The Mark Perlberg CPA Podcast
The Mark Perlberg CPA Podcast
EP 120 - What is Cost Segregation & When do we Use It?
Cost segregation stands as the most powerful tax strategy for real estate investors, allowing identification of property components that can be depreciated faster than the standard 27.5 or 39-year schedules.
• Typical cost segregation studies reclassify 25-30% of a property's value for immediate write-off through bonus depreciation
• Without cost segregation, investors typically write off only about 3% of purchase price in year one
• Two key scenarios maximize benefits: real estate professional tax status and short-term rental properties
• Non-passive losses created can offset W-2 income, business profits, or capital gains from other real estate
• Business owners who own their buildings can use cost segregation to offset business profits
• Investors can put down 10% on short-term rentals and potentially get their entire down payment back in tax savings
• Depreciation recapture means paying taxes on previous deductions when selling, making exit strategy planning important
• Cost segregation studies typically cost $3,000-$6,000 but can save tens or hundreds of thousands in taxes
• Studies can be done retroactively – not just in the first year of ownership
For a personalized opportunity report showing how cost segregation could save you money, visit https://ProsperalCPA.com/opportunityreport. To learn foundational tax planning concepts, get our free Ultimate Tax Planning Checklist at TaxPlanningChecklist.com.
When it comes to real estate and tax planning and tax savings and the tax incentives associated with real estate, you can't ignore one strategy that stands out among the rest. I would say that this strategy is to real estate tax savings as Bob Marley is to reggae, as Super Mario is to video games. You can't talk about real estate tax strategy and savings without talking about this one big word that became even more powerful in the big, beautiful Bill Act, and that word is cost segregation. And I'm sure if you've been listening to me listening to me for a while you've heard me talk a lot about cost segregation, and if you haven't, you should, uh. So in this episode here we are going to dive into what is cost segregation. We're going to talk about not just what is cost segregation here, but when do we do cost segregation studies. And then I'm going to answer some of the most asked questions online and that I've seen with our clients on the topic of cost segregation, to give you greater clarity on the power of cost segregation, when to use it and how this could possibly help you out in driving down your taxes and building that generational wealth and really winning the tax game through real estate ownership and investing. All right, let's dive into the material here and let's get to the big question of first. What is cost segregation? Get to the big question of first. What is cost segregation?
Speaker 1:Cost segregation allows us to identify components of a piece of real estate and depreciate those components faster than we normally would. To illustrate this, imagine we have a long-term rental. That rental property is going to depreciate over 27.5 years. I'm talking about the improvements, the building and the driveway, all that stuff. It's lumped in 27.5 years of its residential. And if it's non-residential, like say an office space, it's going to depreciate over 39 years. So we're waiting a long time to write off that property. And guess what? The land doesn't depreciate at all. And think about the costs here. We shell out typically 20% just to buy this real estate and we only get to write off maybe around 3%, not even of the whole purchase price but of the land portion. So you're thinking to yourself, if you may have heard about all these exciting depreciation incentives with real estate and then you hear about this, you're thinking, wait, what's going on here? We're shelling out 20%. We're not even going to write off a small fraction of that in year one. So how is this at all valuable to us, like how are we not going to go broke buying all this real estate? And cost segregation makes this possible. So we're going to look into that real estate property and we're going to find items that we reclassify and say that it's actually not real estate, it's not part of the improvements or the structure.
Speaker 1:For example, we look into this multifamily real estate investment and we find items that we can separate out and give it a different depreciation life because it goes in the IRS's mind it is going to diminish or depreciate. Or we, in other words, we write this thing off for the wear and tear, because that's what depreciation is. We write it off faster. For example, we go into your home or the multifamily and we find a refrigerator. That refrigerator can be moved out of the property. So when we identify this refrigerator, that refrigerator is not really real estate. In fact it is what we call personal property and the personal property is going to depreciate over five years. So we get that depreciation faster. Another example some other things that are going to depreciate faster the driveways are going to depreciate over 15 years. Faster depreciation, faster write-off. Some other items let's say it's a furnished rental the TV, the linens, those bed sheets aren't going to last 39 years, which is how long we would normally write off short-term rental, building Swimming pools, a lot of these things have different class lines where we're able to write them off faster than the rest of the real estate.
Speaker 1:So we have a cost segregation study where an engineer walks the room or we can do it virtually, depending on the complexity and the size of the property and we identify what are the values of all these things in the real estate that can depreciate faster than the actual building itself. And when we assign values to them, we say hey, this building isn't really all $100,000, all a million dollars. Well, maybe $200,000 of it is actually going to be personal property, such as the furniture, the cabinetry, the crown, molding, the ceiling, fans, the blinds, et cetera, et cetera. So we have a new group of assets within this real estate that qualifies as five-year-life property, depreciates faster. And then we have our 15-year-life property, which is likely going to be the land improvements like the swimming pools, like the driveways, retaining walls, and then we can write off that faster. Now still, you're thinking to yourself well, five to 15 years is still a long time.
