Real Life Planning Podcast Ep57: What is the Impact of a Cost Segregation Study When a Property is Sold?

In Episode 57 of the Real Life Planning Podcast, Cynthia Meyer, CFA®, CFP®, ChFC®, and co-host Vekevia Tillman-Jones, CFP®, MBA, go deep into what happens when an investor sells a rental property that previously had a cost segregation study performed. They explain the tax concepts, how depreciation recapture works, and the questions every real estate investor should ask before considering a sale.

(Now, we know you know this, but we are reminding you that this video podcast is for educational purposes only. Please see your tax advisor for tax advice.)

"Depreciation is a paper expense — it doesn't change the amount of cash in your business checking account." – Cynthia Meyer

This week on Real Life Planning Podcast:

Takeaway Quotes:

"If you've taken accelerated depreciation, you can be taxed at your highest income tax rate — not capped at 25%." — Cynthia Meyer

"There are so many moving parts when you sell a property after a cost segregation study — talk to your CPA!" — Vekevia Tillman-Jones

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About the Real Life Planning Podcast

Hosts Cynthia Meyer and Vekevia Tillman-Jones explore practical steps for real estate investors to build financial freedom and make working for someone else optional.

Episode 57 Transcript

[00:00:11] Cynthia Meyer: What happens when you sell a piece of real estate that you've done a cost segregation study on? Today on the Real Life Planning Podcast, Vekevia Tillman-Jones and I are going to break down all these questions that clients have been asking us recently about cost segregation studies and the implications of that later on when property owner sells the property, Hey, Vekevia.

[00:00:36] Vekevia Tillman-Jones: Hello. Hi, Cynthia. Glad to join this morning.

[00:00:39] Cynthia Meyer: Yeah, so you had some questions recently from a client about this. I was hoping we walk through them one by one because we've really been getting a lot of questions about this. I thought this would be a good opportunity to break it down.

[00:00:50] Vekevia Tillman-Jones: Yeah, Absolutely. I certainly agree, Cynthia. You know, a lot of people they might, they own this real estate and they're working with the CPA, they're doing a great job with that. And then oftentimes it sounds like their CPA suggested they do a cost segregation study, but a client might not really even know exactly what that is and why they did it and how it might actually impact them. So it doesn't mean that it's not a good decision. It is just helping clients understand what exactly it even means for them.

[00:01:17] Cynthia Meyer: That's that is so true, and I think we should start this conversation by saying, this is educational. We're not giving you tax advice here. This is absolutely a situation if you have done a passive loss strategy in your real estate business. If you've performed a cost segregation study and used that for accelerated depreciation of your tax return, you must use a professional tax advisor. You must talk to this person before you even think about selling that property because there could be tax implications to what you do that you might not be aware of. As you grow and scale your real estate business, hopefully you're always getting professional tax advice and guidance.

[00:01:59] Vekevia Tillman-Jones: Absolutely. I agree with that, Cynthia. And I think even as we get started on this about the cost segregation, at some point we almost need to take a step back, always say with clients and help them understand like even if they didn't do it, what would that even mean for them when they go to sale? Because that helps us understand better when you do a cost segregation, how it changes the dynamics really of selling that property and any taxes and gains and so forth.

[00:02:23] Cynthia Meyer: And for people who don't know what a cost segregation study does, (VLOG TITLE) basically it's a tax and engineering analysis that breaks down the components of a piece of real property, a building, into different categories that might be eligible for a faster depreciation on a tax return. So normally, real property, if it's rented for residential purposes, it's depreciated over 27 and a half years in straight line depreciation, meaning the depreciable basis divided by 27.5 and commercial properties depreciated for 39 years. That's called straight line depreciation. In a cost segregation study , tax and engineering experts break out the parts of the building that could be depreciated faster. So for example, three, five or seven years and this allows the real estate investor to take the parts of those parts of the building like the kitchen cabinets the air conditioning system or the heating system the, that maybe the floors or, wood floors or carpeting or something like that. It allow the faucets like allows them to break out that stuff and depreciate it faster. And that gives you a larger depreciation tax deduction in the early years of owning a property. So typically cost segregation studies are done within the first year or two after you have purchased the property.

[00:03:52] Vekevia Tillman-Jones: Yep, absolutely. And so when you think about depreciation, it's essentially you buy a house and or rental property of some sort residential or commercial. And essentially the IRS says that, you know what, you spent quite a bit of money on this house and each year we're going to essentially allow you to take depreciation as an expense. So depreciation is basically another expense that you get to add on Schedule E, and that reduces the income from the property, right? So that makes the amount that you owe on tax lower. So...

