Hype of Cost Segregation – Does it worth?

 Cost Segregation

There is a big hype in the tax market that everyone can save bunch of taxes by doing cost segregation. Is it correct or they are selling their stuff?

Fist let’s understand what cost segregation is and what it does for you.

What is cost segregation

Cost segregation is separating value or cost of a real estate property from the actual structure of the building. It is a process that separates add-ons that are installed on top of the building. In other words, those other assets which can be separated from the building, the can be separately replaced and can be easily differentiated from the property. Examples are cabinets, kitchen tops, floorings, fence, landscaping, sometimes windows, doors, electricity, appliances, and some fixtures and so on.

By separating these values, you can take bigger depreciation or faster write offs on those non-real estate assets with in 5, 7 and 15 years. On the other hand Real Estates are depreciated at slower pace for tax purpose. It has 27.5 years for residential property and 39 years for commercial properties.

It is for real that when you can write off lot of stuff, you have bigger expense to deduct, that will lower your income and your taxes will go down.

Does it worth it?

Yes and no.

Situation when it worth

You are Real Estate Professional or rental guy

You are a real estate professional or spent most of your working time on managing the properties
(at least 750 hours), it worth it. When you do cost segregation of property, first year generally will generate a huge rental loss.  You can off-set your loss with other incomes. As a real estate professional your rental losses are active losses and you can easily off set your loss with other incomes. That will put you to the lower tax bracket for the year of segregation.

You are real estate investor

You are a real estate investor and always looking for new investment properties, you would like to save taxes at once, and put that money again into the real estate. It is a good way of funding that borrowing money from the bank.

You income will expected to go down in future years

If you think your incomes will gradually decreasing, cost segregation is a good option to go for. Since you will have lesser income it is good idea to save taxes now, than saving less taxes in future.

 

You have huge passive income coming in from other sources

You have other investment, like investment partnership as passive partner or any other passive income or some windfalls of passive income coming in this year, it will off-set your other passive income with your rental losses putting you to lower tax rate.

Situation when it does not worth

You are not a real estate professional

If you have one property out for rent and you and your spouse work full time or involved in other business, it may not worth it. In this situation you may not able to fulfill IRS rule of material participation for real estate professionals.

The loss you have does not make sense since this will be passive loss that you will not be able to off-set with other income. It will be suspended and carried forwarded to the future years until you have some other passive income.

Your income will increase in near future

If your are at rising of your career and your income will increase,  then you will end up paying more taxes in long run. You will off-set your rental loss with lower tax bracket income, and in future when you have higher income, you will end up paying more taxes.

No investment opportunities

If you have no other investment opportunities,  the money saved from cost segregation will have no value. It will lose its value by inflation each year.

Thinking of keeping property for short term

If you are thinking of selling properties in near future, cost segregation may put your to larger tax bill. You will have a capital gain at capital gain tax rate, plus higher tax on depreciation recapture. Tax payer may end up paying more taxes than not doing cost segregation. However, generally written off assets (sec 1245 properties-other than real estate properties) would have no value or nominal value after certain years, so tax payer can plan to give most of the value to real estate by planning in advance. Please consult your CPA on this matter. S/he will be a good person to educate on this matter.

What is the take home

Cost segregation is not created equally for everyone. It depends on your financial goals and current situation and future expectations. It can be life saving for someone or it can be disaster for someone else. Therefore, it is worthwhile to consult your CPA or tax advisor before you blindly jump into it.

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