Speaker 1:Well, there's another thing here that we also have to understand, and that concept is bonus depreciation. When we have bonus depreciation, we can write off anything with under a 20-year life immediately in year one on our federal income tax returns. So we are going to write off all that five-year life property and all that 15-year life property. So what we typically see here now we put 20% down on your typical rental, we do a cost segregation study and instead of writing off less than 3% maybe more in certain circumstances, but less than 3% of that purchase price, let me just say let's just say I don't want to confuse it so we put 20% down instead of writing off around 3% in year one, which could be more or less depending on if it's residential or non-residential. But instead of putting down 3% or writing off only 3%, we're now going to write off.
Speaker 1:When we do these cost segregation studies, it's usually around 25 to 30% of the purchase price and some factors could allow us to write off even more than that. I've seen cost segregation could allow us to write off even more than that. I've seen cost segregation studies allow us to write off as much as 50% of the purchase price in year one because of the bonus depreciation right. So first, without a cost seg, we're going to write off the building over either 27.5 or 39 years. Then we do the study and we find this five and 15 year life property and then we write all that off immediately. We write off all of the driveways, the swimming pools, the cabinetry, the crown, molding, the carpets, the TVs, the linens, the kitchen supplies, the pool tables, all those things, the office desks, etc. Etc. We write all those off immediately and that gives us a giant chunk of depreciation. So that's what cost segregation is. It allows us to identify objects in this building that depreciate faster than the building itself and get an immediate write-off, and you can qualify all those items for bonus depreciation on your federal tax return.
Speaker 1:Now let's talk about when we want to do this. Typically, the most common instances when we want to do a cost segregation study is when we have long term rentals with real estate professional tax status or we have short term rentals, and the reason why is because it gives us non-passive losses with our rental activities. Keep this in mind. Back to the concept why we want to create rentals, to create losses and why it's so wonderful. Well, the losses are usually not that powerful if those losses are passive. And if they're passive they can't offset your W-2 income and they can't offset your business income. So, yes, real estate can create losses, but if those losses can't net against your business income and your W-2 when we do your tax return, there's really no value. It just means you're not paying taxes on your revenue. That's good, but wouldn't it be great if we could take these losses and say tell the IRS, hey, because of these rental losses, this guy makes less money and owes less in taxes? That's really where we want to be. And the two scenarios again.
Speaker 1:Let's go back here. If you have real estate professional tax status, that means you or your spouse work at least 750 hours in your real estate trader business and you work at least 50% of your hours and you own 5% of that activity. So most common instances is someone full-time in real estate real estate agent, house flipper, land flippers, construction workers. You just need you or your spouse totime in real estate real estate agent, house flipper, land flippers, construction workers. You just need you or your spouse to have that real estate professional tax status and you need to materially participate. We have a whole conversation on real estate professional tax status. I'll put the link in. We dive deep into that concept. But material participation is a certain amount of activity you got to put into your rentals. Usually we have to save substantially all 100 hours or at least 500 hours, but we're going to not dive too deep into this.
Speaker 1:If you are a real estate, you or your spouse is a real estate professional and you put a certain level of participation into the oversight and the management of this rental property, now we can create losses that are non-passive and can offset any other types of income. Now that's where it gets really exciting. Here you buy the rental, you or your wife is full-time in real estate and now we can accelerate the depreciation of this rental that you manage and it creates a loss that can be used to create to tell the IRS that you make less income and then give you a refund if you have been paying money in taxes. So this is really popular with high income earning doctors and physicians and attorneys or business owners. The spouse is at home. The spouse gets real estate professional by managing rentals or maybe being a real estate agent, and then they manage the rentals so they materially participate. They do a cost segregation study that creates lots of bonus depreciation, tax write-offs. And then what we do when we file the tax return and we've created six figure refunds with this we show the losses from the real estate. It offsets the income and now we get a big tax reduction.
Speaker 1:Now another really common strategy and also you can look into my webinar, my podcast titled what is the Short-Term Rental Loophole. It's short-term rentals. Now, this is really popular because it's hard for you to get that real estate professional tax status. It's hard to say that you or your spouse work full-time in real estate. You can't do that while balancing a W-2, but you can circumvent it with the short-term rental loophole. Basically, what we say here is if the average length of stay is seven days or less, as a short-term rental is usually, and you materially participate, which you usually do when you self-manage it, we can also use a loss as a non-passive to offset that W-2 income or that business income. This is super popular for high-income W-2s as well. When both of the spouses work, they say hey, let's team up and get some short-term rentals, we'll do a cost seg.