[00:04:26] Cynthia Meyer: That's right, but that cash is still in your checking account.

[00:04:28] Vekevia Tillman-Jones: Yes. To your point, Cynthia, that cost segregation study allows us to take larger expenses so much earlier. So that automatically sounds very exciting and it can't have many benefits now. But when you- when it comes time to actually sell the property though, it has different implications that are important and that's why we're discussing all of this.

[00:04:47] Cynthia Meyer: That's great. And another thing that's important to know is that if the listener recalls, real estate income is taxed on as a passive income source, so a loss from real estate typically cannot offset active income, like income from your salary or your business unless there are certain circumstances that are true. The first would be you qualify for real estate professional status, meaning you're working professionally in real estate and you're putting- the most common way to qualify is having 750 hours or more managing your real estate and that you can document and you have a passive loss. And you aren't working in any other job, right? It could also be used with the I guess we would call it the short term rental loophole. Which we are not going to dive in here, but basically somebody that has a short term rental can qualify to use those passive losses with a fewer number of hours if they're the person that's working the most on the property and we can put some links in the show notes to to some articles about all of these things. Again, if you're going to do them, gotta get professional tax advice.

[00:06:01] Vekevia Tillman-Jones: Yes.

[00:06:03] Cynthia Meyer: Some real estate investors who have mature portfolios and they- or maybe their depreciation has run out on some of their other rental properties could use an accelerated depreciation and that creates a passive loss because they have a lot of other real estate income, right? That is they're getting taxed on at ordinary income rates, right? So it helps lower their total taxable real estate income.

[00:06:26] Vekevia Tillman-Jones: And that's such a good point, Cynthia, especially with regarding to the different rates. I think some people automatically assume if they get ready to sell a property that, hey, I bought this house for 200,000 and now it's worth 400,000. So great. I have 200,000. I've held it longer than a year. A lot of people understand that. So it's long-term capital gains rate, which is a lot lower than your ordinary income rate. So automatically, any gain, I'm going to get that full amount taxed at a lower rate. And that's not exactly how that would work when you think about the depreciation.

[00:06:56] Cynthia Meyer: That's correct. And so let's break that down into two situations here. The first of which is any time somebody sells a rental a property, and they're recognizing those gains in that tax year on their tax return, meaning they're not doing a tax deferred 1031 exchange. So they're recognizing the gains, they're paying taxes on those in that tax year. The common misconception is that that the entire gain, the difference between what they purchased the property for and what they sold the property for net of selling costs is taxed as a capital gain, but in fact, that's not true. Any depreciation, any straight line depreciation that the rental property owner has taken over the life of the property is going to it's called Section 1250 Unrecaptured Gains, and it's going to be taxed at ordinary income rates up to 25%, whichever is less. So if the investor took straight line depreciation on their tax return, then all that depreciation that they had taken, like if they own the property for 10 or 20 years, for example, all that depreciation is going to be taxed at ordinary income rates up to 25%. Meaning if the taxpayer is in a higher tax bracket, they're capped at 25%.

[00:08:18] Vekevia Tillman-Jones: Oh, sorry. Go ahead Cynthia.

[00:08:19] Cynthia Meyer: No. Go ahead.

[00:08:20] Vekevia Tillman-Jones: And so that straight line depreciation, Cynthia, that's the, it's important for everybody to understand and clients, especially that straight line is you're taking the same amount of depreciation every year. You're not accelerating anything. It's the same amount every year over the intended useful life. So if it's residential, that's 27.5 years and if it's commercial, it's 39. So the straight line portion is very important because when cost segregation or any bonus depreciation for that instance, and we'll talk about that, would accelerate that and allow you to take more earlier.

[00:08:54] Cynthia Meyer: That's right. And so when it's bonus depreciation, right? When the investor has contracted for a cost segregation study and taken accelerated depreciation, remember, they've stripped out all the parts of the property in a tax and engineering study, and they've said, okay, I'm going to depreciate all the faucets and all the kitchen cabinets and all the wood floors, et cetera, right?

[00:09:15] Then they have taken this accelerated depreciation that changes the rule about what happens when you sell the property. And so what happens is that accelerated depreciation doesn't have a cap on the taxation. So if you accelerated depreciation, you're going to pay ordinary income tax rates up to the highest tax rate.

