Do I need to do Cost Segregation Study?

This year I would like to do bonus depreciation (aka accelerated depreciation) for two mobile home parks. Different people have told me different things.

Some investors say that I need to perform a cost segregation study in order to take advantage of bonus depreciation.

However, other investors say there is no need to do the cost segregation study if I specify in the purchase contract how much the land, improvements, and good will are worth.

You don’t need to so the study, but it can save you on taxes. A cost segregation study can help you to specify in the purchase contract how much is allocated to each asset. For example instead of buying land, improvements, and goodwill, what if you could put some value in equipment (e.g. mowers), refrigerators, ovens, furnaces, water heaters, carpeting, etc. Those things depreciate or amortize faster than land, improvements or goodwill. In the past I have run this myself without using an expert then put the breakdown into my contract.

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The studies can help you significantly if you are ever audited by the IRS. However, you can also make reasonable estimates yourself. Remember that depreciation is great today, but is eventually accounted for with depreciation recapture at future income tax rates (not capital gains rates). So it’s really borrowing from the tomorrow you.

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Disclaimer: I am not a tax professional. Please consult your tax professional for the definitive answer to your questions concerning Cost Segregation Studies or any other subject discussed below. As with most every tax question the best specialist will tell you, “It depends.” That is true of what you will find below but since EVERY situation for EVERY taxpayer cannot be covered here, just consider what you read as food for thought to discuss with YOUR tax professional. (That last part was added to keep people from answering back with things like, "Yeah…but if I am a foreign national and my birthday is before 1959 and my favorite color is blue I can still take the depreciation :wink:

Andriy,

You know the saying, “The devil is in the details?” Well, this definitely applies to Cost Segregation studies and depreciation. Here are some of the “details” I have seen.

Detail: If you are not considered a “Real Estate Professional” (this is an IRS designation that has specific requirements…not just the checking of a box that says Real Estate Professional on your tax forms), then the amount of depreciation you can take is very limited ($25,000). So even if a cost segregation study gives you $100,000 of depreciation, you can only take $25,000 of it if you don’t qualify as a Real Estate Professional. (The actual qualification is complicated enough for another post of its own but is often unknown to new investors).

Detail: Again, without qualifying for Real Estate Professional status, even how much of that $25,000 that IS allowed phases out with your income. If you have over $100,000 in income the amount of depreciation you can take starts to be less and less, (these are Passive activity loss rules). Once your income reaches $150,000 your ability to claim depreciation deduction is completely eliminated.

Detail: 1st year bonus depreciation is going to start phasing out in 2023 and, unless changed in new tax law, will be completely eliminated by 1 January 2027. (Again, unless Congress extends it).

The 100% bonus depreciation amount remains in effect from September 27, 2017 until January 1, 2023.

After that first-year bonus depreciation goes down as follows:

  • 80% for property placed in service after December 31, 2022 and before January 1, 2024.
  • 60% for property placed in service after December 31, 2023 and before January 1, 2025.
  • 40% for property placed in service after December 31, 2024 and before January1, 2026.
  • 20% for property placed in service after December 31, 2025 and before January 1, 2027.

(Yes, there is overlap in the years…talk to your tax professional about what you can take and when).

Detail: Depreciation is often considered to be analogous to a “loan” from the IRS. In other words, you can take depreciation but you will eventually have to pay it back (depreciation recapture tax). Doing a 1031 is analogous to an extension on that loan. However, to eliminate having to ever pay that loan back you have the pleasure of dying and then your heirs get a “stepped up basis” on the property (wiping the “loan” off the books). (Note: Stepped Up Basis, along with 1031’s were recently two of the incredible tax breaks attacked by the legislature. At this time they are considered safe, as is the holding of “accredited investor only” type investments in your Self Directed IRA).

Other thoughts/rules of thumb I have seen;

If the property value is less than 500k it probably would not be worth hiring a firm to do a cost segregation study.

Cost segregation studies, done correctly, by a professional firm hiring engineers to do the study will be your strongest protection against having the depreciation questioned/disallowed by the IRS.

And, I hate to say it, and many will probably argue but, if you have a valuable community and you are a Real Estate Professional I would not do a cost segregation study by myself. I would hire a professional. I would be happy to recommend one if anyone is interested you can DM me.

Hope this helps, if it only confused you more you can DM me or write here and I’ll try to answer to send you to a professional who can.

Capt Sam.

Sam,

I recently bought 2 separate MF Properties each over $500K and I am a Real Estate Professional. Do you recommend doing a Cost Segregation? Benifits?

Thanks

Hi,

There are too many variables that I do not know which would really determine the best course of action. When you say they are "over $500k that could be $510k or 3MM. You could have a lot of infrastructure such as paved streets, roads, driveways, sidewalks etc…or none. You could have 50 Tenant Owned Homes from which you could take no deduction or 300 Park Owned Homes from which a Cost Segregation Study could pull items to fall under the first year bonus depreciation schedule.

Do you hear the familiar “It depends” ringing through this reply? I hope so…because…it depends.

But here is the good news. You will find that most of your reputable companies that do these studies will give you a free estimate so you can determine if it is worth it to do one. They will look at all your numbers and what you have to depreciate and can usually tell you, “Yes, you would benefit by getting around a $100,000 depreciation deduction and our study will cost only $5,000” or “No, because you have so little to depreciate it would probably not pencil out to pay us to do a study.” Sounds strange and you might think that they would, in all cases say, “Yes, definitely…you need one.” But if you think about it, once they started saying that to the owners of small communities who would NOT benefit from a study, the word would get around (and it’s not that big a world when it comes to these studies).

My advice would be to reach out to a company (or multiple companies) who do these studies, talk with them about what you have, ask if they will do a free analysis and what their price would be and then make the decision based on what sort of return you would see from getting a study.

With respect to the second part of your question, “Benefits,” these are summed up in one word: depreciation. The whole purpose of one of these studies is to maximize the amount of depreciation you are able to claim on your tax return. In other words, if you earn $100,000 per year from your community after your other write offs, and a cost segregation study finds $100,000 in depreciation the first year you will effectively pay ZERO taxes on that 100k (Notes: you will only get this very large deduction in the first year since you are taking advantage of the “First Year Bonus Depreciation” that is still available. You will still have depreciation deductions the following years but not as big as the first year. The point is, you pay less taxes and have more money to: invest elsewhere, spend on capital expenses in order to justify rent increases or keep turnover lower etc.

Here is a great place to start: Yonah Weiss with Madison SPECS. His phone is 732-298-9002 and his email is yonahweiss@gmail.com

Hope this helps.

CaptSam

It helps, but you can always get one after the fact if need be. I find it rare that a seller will agree to actually allocate what truly should be allocated to the land improvements anyways.

Replacement costs are essentially north of $60k per pad these days. Would be interested to know if anyone has had a cost seg done recently that indicated an amount below this figure.