The Honest Truth about Cost Segregations! Do they Work?

Do cost segs work? Cost segregation studies. You know that bonus depreciation to save you thousands of dollars in taxes. Do they really work? Yes, they do. But. But only in a few limited circumstances for just a few select people. In certain circumstances I just think they are overly sold, overly used and frankly overly talked about. I just don't see it. I want to break it down. I want to tell you the good, the bad and the ugly. And why in our accounting firm doing thousands of tax returns around the country, we see a handful of people actually get any benefit out of this strategy. Let's break it down. First. Let's talk about what a cost segregation really is, why it's used, what it looks like. So we're on the same page. Now let's assume again, left side, right side. Your ops are over here. You might have a little sole proprietorship, you might have an S corporation, you might have a W2 or your spouse has a W2 and you've got all this income over here and you're paying way too much in taxes. But you know the benefit of rental real estate and you want to get write offs down here on your 1040 tax return, which is down here at the bottom. So let's assume you're going to buy a commercial property. I know you might even try a cost segregation on a single family home or a duplex or a four plex. But you know what I'm saying, if you're already looking into this, the benefits get less and less the lower value of the property. So I'm going to just use something I think is the most common circumstance of where a cost seg is used. You got a million dollar property. So you've got this million dollar commercial property, $1 million and you pop it into an LLC and you want some write offs. Okay? Now what normally happens is you're going to have to depreciate this million dollars the building over 39 years. And you don't want that. You want to get a bigger write off because you're trying to save taxes. So you say, alright, let's go look at what the personal property portion of this building is. But we got to start at the top. So let's say, and I'll be generous here, let's say that 20% or $200,000 is the land value. Now can you depreciate the land? No, you can't. So the 80% is the building or $800,000. Now let's say we do this cost segregation study and we'll come to the cost benefit analysis in a moment. But let's just say I do 25% is personal property. Whoa. Oh my gosh. 25% of this 800,000. So if we do the math, 25% times this $80,000, that's going to give us a $200,000 personal property allocation. Well we can bonus depreciate that. I mean this is great. I can take this $200,000, drop it onto my 1040 as a loss because I get to write off this $200,000 all in one pop. Now if I'm in a let's say 35% bracket at 30% fed and 5% state tax bracket, so that's 35% and let's say, and some of you may be in a higher bracket, if you're making a lot of money and you're buying a million dollar building, you could be even in a higher bracket. But let's just say it's 35% fed and state. Well, 35% of 200 grand is 70,000. So you just saved $70,000 in taxes by doing a cost seg. Now let me repeat that because I get a $200,000 write off, my AGI goes down by 200,000. And so if I'm in a 35% tax bracket, I pay 35% less taxes on $200,000. So I just saved $70,000. Woohoo. I'm done, right? Oh no. This is where the truth of a cost seg needs to come into play. We've got three problems I want to talk about. Let's break it down. Alright? Problem number one and this is what drives me crazy and is not even talked about it as much as it should be. Does Everybody get this $200,000 write off? I've got these real estate losses. Shouldn't I deserve that because I went out and bought this real estate. Now if you or your spouse don't qualify as a real estate professional, then you do not get this write off. It goes into a bucket. This is the first problem is it turns into a passive loss carry forward and I'll tell you in just a quick summary and you can watch my other videos on YouTube. Type in Mark Kohler, Real estate professional. I've got videos where I break it down and I love the strategy but you've got to be you or your spouse full time or your primary occupation in real estate. If you got a part time job or a W2 doing something else, forget it, it ain't going to happen. Number two, you got to do 750 hours of real estate throughout the year. That's 13 hours a week of managing, fixing, repairing, selling. That's not just shopping around trying to buy other real estate or even bookkeeping. You got to be careful there. And number three, you got to show material participation. Now you can have a property manager, but you got another 500 hour rule to deal with. So you got to know what the rules are. And if you say, oh, I'm a real estate professional and check the box, oh, I've had clients come to me that checked that box and got audited, it's not pretty because you got to give this deduction back. So if you or your spouse and you got to talk to your CPA first because they got to sign off on that tax return, trust me, you're not doing this freaking thing on TurboTax. So you're going to be like, oh, is my CPA going to buy that? Me or my spouse or a real estate professional? If they do, then we're over the first hurdle of this being deductible. 100% against your other income because you qualify as a real estate professional. If not, it's going to go into a passive loss carry forward. That's problem number one. So if you don't even classify as that, don't even talk about a cost seg, it's a waste of freaking time. Okay, let's go to problem number two. Assuming you're a real estate professional or your spouse and you're going to get this write off. So, so we're past this. Let's flip this over and let's kind of zoom in on this little property here. So you've got your property and you've been getting your $200,000 write off, which equates to $70,000 in tax savings. You're pretty happy camper. Now, if you're in the real estate industry, you know that you're going to sell this property someday. Is it going to be in 3 years, 5 years, 7 years, 10 years? What are you going to think about when you go to sell this property? You're going to think about, yeah, a 1031 exchange. Because I don't want to recapture depreciation, I don't want to pay capital gains tax. I'm going to take this property that I bought for a million that's now worth $2 million, and I'm going to exchange it for maybe another property, maybe two properties, maybe three properties. We did a 1031 exchange two years ago where we sold one property worth 3.5 million and bought 20 other properties, no tax. They're pretty cool. You can sell one, buy five. You could sell five and buy one. As long as you invest the sales price in an equal or greater value manner, you can avoid any tax at all and just kick the can. And you can do that throughout your life, creating more cash flow and not pay any tax. And then when you die, your family inheritance the property, this is all that property stepped up basis. This is called the 1031 exchange. Okay, you're like Mark, why are you talking