The Mark Perlberg CPA Podcast
The Mark Perlberg CPA Podcast
EP 121 - How Timing Your Cost Segregation Studies Can Save You Millions in Taxes
Strategic timing is the unsung hero of tax planning, especially when it comes to cost segregation studies for real estate investors. The difference between performing these studies at the optimal time versus the wrong time can mean hundreds of thousands of dollars in tax savings.
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• Cost segregation studies should be timed to match high income years when tax deductions are most valuable
• Moving income into low tax bracket years and expenses into high tax bracket years maximizes tax savings
• Recognizing deductions early frees up capital for reinvestment and compound growth
• Suspended losses from poorly timed cost segregation studies may never offset ordinary income
• Pregnancy or other life changes can create temporary windows for real estate professional tax status
• Cost segregation studies can be strategically timed to offset capital gain events
• You can amend returns to add cost segregation studies, but only for the first service year of a property
• When selling properties after cost segregation, be prepared for potentially painful depreciation recapture
• Cost segregation can work with 1031 exchanges but requires careful planning and professional guidance
• Different depreciation elections provide flexibility in how quickly you recognize tax benefits
Go to prosperalcpa.com/opportunityreport for a free video analysis of your potential tax savings through advanced planning strategies, or visit taxplanningchecklist.com to begin exploring tax planning with a free ultimate tax planning checklist and mini-course.
So not too long ago, I did a speech in front of a very affluent group of entrepreneurs and the topic was that tax planning is all about timing and you're going to see all these fancy and sexy strategies and different creative ways to do stuff and at the end of the day, you're most likely going to find that the majority of these really that the majority of these really fancy and impactful and sophisticated strategies for tax savings are really just timing strategies. And I'll probably dive deeper into some of these timing strategies, as I have in the past, but today, as we just talked about cost segregation the other day, we're going to talk about how these broad timing strategies can apply to cost segregation. Now, a lot of you probably think what's this guy talking about? I buy a property, I do a cost seg in year one, I get my savings. Why are we going to have a whole conversation on this? Why are we going to do a whole episode on this? Well, hang in there. When you work with an elite firm, someone who really understands the law and the strategies around this and wants to optimize your savings, you're going to find that there are many opportunities when you're thinking about planning as it relates to cost segregation studies. So today we're going to learn about these key concepts of planning to optimize and maximize your tax savings, and we're going to talk about how those concepts apply to cost segregation. I'm going to share with you real world examples of what this means and how you can use this in some advanced planning strategies that you can apply to your business and your real estate investment portfolio.
Speaker 1:Now, first I want to share with you a story to illustrate how important this is. A while back we had a prospect and we looked at his tax return and he had $850,000 of unused rental losses on that 1040 tax return. And so we said that's a lot of losses for losses for 1040 suspended losses. So he didn't have real estate professional tax status and he took an 850 000 tax loss that was not used at all. And when you don't use your loss, it's suspended, it's carried forward, and when it's a rental loss, it'll only offset future rental cap gains or other positive passive income and, by the way, I'm not talking about capital gains from your stocks. It's very hard for most people to generate that positive passive income. While there are opportunities, it's rare that we see it, especially for a W-2 guy. But anyways, we thought to ourselves why did this guy do it? So I'm doing this discovery clause and why did you do all these cost checks? Well, I figured it would save me a lot of money, so I paid some engineers to do it. So here's what's interesting. So we probably paid about $30,000 in fees to get this $850,000 tax loss. That saved him absolutely no money at all on his taxes because it wasn't a tax loss, it was just an unused business law.
Speaker 1:Now here's to really, if you really want to see how stupid this was, to put salt on the wound of this guy's foolishness of trying to DIY his own tax planning, because he heard that cost segregation studies saving money on taxes. In the year that we met him, he finally had real estate professional tax status so he could have created that $850,000 of losses on his current year tax return and reduce his taxable income by that amount. He could have saved himself hundreds of thousands of dollars with that $850,000 tax deduction. In the current year he was a high income earner, but now those losses are suspended. They will not offset his current year income Because when you suspend them and carry them forward, they do not offset your ordinary income, even if you have passed real estate professional tax status.