Speaker 1:You typically write off 30% with these short-term rentals because it comes with all these additional items like the beds and all this personal property and TVs and the couches. You write it all off. A lot of times it comes furnished. You write off all those items and now you get a big refund because the losses are going to offset your W-2 income when you file your taxes. Really exciting stuff here. And if you really want to put gasoline on the fire, get a second home mortgage. We see short-term rentals put 10% down on second home mortgages where they're at least 50 or 60 miles away from their home, and now they only have to put 10% down. So think about the math here. You're going to get more of a loss from the cost seg and you put less money down. So imagine you put 10% down, or $80,000 down on a log cabin that comes with furniture. You write off 30%, so you get a $240,000 write off. Think about the tax savings that creates. You may get back all of your down payment in year one in the form of a refund or tax savings from this purchase. And what do you do? You take that refund and you can put it down on another rental and another, and another. And here's just an example of how you can use the compounding effects of the tax savings to grow your portfolio exponentially.
Speaker 1:Now there are some other instances, though, where we may do cost segregation study. Now, even if it doesn't offset your ordinary income, it can also offset capital gains events from your real estate. It won't offset the stock gains, but we can use losses from one rental property to offset the capital gain from another. To give you an example let's say we're selling a multifamily rental property for a gain of half a million dollars and we don't want to do a 1031 and we don't really have any opportunities to reduce our taxes. But we have another multifamily rental property that we're going to keep and that multifamily rental property is $5 million. So let's say we do a cost segregation study on the $5 million property and we write off 25%. So that's a $1.25 million tax deduction. So now we have enough tax deductions to offset all of the capital gains from the other transaction here.
Speaker 1:So when you have a capital gain event, you can utilize cost seg from. Let me say that again, when you have a real estate capital gain event, you can utilize the cost segregation study from another have positive cash flow. You can use the loss from one rental to create a passive loss to offset the positive passive profits from the other rental, whether it be capital gains or you just have lots of cash flow, or you just have lots of cash flow. The cost seg can create a loss that nets against the profits. And then, finally, another instance that is very common is if you own the real estate where you work. So if you own your building, if you own your factory, your warehouse, your office building, if you own and work there, we don't need real estate professional tax status anymore.
Speaker 1:We can do a cost segregation study on your business property to create a massive loss and that loss will offset the profits from your business. So we've done this multiple times with our clients and, by the way, to best structure this you will want you never want to own structure this. You never want to own real estate, or almost never want to own real estate in your S-corporation. You want to own it in your own name and you rent it out to your S-corp. Now I know, I know there's all these restrictions with whether you can use your rental losses or not. There's a special carve out when you're renting it out to your own business where you can do a grouping election and now use your losses from the rental as non-passive. So you rent out your office building to your company. We do a cost segregation study, we create massive losses and that offsets the profits from your business and drives down your taxes.
Speaker 1:Let me give you an example here. We actually had a dentist that did this recently Bought a property for about $1.2 million. A dentist that did this recently bought a property for about $1.2 million. In this example here we had around a 20% of purchase price tax deduction. So that would be around $240,000 of a tax deduction from the cost segregation study. The engineer came in, inspected the place, identified enough five-year-life property and 15-year-life property that it came to around $240,000 of non-real estate items. That gave us that bonus depreciation deduction. So when we run that cost segregation study now, now we have a $240,000 tax deduction offsetting the half a million dollars of profit from the S-Corporation. Very exciting stuff, by the way. If you want to sweeten the deal, put a solar panel on it. So those are some other instances.
Speaker 1:Now let's get into some frequently asked questions on cost segregation study. Okay, how much can I deduct from a cost segregation study? Your best rule of thumb that we've seen after seeing hundreds of cost segregation studies is if it's a long-term rental, we ballpark 25% of the purchase price. If it's a short-term rental, 30% of the purchase price becomes a tax deduction from the cost segregation study. Next question segregation study. Next question how much can I save from a cost segregation study?
Speaker 1:Well, you can offset up to your excess business loss limitation as a deduction against your W-2. What I mean by that is, if you are single, the IRS only allows you to offset up to $313,000 of your income if you're a W-2 earner or any non-business income Could be stock gains or interest income. If you're a married filing joint, you can offset $626,000 of your W-2 and non-business income with the cost segregation study losses and any other losses from your real estate. Now, if you're a business owner, you can use your real estate losses created from those cost segregation studies to offset 100% of your business profits. Can I do a cost segregation study after the first year? Absolutely. There are many instances where we buy a rental property or business property and we don't see a need to create the losses from the cost segregation study. Maybe the income isn't high enough, maybe we have enough tax deductions from other sources or we're expecting a spike in a later year. So the beautiful thing about cost segregation studies is the timing and flexibility. We can wait until the best year to do a cost segregation study and recognize that bonus depreciation. After year one you get what's called catch-up depreciation and you get to take any tax deductions that you may have missed had you done that cost segregation study and gotten that additional bonus depreciation in the first year.
