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?
They see a handful of people actually get any benefit out of this strategy. Well, 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
W-2 or your spouse has a w-2 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 gonna buy a commercial property
I know you might even try a cost segregation on it 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 the benefits get less and less the lower value of the property
So I'm gonna just use something I think is the most common circumstance of where costs egg is used
You got a million dollar property. So you've got this million dollar commercial property
$1,000,000 and you pop it into an LLC and you want some write-offs. Okay?
Now what normally happens is you're gonna have to depreciate this million dollars only 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 all right
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 gonna give us a
$200,000 personal property allocation. Well, we can bonused appreciate 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% 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 two hundred grand is seventy thousand so you just saved
$70,000 in taxes by doing a costs egg now, let me repeat that
Because I get a two hundred thousand dollar right off my AGI goes down by two hundred thousand
and so if I'm in a thirty five percent tax bracket
I pay thirty five percent less taxes on two hundred thousand dollars. So I just saved 70 thousand dollars. Well who signed me up?
I'm done, right? Oh, no, this is where the truth of a costs egg needs to come into play
We've got three problems. I want to talk about
Let's break it in. All right problem
Number one and this is what drives me crazy and has not even talked about it as much as it should be
Does everybody get this?
$200,000 right off. I've got these real estate losses and 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 right 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 w-2 doing something else forget
It ain't gonna happen. Number two you've 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've 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 did 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 gonna be like, oh is my CPA gonna buy that me or my spouse or real estate professional if they do?
then
We're over the first hurdle of this
Being deductible hundred percent against your other income because you qualify as a real estate professional
If not, it's gonna 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 cos seg, it's a waste of frickin time
Okay, let's go to problem number two. Assuming you're a
real estate professional or your spouse and
You're gonna get this right off. So we're past this
Let's flip this over and this 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 gonna sell this property someday
Is that it going to be in three years five years seven years ten years
What are you gonna think about when you go to sell this property?
You're gonna think about oh, yeah a 1031 exchange because I don't want to recapture depreciation
I don't want to pay capital gains tax. I'm gonna take this property that I've bought for a million
That's now worth two million dollars and I'm gonna 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 by five you could sell five and buy one as long as you invest that 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 at the property
This is called the all that property stepped up basis. This is called the 1031 exchange
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 right off that you got comes back even in a 1031 exchange
The 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 gonna want you to claim this
$200,000 as income and
Then you're gonna have to give back that
$70,000 tax deduction you got oh
so
Wow, I didn't know that I thought these costs eggs were just freakin awesome and I I get this bonus depreciation that's unlimited
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 it 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 gonna be another hurdle
Because you got to give this 200 grand back and that's in three years five years
So 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 got to spend some money to get this thing done. And is it worth it now?
I'm not even 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 gonna be worth your time and energy?
I'm not gonna 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 SEC now on a million-dollar property and I even text a friend right before this - I called my partner we think
$4,000 is being pretty generous
We could see that price for a costs egg analysis on a million dollar property be anywhere from four to six thousand dollars
But let's say I spend four thousand dollars on this costs egg. All right, cool. Now remember I'm gonna
get a
$70,000 write-off and everybody wants to talk about that. So let's look at it
Oh my gosh, I spend four thousand and I save seventy thousand sign me up
Mmm, 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 percent depreciation recapture rate you and you and again on a 1031 it doesn't matter
You can't even kick the can
you've got to
Recapture it at that thirty five percent 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 it's 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 gonna sell this property in five years
Okay
I sell it in five years and
Let's say I could take that
Seventy thousand 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 doodles of money
I don't know but let's just say you put it in a pretty strong ETF for a 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% I'm gonna have
Approximately a hundred and three thousand dollars in five years
So that means I made thirty three thousand dollars. I
Got an interest-free loan from the IRS
I got seventy now and assuming I'm in the same tax bracket five years from now
I got to give the seventy back
But in the meantime, I invested it or I had the use of that money and I made thirty three thousand dollars
Okay mark, I'm still gonna do it. Well, let's think you had to spend four thousand now
What would be the future value of that four thousand if I invested it at eight percent over five years. It's going to be approximately
six thousand dollars
So I've got to compare apples to apples
So if I am gonna make thirty three thousand dollars down the road future value
Well, I got to think what did that four thousand really cost me future value
so I've got to subtract it here six thousand off of my
33 and so I'm gonna net twenty seven thousand. That's my real
benefit but you have to remember this - that's a
interest-free
Loan from the IRS where I made twenty seven thousand dollars on the money
During that five year period if you take this seventy thousand 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 eight percent 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 gonna have to give the money back
In summary, this is the third problem this cost to do the cost sag
And I'm not saying it's not worth it again
But we need to go in with our eyes wide open and realize that it's not just this island of of tax, you know
The paradise where I you know
I just get this money from the IRS and I saved 70 grand and I forget about all this other crap down the road
So this is the third problem
We've 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 on a
allocation and then a
25% personal property allocation and we're going to assume you're gonna make 8% on this money theoretically over time and
That the cost is four thousand. Those are a lot of variables to assume in order to just make twenty seven thousand dollars and
You better darn. Well be a real estate professional in summary. I love saving taxes. I love real estate
I'm a CPA an 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 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 tax match calm
I'll find that perfect tax spouse for you. That saves you thousands
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