Speaker 1:So this huge opportunity, this massive deduction that could have been used in the current year to save him hundreds of thousands of dollars, potentially amplifying and magnifying his ability to build generational wealth, that is completely lost because of his foolishness. We couldn't even amend out of it, because you can't amend out of a cost seg, and, furthermore, there were no other properties that he didn't do a cost seg on, so he couldn't even see some of the benefits on his rental portfolio. So that's why timing is really important, but also that's why you really want to work with a professional who really knows this stuff when you're doing cost segregation studies, because you don't even know what opportunities are leaving on the table and don't try to do this at home. Don't even know what opportunities are leaving on the table and don't try to do this at home. Even if you love the podcast here and all my videos, you're not going to be able to do this unless you have dedicated thousands of hours as a professional, as a tax professional, to do this stuff. Okay, but anyways, there's still a lot you can learn and apply from this episode. So listen up.
Speaker 1:So here are some four. Here are Sorry, I got to check my notes here, ok, so here are the major Concepts I want you to think about when it comes to timing of your income and expenses, and we'll talk about how this fits into cost segregation. Number one you want to move your income, your revenue, into low tax bracket years and your expenses into the high tax bracket years. Now that makes sense, right? You want to recognize your profits at the lowest possible tax bracket and you want to have your expenses come in where they're going to be most impactful, get the most bang for your buck on those expenses and they create the most amount of tax savings possible. So that's one key concept.
Speaker 1:When it comes to timing, we'll talk about how cost-save comes into play. Generally speaking, all things constant. You typically are going to want to recognize your deductions as soon as possible and your profits over time. Think about this because of the time value of money. You get that deduction as soon as possible. That allows you to free up the capital resulting from the tax deductions in the tax savings. And if you recognize your income down the road through various strategies, you are pushing, kicking the can down the road. You're prolonging the effect by which the tax burden takes a bite out of your wealth and your profits. And then, finally, you want to utilize your tax deductions when they are most impactful, because there are all sorts of rules and scenarios where you may not be able to use those deductions at all and if the deduction doesn't save you any money, as it did for the earlier example, there's no point in taking it. Well, there's a little bit, but there's certainly a lot more when you can actually create tax savings. So let's talk about how these concepts apply when we're talking about cost segregation, how these concepts apply when we're talking about cost segregation. We want to move income into those low bracket years and our expenses into the high bracket years.
Speaker 1:So what we see for most of our clients is, when you are buying real estate, you want to get your deduction as soon as possible because you're paying a lot of taxes and by getting that immediate tax deduction, that is going to free up capital. Think about this you do a cost segregation study. Let's just say it saves you $60,000 in taxes. That's $60,000 that can be reinvested and can grow and compound. But let's say another example here. Let's say that you are not making a lot. Or let's just say, because of certain scenarios you're not really paying a lot in taxes. You have other sources of depreciation. Maybe a large payout didn't come, or maybe the business is just not recognizing a lot of profit, for whatever reason. You're not paying a lot of taxes in your low bracket, not recognizing a lot of profit, for whatever reason you're not paying a lot of taxes in your low bracket. You're not going to want to do a cost segregation study, even if you just bought that rental property because it doesn't save you any money in taxes.
