Tom Talks Taxes - November 17, 2022
An interview with Natalie Kolodij, EA about cost segregation studies
Many of your clients may be interested in cost segregation studies for real estate owned in a business or rental activity. In a cost segregation study, real property generally depreciated over 27.5 or 39 years is divided into components that can be depreciated over shorter lives, such as five years or 15 years. These assets are also eligible for §168(k) bonus depreciation. By front-loading the depreciation expense, the taxpayer accelerates tax deduction forward, creating savings due to the time value of money.
For the right taxpayer in the right situation — like all tax planning strategies — a cost segregation study absolutely makes sense. If you don’t offer this type of tax planning, someone else or another firm will fill the void.
To help you determine if a cost segregation study is a good fit for a client, I’m excited to speak with Natalie Kolodij, EA.
Natalie is an Enrolled Agent and Real Estate Tax Strategist™. She focuses on tax reduction strategies for those building wealth through real estate. She works directly with taxpayers and provides advising and research services for tax professionals. Visit www.ReTaxStrategist.com and @re_tax_strategist on all social media channels.
What rental activity owners are ideal candidates for cost segregation?
Any rental activity owner with modified adjusted gross income (MAGI) under $100,000, rental activity owners who own short-term non-passive rentals, real estate investors who are selling one rental for significant gain but who own (or are acquiring) additional rentals during the same tax year, and real estate professionals.
What rental activity owners are NOT ideal candidates for cost segregation?
Those who may qualify as a real estate professional in the next few years. We do not want to generate a large passive loss before they meet those qualifications. In addition, those with very low-cost rental properties would likely not see enough benefit to justify the costs.
Can business owners who own a building or self-rent a building benefit from this?
Absolutely! If the building is used directly by the business and not rented, there is no issue with the passive loss rules as long as the taxpayer materially participates in the business. In the self-rental case, an election is available to potentially group the rental activity with the business activity and avoid the passive loss issue.
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One concern I often hear about is depreciation recapture. Any thoughts on that?
This is why tax planning is so important! The client may be younger and in a very high bracket now, and their plan may be to sell the rental in retirement while in a much lower bracket. I’d happily take a $400,000 write-off in a 37% bracket, paired with the time value of money, in exchange for paying back $400,000 at a presumed lower rate 40 years later.
Also, if the property is passed to the next generation via inheritance, it gets a stepped-up basis, and the accumulated depreciation is wiped away. There never is any depreciation recapture in that case.
Do you have an example of a client who used cost segregation successfully?
This year I had a client who was a physician with wage income of over $600,000. They purchased two turn-key short-term rentals in the Smokey Mountains. The combined purchase price for both was $1,750,000. A cost segregation study was completed on both properties resulting in a combined bonus depreciation write-off of $382,750 in the first year.
Because these properties met the criteria for material participation with an average tenant length stay of seven days or less, the rental activities were classified as non-passive. This combination of strategies allowed us to offset almost $400,000 of the client’s wage income with the rental losses generated via the cost segregation study.
I also had a client whose AGI each year is about $85,000 (allowing passive losses up to $25,000 because they actively participated in the rentals), but their four rentals all show net income even after depreciation, averaging about $9,000 of income annually. We utilized a cost segregation study on their new rental acquired in 2021 (avoiding the need for a change in the method of accounting on Form 3115) and generated a passive loss that will reduce their taxable rental income to $0 for the next seven years.
Why are some tax advisors actively discouraging the cost segregation strategy?
Ultimately a cost segregation study robs some of your depreciation deduction from later years to have a more significant write-off today. It’s not something that should not be done without big-picture planning and discussions with your client.
Do you have any closing thoughts you’d like to share?
If a client didn’t do a cost segregation study but did an extensive renovation, you can likely break out a good portion of those costs into shorter-year assets, qualifying for bonus depreciation. I cry a little inside every time I see a $150,000 “renovations” line item on a depreciation schedule (especially when the client can utilize any losses).
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