Looking for a Cost Seg Study for your property?
Delayed Benefits of Cost Segregation: What to Expect
Many real estate investors are familiar with the immediate tax benefits of cost segregation. I highlighted many of these benefits in a previous newsletter. But what if you don’t need those benefits in the short term?The good news is, that when you complete a cost segregation study, the tax advantages are not lost if they aren't used right away. Instead, they get stored for when you need them most.
Today, I'm going to break down how this works and why it can be a smart move to get a cost segregation study done today to help your long-term strategy.
How Suspended Passive Losses Affect Your Tax Strategy
As a refresher, cost segregation is a tax planning tool that allows real estate investors to accelerate depreciation deductions on your properties. By reclassifying certain building components and land improvements into shorter class lives, such as 5, 7, or 15 years instead of the standard 27.5 years, you can reduce your tax liability and help you increase your cash flow.
Options When You Can’t Use Deductions ImmediatelyIf those big depreciation deductions exceed your rental income (which is common for high-income earners), you might not be able to use all of those deductions right away. Instead, those unused deductions become suspended passive losses. These suspended losses roll forward and accumulate year after year, waiting for the best time to be used.
Timing Cost Segregation Benefits for Maximum Impact
One option is for you or your spouse to become eligible for the IRS Real Estate Professional Status (REPS). This is a tax designation that allows certain real estate investors to fully deduct their real estate losses against other types of income, such as wages or business profits, without the usual passive activity limitations. This allows high-income earners to offset their ordinary income, not just their rental income.
I plan on breaking down REPS in more detail in a future newsletter but at a high level, there are two main criteria you must meet:
- Material Participation Test: You must spend at least 750 hours per year in real estate-related activities, such as property management, leasing, or construction. These activities can include your own properties or working in the real estate industry, but you must materially participate in the management and operation of the properties.
- More Than Half Your Time in Real Estate: In addition to the 750-hour requirement, more than 50% of your total working time must be spent on real estate activities. This is especially important for individuals with full-time jobs outside of real estate, as they may struggle to meet this criterion.
However, there is another option for those who don't qualify for REPS.
You can take advantage of the suspended losses when you sell the property. Once the property is sold, all those suspended losses are released and become ordinary losses that can offset any type of income—ordinary income, capital gains, etc.—in the year of sale. Importantly, these suspended losses are not subject to depreciation recapture taxes. They simply reduce your overall taxable income in the year of the sale.
Note that Depreciation Recapture Still Applies
The suspended losses help reduce your overall taxable income, including the gain from the sale, but you will still owe the normal depreciation recapture tax on the amount of depreciation you've claimed. This is standard for all cost segregation studies and is taxed at a 25% rate. The net tax impact in the year you use the benefits will likely still be favorable, but it's important not to forget to factor in these costs.
Example Case Study
Let’s say you buy a property for $500,000 and conduct a cost segregation study, which results in $100,000 of accelerated depreciation over several years.- In those years, your rental income is low, so you can’t use all $100,000 in depreciation right away. Instead, these losses are “suspended” and carried forward.
- Fast forward to the day you sell the property for $600,000. You have a $200,000 gain, which includes $100,000 in depreciation recapture (which is taxed at 25%) and $100,000 in capital gains.
- Thanks to those $100,000 in suspended losses, you can now apply them to reduce your overall taxable income for that year, including the gain from the sale.
The Importance of Long-Term Tax Strategies with Cost Segregation
While the immediate benefits of cost segregation are great, it's important to remember that performing these studies on your properties can also be a long-term play. Maybe you plan on going into real estate full time in the next 3-5 years or you want to sell the property in 10 years to pay for your child's college tuition. Being able to bank the losses for down the road, can result in significant savings on your tax bill.
Thank you for reading. Please reach out and let me know what resonated with you. I read every email!
Cheers,
Sean
Maven Cost Seg | Maven Success | Maven Equities P.S. Forwarded this email? Click here to make sure you get added to the weekly distribution list! 