Speaker 1:I always say that there's a sweet spot of adjusted gross income and that's around like 30. There's a few of them, but one of them is around $30,000 if you're married filing joint, because then you don't pay any taxes because typically your standard deduction, if you're married filing joint, is going to kick in and it's going to eliminate all the taxes. Now when you go below $30,000 of adjusted gross income, there's not very much value at all to reducing your adjusted gross, your adjusted gross income anymore, because now you actually lose that standard deduction. So if you actually have a zero dollar adjusted gross income, that means we can't even take the standard deduction and that standard deduction won't pay forward. Now some of you may even have large itemized deductions, especially in the current changes in the tax law that give you more state and local tax deductions, especially in the current changes in the tax law that give you more state and local tax deductions. So you may miss out on the opportunity to deduct your mortgage interest and you may miss out on the opportunity to deduct your state and local taxes and your charitable deductions because your income is so low and because you don't need those deductions, they're unused and you lose them forever, and you may also lose some or all of your child tax credit. So you really want to look at the movement in and out of these different brackets and how your deductions are going to impact that when it comes to the timing and optimal strategies of using your deductions and, in particular, with your cost segregation studies.
Speaker 1:So we've had instances where clients quit their W-2 jobs and they bought lots of real estate. Or maybe the husband quits one year and the wife quits the other year and as they quit, they buy more and more real estate. Well, we may find that we have so much real estate that we have more losses real estate that we have more losses than we need to offset all their W-2 income. And if that's the case, we may only do a cost segregation study on one of the two properties. We may do a cost segregation study on both of the properties and then we may think to ourselves well, we know that you're in a high bracket this year and then you're not going to be as high a bracket this year. So between the two studies and we know you're not buying another rental property, we're going to use this property this year and then this property the next year, because that's going to offset more of the income, that's going to give you more of a deduction. You can see where the analysis comes in here, right, and some other things here.
Speaker 1:Now, not only can we time which properties we do the cost seg and in which year we do them, and if you listen to the prior episode I talked about this you don't have to do the cost segregation study in the year of purchase. You can wait until the following year and you can get what's called catch up depreciation, where you're typically saying, hey, had I done that cost segregation study in year one, I could have taken all this tax deduction. Well, because we're in year two or three or four, whatever year, and I still want to take that tax deduction. So let's do the cost seg and whatever I miss. Had I taken all that minus what was already taken, let to take that tax deduction. So let's do the cost seg and whatever I miss, had I taken all of that minus what was already taken. Let's take that bonus depreciation I could have taken in the prior year. Let's deduct it in this year because I need it more this year. So that's pretty much what you're saying here.
Speaker 1:But anyways, back to that conversation. Not only can we time when we do these cost segs for the different properties, we can decide how we're going to depreciate it, because you may decide when you look at a cost seg and we've seen this before maybe the numbers turn out really well. Maybe we have like a half a million dollars of deductions but we only need $300,000. We may actually decide. Then you know what. Let's opt out of bonus depreciation and just accelerate the depreciation, because at a certain threshold we pass let's say in this example it's past $300,000 deduction, there's no more value to our tax deduction and because we're accelerating the depreciation, we're losing future depreciation. So in our analysis we look at this and all the possible scenarios bonus depreciation straight line and accelerated depreciation all our other items and we elect for each class life how we're going to depreciate it. Now this may sound complex to you as a listener if you're not a tax professional, and this requires a lot of time on our end, and this is why, unlike other firms that may silo out their planners and preparers, we need to integrate this, especially when there is uncertainty on the best method to create lifelong optimal tax savings. We have communication between the planner and the preparer and we're strategic in how we execute and report these cost segregation studies to make sure we're getting the most value out of these studies.
Speaker 1:Now let's talk about what we typically want to do here. This is the concept of recognizing deductions as soon as possible. Actually, let's hold on a little bit. So we've had instances where clients were in. As I said earlier, if you're in a low bracket and you just purchased a rental, you're likely not going to need as much of the cost seg deduction and you can wait. And then, similarly, if you have been in a low bracket and now you're in a high bracket, you can do the cost seg deductors. Some other things to consider is let's say, you have a major capital gain event and you've never done a cost seg, you can use that cost segregation study to offset a capital gain event. So let's say we have tons of rentals and we just recognize a major cap gain event on one of our rental properties. You can say, okay, now's the time to utilize cost seg to offset that capital gain event because that's going to pump us up into a higher bracket if we don't do anything here and that's going to cost us a lot in taxes.