about this? Of course I want to consider a 1031 exchange. Oh, guess what? You can't 1031 exchange personal property anymore under the Tax cuts and jobs act. So this $200,000 write off that you got comes back Even in a 1031 exchange, the depreciation recapture on the building, you don't have to pay taxes on that. You can kick the can on capital gains on this increase. Don't have to pay tax on that. Oh, but when you go to do a 1031 exchange, they're going to want you to claim this $200,000 as income and then you're going to have to give back that $70,000 tax deduction you got. Oh, so wow, I didn't know that. I thought these cost segs were just freaking awesome. And I get this bonus depreciation that's unlimited. Well, well this is problem number two, my friends, they don't work in a 1031 exchange. So ouch. I better be thinking about this because really, and this is going to lead us into problem number three. All this is is an interest free loan from the IRS because I can never 1031 exchange out of this. I think one of the only things you might be able to do is a charitable remainder trust to get out of the tax on this and donate the whole thing to a charity you might set up. We do those too. I love them. Got another video out on YouTube on that. Not everybody wants to give their real estate to charity. So this 1031 exchange is going to be another hurdle because you got to give this 200 grand back and that's in three years, five years, whenever you go to sell the property, I got to give it back. Alright. Now, third and final problem. I want to talk about the cost benefit analysis. You've got to spend some money to get this thing done and is it worth it? Now I'm not even going to talk about the time and energy that you spent wasting thinking about this when it really Wouldn't work for you. Sorry, I'm just throwing that out there, but this is not an easy project to embark on. And is it going to be worth your time and energy? I'm not going to worry about that. Let's just talk hard numbers. Does anybody really talk about present value or future value of the fact I've got to give that $70,000 back in the future? Let's run a cost benefit analysis. So under this cost benefit, how much am I going to spend for this cost seg now on a million dollar property? And I even text a friend right before this too, I called my partner. We think $4,000 is being pretty generous. We could see that price for a cost seg analysis on a million dollar property be anywhere from 4 to $6,000. But let's say I spend $4,000 on this cost seg. Alright, cool. Now remember, I'm going to get a $70,000 write off and everybody wants to talk about that. So let's look at it. Oh my gosh. I spend 4,000 and I save 70,000. Sign me up. But do they mention you've got to give that $70,000 back even if you do a 1031 exchange and you've got to give it back at ordinary income rates, not the 25% depreciation recapture rate you. And again on a 1031, it doesn't matter. You can't even kick the car, can. You've got to recapture it at that 35% rate of what you got in the first place or whatever your rate is in the future. Hmm. So I've got to give this 70 grand back, but what is it worth in the future? So let's talk about future value. Now for you financial geeks out there, you might like to talk present value, but I think it makes more sense in a future value concept. So let's say I'm going to sell this property in five years. Okay, I sell it in five years. And let's say I could take that 70,000 that I made in tax savings and invest it. And let's just be moderate here. Now you might invest it in your business and make goodles of money. I don't know. But let's just say you put it in a pretty strong ETF or mutual fund and you make 8%. Fair enough, just 8%. Now if I take this 70 grand and invest it for five years at 8%, going to have approximately $103,000 in five years. So that means I made $33,000, I got an interest free loan from the IRS. I got 70 now and assuming I'm in the same tax bracket five years from now, I got to give the 70 back. But in the meantime I invested it or I had the use of that money and I made $33,000. Okay, Mark, I'm still going to do it. Well, let's think. You had to spend 4,000. Now what would be the future value of that 4,000? If I invested it at 8% over five years, it's going to be approximately $6,000. So I've got to compare apples to apples. So if I am going to make $33,000 down the road, future value. Well, I got to think what did that 4,000 really cost me? Future value. So I've got to subtract it here, 6,000 off of my 33. And so I'm going to net 27,000. That's my real benefit. But you have to remember this too. That's a interest free loan from the IRS where I made $27,000 on the money during that five year period. If you take this 70,000 and put it in your mattress, you're not even, you're losing money, right? You've got to go out and at least make 8% and you can start doing the math backwards and find out real quick it wasn't worth it all the time, energy and money to do this if I'm only just going to have to give the money back. In summary, this is the third problem. This cost to do the cost seg. And I'm not saying it's not worth it again, but we need to go in with our eyes wide open, realize that it's not just this island of tax, you know, paradise where I, you know, I just get this money from the IRS and I save 70 grand and I forget about all this other crap down the road. So this is the third problem we got to be thinking about when we really do the math on the benefits of this. And just think of that, that million dollar property, we're assuming you get 80% building allocation and then a 25% personal property allocation. And we're going to assume you're going to make 8% on this money theoretically over time and that the cost is 4,000. Those are a lot of variables to assume in order to just make $27,000. And you better darn well be a real estate professional. In summary, I love saving taxes, I love real estate. I'm a CPA and attorney helping clients all over the country and I've got an amazing team in my accounting firm that breaks this stuff down. I go out on the streets and talk about it. I live in a van down by the river trying to help people all over the country with this great books newsletter, all that stuff. But the point is people have got to go in to these tax strategies, asking the hard questions and getting a second opinion when it sounds so sexy and cool. So I hope this has been helpful. Keep investing in real estate. I hope someday you might even qualify as a real estate professional or your spouse. I'm working on taxmatch.com I'll find that perfect tax spouse for you that saves you thousands. Anyway, please continue to watch my videos. Subscribe below. Hit the bell. So when I go live, you're going to get a ping whenever I shoot a new video as well. And I've got links down there to my social media, my newsletter where I give out a free newsletter every week to help clients with tax tips, deadlines, little videos and clips and all that good stuff. Keep living the dream. It's real and I'll be right there alongside with you. Thanks.