Speaker 1:Is cost segregation? Next frequently asked question is cost segregation only for new properties? Absolutely not. It doesn't have to be a new construction and it doesn't have to be in the first year placed into service. You can buy a property that is 100 years old and still do a cost segregation study on it. You don't have to do the cost segregation study in the first year you purchased it. And, by the way, as far as when you want to do a cost segregation study, you can do it as you're filing the return. So if you want to do a cost segregation study, you can do it as you're filing the return. So if you want to do a cost segregation study and apply it to 2025, you can do it as you're filing the 26 return. You don't have to do it in 2025.
Speaker 1:For some of you, you may not know yet, based on how everything comes together in your businesses and income whether or not it's worth it. Sometimes we got to wait until the dust settles and we see how everything comes together on the return before we determine if the cost segregation study is really necessary. Is there a minimum cost? I've seen all sorts of different programs and systems and DIYs. The lowest I've seen it cost is maybe an internet DIY service for 500 bucks and I've seen it go up to as high as $15,000. I would say the average cost to have someone else do it is around three to $6,000 for most of the rental properties we see and it goes up with complexity. Now if you're going to a side note on that is, if you're going to use one of the cheaper versions, make sure it's a smaller property and you're not really doing anything too material. If you're going to use one of those simpler DIY services, because you can really miss a lot of important details. If you're going to just wing it on some cheap cost setting service, what if I sell the property after I do a cost segregation study?
Speaker 1:Now this is where you got to do some tax planning, because remember all those tax deductions you got for the depreciation. That depreciation is for the write-off of the wear and tear of the rental when we sell it at a profit or even at cost. It's like we're telling the IRS wait, this is actually worth something. So we have what's called depreciation recapture, where we pay taxes as though that write-off becomes income again, and the recapture of your tax deductions from the cost. That gets taxed at your marginal rate. So you're going to pay taxes on that. You're going to pretty much pay back all the write-offs at whatever your federal marginal rate is not your capital gains rate. So it can be very tricky. So you got to do planning around it. You do 1031s out of it. You can create other losses to net against it all sorts of capital gains and sales strategies to mitigate the taxes on that transaction. Sales strategies to mitigate the taxes on that transaction.
Speaker 1:What types of properties qualify for cost segregation study? Any type of real estate with some sort of improvements. It could even be a parking lot, but it could also be self-storage. We've seen multifamily, single family, We've seen stadiums and we've seen all sorts of different opportunities, whether it's a restaurant or a store, any type of building or structure. What's most important is are you going to get a return of investment on that cost segregation study? Is it going to create enough tax deductions, so it's worth investing into the procedure to save you money on taxes.
Speaker 1:And what is bonus depreciation? As I already said, the bonus depreciation allows us to take those items that we've found in the cost segregation studies, whether it be a five-year life property or a 15-life property, and bonus depreciation allows us to immediately write off those items that we've identified as non-real estate in our cost segregation studies. Now you can also get bonus depreciation for other things. By the way, like you can get bonus depreciation on a vehicle that costs over 6,000 pounds, or maybe some equipment or machinery or some supplies that cost over $2,500. If you have to depreciate it, you usually can write it off faster Any personal property. So here's a strategy Maybe you want to get some other items that qualify for bonus, even if you're not even once you've maxed out the cost setting.
Speaker 1:Maybe you put a vehicle in the business. All sorts of other strategies. All right, I hope this helps you out in getting an initial understanding of what cost segregation is. Stay tuned, we'll dive deeper into this topic and how you can use this and really take full advantage of cost segregation studies. We really love this strategy.
Speaker 1:We've saved our clients literally tens of millions of dollars with this. In fact, we had one client not too long ago. We did a cost segregation. A series of cost segs saved them about $4 million in taxes. So really cool stuff here. Now another thing here is if you're interested in learning more about how cost segregation or any of these other concepts and we have a lot more advanced and sophisticated concepts too, by the way you can go to prosperal prosper with an L cpacom slash opportunity report If you want me personally to prepare an opportunity report video for you illustrating how cost segregation studies and any other particular strategy for high income earners and real estate investors could apply to you to help you save money in taxes, and I'll share with you how much I think that could save you. Also, if you want to get acclimated to some of the foundational concepts of tax planning, go to taxplanningchecklistcom for a free ultimate tax planning checklist and mini course. Hope you enjoyed the content and happy tax savings.