Speaker 1:Now let's move on to the concept of typically, we want to recognize our tax deductions as soon as possible. Now, if you were one of those folks who likes to DIY their own tax plans and likes to do cost seg most of the time, if you have zero volatility most of the time, you're going to find that doing the cost segregation study in the year purchase makes the most sense. Because if we expect the income to remain completely unchanged and the brackets to stay the same, you're going to find it's better to save $50,000 in taxes now than $50,000 in taxes down the road. For obvious reasons. If we save it now, it's worth more. We can reinvest that $50,000 to grow and compound and build more of your wealth. So what most people are going to do here is they're going to recognize it as soon as possible.
Speaker 1:And then to the concept that we want to recognize our profits at a later date. So even if you're cash flow positive, let's say we can't use the losses. We have lots of cash flow. Let's say we can't use the losses, we have lots of cash flow. Anything we can do to offset our earlier years of profits is going to benefit us to ensure that we're not paying taxes on our rental revenues and we have enough profit that's going to be untaxed to allow us to reinvest and grow and compound our portfolio.
Speaker 1:Now, this is also assuming that you're in a lower enough bracket. It's already that you're in a high enough bracket for this concept to even matter. So most of you, when it comes to planning all things constant, you want to get your tax deduction as soon as you can, or you want to avoid showing profits on your rental property as long as you can, so you have the ability to reinvest those profits without paying it to Uncle Sam. And now let's talk about utilizing deductions when they are most impactful. I'm going to share you a few stories here. So, when it comes to timing, it's not just about looking at the different tax practice and events While that's incredibly important and you want to have a holistic look at all the events but also we want to look at where are these tax deductions going to even matter, where are they going to be the most impactful? And let me share with you what I mean by that.
Speaker 1:So we have a client who invests in real estate and has a full-time job, cannot get real estate professional tax status, but his wife is pregnant and this opens up the doors to some really cool opportunities in planning. So the client's wife is pregnant and this finally gives us access to his wife having real estate professional tax status. So now we have some awesome planning opportunities. We are going to shift as many expenses as we can into his portfolio to make sure that we can use this real estate professional tax status to create non-passive losses that will offset his W-2 and create the most amount of tax savings possible. We have one year before she goes back to work, most likely, so that means we have one year to dump as many expenses and costs into that tax year to create as much savings as we can before she loses that real estate professional tax status and the real estate will no longer offset his W-2 income. So how are we going to do that? We have properties where it never made sense before to do the cost segregation study. Now we're going to do that cost seg. So we have a couple million dollars in real estate, we run the cost segs and we're going to create as many losses as we can.
Speaker 1:But I'm going to try to hit what we call the excess business loss limitation. So there's a maximum amount of losses from our businesses or real estate that we can take against W-2 jobs and that for 2025 is around 630. If you're listening after, you can just assume it's increased a little bit for inflation and it's half that amount if you're single, by the way. So that would be 315. In fact this amount might not be exact you might want to just check your references there but it's around 630. It might be 650. I don't remember the exact amount for 25. But anyways, we want to hit that maximum amount of losses that's allowable to be taken in the current year. Now we may not just do cost tag. We might say, hey, here's a good year to do some renovations on that property because we can get some more depreciation, we can write off some more stuff, some more improvement, any other expenses. If you were thinking about putting a vehicle in your business, this is the year to do it because you have that treasured real estate professional tax status. Let's take as much advantage of this opportunity as we can before it goes away.
