. Right. Anyone who has bought real estate, you typically don't receive a breakout of everything you're buying. It's normally just the property, right? You're buying one lump sum.

Of a building of land, have everything in it, have everything attached to it, of all of the appliances that came with it, et cetera. So people like a cost segregation study because it's more accurate. Because it can potentially give us larger depreciable amounts per year. And. Because we've had bonus depreciation. Which is a fancy word for writing off a bunch in the first year. And anything with the life of 20 years or less could qualify for bonus.

So it was preferential to separate out as much as we could from that long building value. Because then it could qualify for bonus depreciation. So those are all the reasons, people like a cost SEG and what they are.

Now let's get into when someone should actually consider a cost segregation study. Like I mentioned at the start of the episode. Anyone who provides a clear black and white when you should or shouldn't with no wiggle room. It's probably not the person to be discussing this with.

There are two kinds of cost segregation studies. There are a D I Y a study where you enter your information on a website. And it uses a gathered information algorithm to take a best guessed estimate. At your values of components. And spits it out. We don't like these. In the past year or two. I've known multiple colleagues who have had these DIY studies. Specifically, fully disallowed by IRS auditors. So even though a DIY study can be under a thousand dollars. It's almost never going to pass.

An IRS audit.

Now if a DIY study is just under a thousand dollars. What can we expect to pay for a full study? With a full study. An actual expert, an engineer analyzes the property. They come out and tore it, or they have you do a video tour of it. And then they look at the actual size and components and materials of your property. And assign reasonable values based on an expertise. One of these full scope studies. We'll typically cost between $3,000 and $15,000 for a single family home.

I know this is quite a range. On average, if you are talking about your standard. Three two and a residential neighborhood. You're probably in the three to $5,000 range. If you have a unique property way out in the mountains, you're going to get into that higher range. Once you go into commercial real estate, it goes up from there. So one of the initial things that I hear when it comes to the question of who should do, or when should someone do a cost segregation study?

Is a specific price point of real estate. A cost segregation is only worth doing. If the house was $300,000 or a cost segregation is only worth doing on real estate of a million dollars or more. This is a stupid response, and I'm going to tell you why.

What a property costs. And what its depreciable value are, can be dramatically different. When we have a piece of depreciable real estate. We typically have purchased everything in one amount. And then we need to separate out the value. For the land. Versus the building. Land value is not appreciable. Building value is. There are some locations where I have seen. 70%, 80% being all land value. If this is a tiny house in a really populated city. The land is what holds the high value.

Not the tiny crappy house. That's going to get torn down and probably built with something new. If you're looking at houses. In the rural Midwest. Then there's a good chance that the land value is 10% or less on many of these properties. So a dollar to dollar comparison. To say this purchase price is where it makes sense. Doesn't matter. The amount that is depreciable is what matters. If you have a $500,000 house. But 50% of that is land value. You're only getting to depreciate $250,000.

If you have a $300,000 house. But only 15% of that is land value. You're going to have 255,000 of depreciable value. So the purchase price of the house is not what's relevant. It is what is the depreciable basis? I will typically say, but if a property has an appreciable basis of $250,000 or more. That's where it makes sense to look at a cost segregation study. If it's less than that. Would it make sense? Maybe. Everyone's circumstances are different. So for me. $250,000.

Of depreciable value, not purchase price. That's going to be my sweet spot. We're from there and up. I will absolutely look at this. Most cost segregation firms will also do a feasibility study on the front end. now you can do a quick analysis on what the cost will be. And the potential savings will be. Once you have figured out if the property is worth investing in one of these studies. The next question that comes into play. Is really, is there a benefit of having the study done?

There are multiple situations. Where someone is unable to use losses created by real estate. Long-term rentals are typically passive. And passive losses are limited. Once your income gets above a hundred thousand dollars. If your income is above 150,000, you might not be able to use any amount of losses. So that being said, A key consideration of if someone should or should not do a cost segregation study. Also comes down to, is there an actual, usable purpose? For this study.

Or will you be spending $5,000 per rental this year? To get back zero in savings because you've created. A hundred thousand dollars of losses. But you can't actually deduct a penny of them. So you need to look at if the loss can actually be utilized and help your tax situation. There are four scenarios where it is typically worth it. The first one being real estate professional status. If you have real estate professional status.

Where you spend more time on real estate than any other activity spend at least 750 hours a year in real estate. Then you're normally passive rental activities. We'll be classified as non passive, and as long as you're materially participating in that activity. You can use losses. It creates your only limitation is going to be the excess business loss limit. If you're a real estate professional. And if your property has a depreciable basis of 250,000 or more. Absolutely.

Take the next step and look into doing a cost segregation study. You'll be able to use those losses to offset your other income. See if that helps and make sense for your tax position this year. The second time when it makes sense to investigate a cost segregation study. Is if your adjusted gross income. Is under a hundred thousand dollars. If your income is under a hundred thousand dollars. You can utilize up to $25,000 a year of passive losses.

So, what this means is if you do cost segregation studies this year, And you create a hundred thousand dollar loss. You can potentially take a quarter of that every year for the next four years. That's not a bad position to be in. The third circumstance where it's worth looking at a cost segregation study would be the short-term rental loophole. If your rental has an average guest stay of seven days or less. And you materially participate in the property. It is by nature.

Non-passive it falls out of the definition of a passive rental. In this case, any losses that it generates you can deduct against your other income sources. Even if your income is above that $150,000 mark. The last circumstance that people often forget. Is, if you have a large amount of passive income for a year. Including gain from the sale of a passive rental. If you have 10 rental properties. And this year you are going to be selling two of them.