Speaker 1:And let's talk about another planning opportunity, and this was a really fun one, very impactful. We have a client who had a large real estate portfolio, decent sized real estate portfolio, had a capital gain event, sold their business, no tax planning done, the return was compliant, no issues done. But the tax preparer was unaware of how advanced tax planning could save them a lot of money on their taxes. Luckily we had the opportunity to amend the tax return and perform cost segregation studies A few years after the return was filed. You can go back three years. With that amendment we created a half a million dollar deduction and the client got a refund of the savings amount of $200,000. Now, ideally those cost segs would have been done on the original return, but luckily we were still able to do the cost segregation studies and create a ton of savings for that client. Think about how awesome that is. We were able to time that. Now in later years they didn't have nearly enough taxable income in the years that we were filing their returns since then to use that half a million dollar deduction. So if we didn't do that amendment the following years we were only looking at maybe $200,000, $150,000 of taxable income not nearly enough to justify the work of those cost sets. So this was a huge savings opportunity. By going into a prior year and using those cost sets Again, you can really go deep and have some fun with this and run some scenarios and you can just see how, understanding the opportunities and knowing your clients and how we can really be resourceful with these strategies, we could really make the most of these cost segs. Now here are some more things that you can think about when it comes to timing and strategies.
Speaker 1:You can amend a return to report a cost segregation study, but only in the first year that property is placed into service. In a following year you cannot amend it. So to give you an example, let's say we purchase a property in 2023 and place it into service in 23. I can amend the 23 return and do a cost seg on it, but I cannot amend the 2024 return if there was no cost seg on it. But I cannot amend the 2024 return if there was no cost seg done. I cannot say that we want catch-up depreciation on an amended 2024 return. I can get catch-up depreciation on a 2024 return. I can get that bonus depreciation and pull it into the 2024 return. But if you're doing it in a year after it's placed into service, that cost seg has to be on the original year's filing, meaning the 2024 return. We have to run that cost seg and recognize the catch-up depreciation on that 2024 return. We can't go back and amend the 24 in a later date and do a cost seg unless the property was purchased in 24. Some other things you can think about here is you may want to consider Some other things I want you to think about here is if you're not sure whether or not to do a cost segregation study, a lot of the times as tax professionals we don't know what the answer is because we just don't know enough details.
Speaker 1:A lot of the times we don't know what the results are of the cost seg. We don't know what your books are going to look like at the end of the day. We just don't know how things are going to come together and in those instances we wait until the dust settles. We look at the drafted return. Those instances we wait until the dust settles. We look at the drafted return and then we can have a clear understanding of what's the projected deduction and what's the potential return on investment of this cost segregation study to help understand is it worth performing in the tax return we're preparing.
Speaker 1:Sometimes we may decide we may even wait until the following year because we may want to see are we going to buy a rental property in the following year? Because we know we're in a higher bracket, we may want to apply it to the following year. So we wait a little bit and we extend the return until we know that we want the cost to apply to the prior year instead of the current year as we're preparing. So, for example, if we have a client that has a property purchased in 2024, as we're drafting the return, while we know a cost seg could save them some money, we're going to wait a little bit because we know that they're going to use they could use that deduction more in the 2025 year, but we don't know if they're going to buy enough rentals in 2025. So we may wait a little bit to decide which year is going to be the best year to apply that cost seg. You see what I mean, how deep you can go into the analysis and the scenarios when you're strategic with this stuff.
Speaker 1:Some of the things here. You don't have to do a cost segregation study on all the properties. You can decide which properties you want to do the cost seg on and there are multiple depreciation elections so you can decide whether you want to get bonus depreciation In the 25 returns. You can even elect into 40% bonus if that's what you would prefer returns. You can even elect into 40% bonus if that's what you would prefer. So there's all these different ways that we can look at this, depending on what's going to create the optimal solution for you. Some of you may want to elect out of some of your bonus and stretch it out over a longer period where you're going to see a more prolonged benefit of that accelerated depreciation and tax deduction.
Speaker 1:And another thing you may want to think about here is what's called a partial asset disposition. With a partial asset disposition remember with a cost segregation study we are assigning value to all these different items in the property. Then we replace them. So let's say we're replacing a roof. A cost segregation study is going to allow us to assign a value to that roof, and so that allows us to immediately write off whatever that value was. So let's say the roof's value is $100,000. We can write off 100% of that roof because we're replacing it. There's just another creative way where we can do some cost segregation studies and valuation strategies to move some more expenses into the current year.