And you know, you're going to have a $500,000 gain. Could you do cost segregation studies. On one or more of your remaining rentals. And use the losses that generates to offset that gain. Passive rental losses. Can offset the gain from the sale of what was a passive rental property. So even though those losses wouldn't be deductible against your other income, had you not sold those rentals?

Because you have sales from rentals in the same tax year, the gain from the sale of rental properties can be offset. By current year or prior year, carry over passive losses. If you have this circumstance or, you know, this is coming up where you're going to be selling some of your properties. That is another fantastic opportunity to look into a cost segregation study.

A few other considerations. How long have you already owned that property? If you have owned that property. For 30 years already. And it's a 39 year asset. You don't have much depreciation left to separate out and have benefit from. You've already used up. Most of it. The shortest asset class that we are separating costs into in a cost segregation study is going to be five-year assets.

So if you have already owned the property and been depreciating it for 10 years at this point, All of those five-year costs of depreciation. You've already worn out. the longer you've owned a piece of real estate, the less beneficial this becomes because you have less depreciation left to tap into. The next consideration. If you are doing this study in a later year. Your tax professional will need to complete form 31 15. With your tax return that year. Now, this is a pretty in-depth form.

And you can expect to be charged a higher amount for your taxes. In the year that it requires a 31 15. If you look at the instructions for this form. It literally notes that just the time to prepare it. Not including time for bookkeeping and preparation ahead of time. But just the time to complete the form. The estimated time it has on the instructions is 21 hours. So when you are running numbers to decide if a cost segregation study is worth it.

You will need to consider both the cost of the study. And the additional cost from your tax professional. To include that 31 15 and the extra time on your tax return that year. The final two items for consideration. On, if you should do a cost segregation study. Our two that are often overlooked. And can be fantastic strategies. The first one being. If that rental property was in service when you purchased it. And then you have it vacated so that you can do a large renovation on it.

Doing a cost segregation study at that point, before you do the renovation. Effectively means you're going to get to almost right off. More than one single renovation. Let me explain. If you had no cost segregation. And the building value that appreciable value on that property was a hundred thousand dollars. And then you went in and spent. 50,000 on a full studs out, rent out.

All of those pieces of assets that you disposed of everything from that original property that you threw out there, floors that were in there when you bought it right. The appliances that were in there when you bought it. You don't know the values of each of those without a study. So even though you disposed of those. You can't write off any carrying value. If you have a cost segregation study done. On the property that's in service already has a tenant when you buy it.

Then, you know, the cost of. Those five-year floors. So if the cost segregation study says these floors have a value of $5,000. And six months later, you throw them out. You get to write off whatever their remaining carrying value was. And then you turn around and install new floors that costs $8,000. And now you get to treat those new floors as a five-year asset that qualifies for bonus depreciation. So if you buy a rental that is already in service, when you purchase it, it came occupied.

And, you know, you're going to be doing a large renovation. Doing a cost segregation before it can have a huge benefit. The final consideration for if you should do a cost segregation. Is, if you are going to be selling a property. That you've owned for a while and it has some 1245 assets broken out. These are your, what are called personal assets, personal property. So this is going to be those items that we could separate with a cost SEG. Such as carpet LVP fences. Appliances are a big one.

You might also have some of these assets on the depreciation schedule, even if you didn't do a study already. If you went through and replaced any of these assets. You will probably have appliances listed as five-year assets. If you put all new flooring in your accountant should have separated out, you know, that carpet as five-year assets. When you sell. Those 1245 assets are taxed at your ordinary income tax rate. And there's not a cap on it. Whereas 1250, which is your permanent assets.

This is what you're building. That's depreciated on a straight line. Value is considered. 1250 property. Is taxed at your ordinary income tax rate, but capped at 25%. So a large concern for people when they sell a real estate. That has had large amounts of bonus depreciation taken. There have been a lot of these shorter life assets written off over the years is when they sell, having to pay those amounts back for that depreciation recapture. But at the ordinary income tax rate.

That can be twice as high as capital gains. So if you know that that's the case. Before that property is sold, you should consider doing a cost segregation study. Prior to the disposal. Because again, what this study does is goes in and Gibbs. A value of the components of a property now. If it has figured out that what this property had was five-year carpet and it was installed 15 years ago. The value of that carpet today might be nothing. If it has no value, it won't have any portion of gain.

So by doing a cost segregation before you sell a property. You can potentially shift more of that gain from that higher tax 1245 depreciation recapture. Back into that maximum of 25%, 1250 gain. So another consideration. Everyone's circumstances are different. And your tax situation can be dramatically different. Then the person who was told something was the writer wrong response for them?

So if you have rental real estate, If you have a depreciable basis on a property that's 250,000 or more, I would recommend absolutely investigating the idea of a cost segregation study farther with your tax professional. And if you're a tax professional listening, who's been a little gun shy about cost segregation studies. A lot of professionals still think they're very, very expensive and typically not worth it.

That hasn't been the case since T C J a. Since we had those new, tangible property regs, there's a lot more value of the studies and the price of them has come down significantly. If you're a tax professional who is looking for somewhere to get guidance and to community and mentorship on all things tax from a point of accuracy and cited responses and feedback and support from people who have been in the industry for decades. Come check out the insight tax community.

It is an online private community for tax professionals, accountants and bookkeepers. It was established by four industry educators. And it is the only community that requires all technical answers. To be provided for questions with some kind of citation or reference. We're not letting people just make crap up on Facebook anymore. If you're in the insight group, you've got to pick up and put down the receipts for whatever it is you're saying. So I hope you come check us out.

As always, I hope that you guys have found some value from this episode. Please like subscribe and share. Thanks so much you guys, and as always, I will talk to you next week.