Speaker 1:And now some may argue that this strategy of the partial asset distribution and doing the cost seg is actually going to put you in greater compliance. Because, think about it, when most tax preparers see that a new HVAC is put in, they're just going to group it as an improvement. But you're really replacing something. So it's not really the most accurate way to account for an improvement because you have to account for the removal of an older asset. But we don't really have the value for that because if no cost seg was done, so it's actually puts you in greater compliance. How interesting is that?
Speaker 1:Now let's get into some really quickly, just some commonly asked questions that I want to help you guys out with here. What if I sell the property sooner than expected? Well then you're going to have to worry about depreciation recapture and check the episodes. I have a whole episode on depreciation recapture. I'm going to read this question again what if I sell the property sooner than expected? Well then you have to worry about sorry, I misread this what if I do a cost segregation study and sell it sooner than expected? Well, if that's the case, now you have to worry about depreciation recapture. So when you take a tax deduction for the cost segregation study that amount that you claim as bonus depreciation the non-real estate so let's say we create a six-figure deduction. Now we have to worry about recapture and that is going to be taxed at your marginal rate. So you can be taxed as high as 37% on the federal side. So this could be painful. It might make sense, it might be okay if you do it, but you want to make sure that you're prepared for it. There might be strategies to mitigate that in the following year when you sell it. Just make sure you're working with an advisor and being strategic, because you could get hit with a major recapture tax.
Speaker 1:How does cost segregation work with 1031s? You can do a cost segregation study with a property in 1031 when you sell. You could also 1031 into a property and then do a cost segregation study. However, you have to be careful and make sure you're working with a specialist. When you're doing a 1031 to sell your property after doing a cost seg, you got to make sure that the replacements have comparable value or at least greater or equal or greater value of the assets you've identified in the cost segregation study as 5, 7, and 15 year life property. And then when you do a cost seg after 1031, because you're deferring gain, your basis is going to be reduced and you see less benefit of the cost seg. It still could make a lot of sense to do the cost seg, so sure, why not? As long as it makes sense and you're working with a professional, you can do a cost tag before the 1031 and after the 1031.
Speaker 1:And then what happens if I don't qualify to use the losses right away? So, as mentioned in the prior example, let's say you have losses in excess of the excess business loss limitation we talked about earlier, or let's just say you can't use them. Well, in that case, when the losses carry forward, they're not nearly as helpful. Your suspended losses from the real estate are only going to offset future positive passive income, capital gains events or when you dispose of that rental property, the losses could be freed up and could be treated as non-passive Probably not worth it if you can't use the losses.
Speaker 1:And then some other things I want to just mention which I didn't get to dive into, is all these concepts are also going to apply to you. If you have business property, if you own where you work, you own your office space, you own your warehouse or whatever it is, any piece of real estate that you own, you are going to really want to apply these timing strategies when considering cost segregation. Now, if I've overwhelmed you at all, you know, don't worry, there are answers out there. And if you want to see how these advanced planning and timing strategies may apply to you, and if you're thinking about doing cost eggs and if you're not sure you know the right solution, you can have a free opportunity report where we have a brief survey, we get some information and I will personally send you a video illustrating what may be possible with advanced tax planning and how much that can save you.
Speaker 1:To get that, go to prosperalcpacom slash opportunity report, that's, prosper with an L? Cpacom slash opportunity report. With an L? Cpacom slash opportunity report, and if you would like to begin the journey of exploring advanced tax planning with a free ultimate tax planning checklist and mini course. Go to taxplanningchecklistcom. I really hope that this gave you some inspiration and understanding of how timing is so important with tax planning, and we're looking at all these different variables in the current, future and past years to optimize your savings with cost segregation studies and not just cost segregation studies. By the way, all of our holistic tax planning strategies put a very strong emphasis on timing. All right, stay tuned. We have more great stuff coming your way. Hope to hear from you soon.