[00:09:44] There's no cap at 25% and so you can be taxed up to the highest tax rate.

[00:09:51] Vekevia Tillman-Jones: That's exactly correct. If you've taken any accelerated depreciation like you were mentioning earlier, Cynthia, there are going to be two parts, right? You're going to have- the whole thing may not be accelerated, so you might have some depreciation that in fact, is entitled to that straight line, up to the 25%. And you may also have a portion of it, like Cynthia mentioned, the cabinets, maybe you made major improvements. A lot of people like to do that when they first buy a property. Maybe they add it onto it. And so then you have this second part that you're dealing with that's now subject to up to 37% or with the highest ordinary income tax bracket. It's really important to speak with the CPA because there are so many moving parts that are going to be important, and all of those impact your gain. And so then on top that this only dealing with the depreciation portion. There's the third portion that you would be dealing with, which is in fact the true gain that you just had, which is excluding thinking about depreciation, the true long-term capital gain, if you've held it for a year longer, that will be due on that property.

[00:10:49] Cynthia Meyer: That's right. If somebody has done a cost segregation study and then wants to sell their property later and not do a 1031 exchange, what are some implications of that? Like to just give a really simple math example here that, this is not a realistic example here, but let's say they bought the property for 200,000. They did a cost segregation study and accelerated depreciation on $75,000 worth of components of that property and that it created a passive loss. And then they also rented the property for a couple of years and took an additional $25,000 in straight line depreciation. They bought the property at 200,000. They've taken a total of a $100,000 in depreciation expense; 75,000 of which is from a cost segregation study and accelerated depreciation, and 25,000 of which is from straight line depreciation. Then they turn around and sell the property for 300,000 net of selling costs. So a 100,000 of that is capital gain. 75,000 of that is taxed at ordinary income rates, and 25,000 of that is taxed at the cap of 25% or the ordinary income rate, whichever is lower.

[00:12:27] Vekevia Tillman-Jones: Yeah. So essentially three buckets.

[00:12:29] Cynthia Meyer: Yeah, three buckets. That's right.

[00:12:31] Vekevia Tillman-Jones: Yeah. So before you make a decision, a lot of times people will- is it worth to just go ahead and sell it anyway? Or should I even do the cost segregation study in the first place? Cost segregation studies can be costly and they can take time to get that done. But it can make sense in certain situations, especially- and this is why it's so important to be working with your tax professional and your financial planner, because they're going to be looking at any potential income changes that you might have in the short term, midterm, right? terms of when that might make the most sense to do and take those greater deductions in any one particular year.

[00:13:04] Cynthia Meyer: That's right. And so this is the- for anybody that's listening, that is considering doing this in their own real estate business and hasn't done one, hasn't done this before, couple of questions to discuss with your financial planner and your tax preparer. The first is, if I did this, would I qualify under real estate professional status or the short term rental rules? So question number one, would I qualify with this property and my circumstance managing these properties, would I even qualify? If that person doesn't qualify, could they still benefit from having based on the rest of their portfolio, could they still benefit by having passive losses that would offset passive gains? Do they have large passive gains? And so they can't offset their active income, but maybe they have other passive income that they offset. Okay. So that's the second thing. The third question is, what's my holding period? If you plan to continue to keep that money invested in real estate, forever and always, and you intend to just kick the kick the can forward, if you will, by doing 1031 exchanges all the way up until when you pass away or until when you're in a much lower income tax bracket, then that it might make sense to still go ahead and do it. So lots and lots of ifs here and it's important to get ahead of it.

[00:14:26] Vekevia Tillman-Jones: And a lot of people might wonder what happens to the basis if they, let's say if they exchange that property and do a 1031, sometimes that's just a better decision, especially if they want to stick to real estate. A lot of people might ask, does the basis start over? What exactly happens at that point?

[00:14:42] Cynthia Meyer: So if you do a 1031 exchange and my husband Steve and I have done several 1031, we did several 1031 exchanges during Covid and to, we were looking for more doors and higher cash flow on some of these highly appreciated single family homes that we had at the time and we did achieve more doors and higher cash flow. We exchanged one single family home for a duplex and one for a small apartment complex. So what happens- and again this is always a CPA question as to what the exact numbers are. If you are exchanging into a property that's that's worth more then what your original purchase was, then you will have- you will carry forward that lower basis and then your CPA will be able to adjust up for the additional value of the new property. So it'll be proportionate. It would not be the same amount of straight line depreciation if you were just buying it from scratch without a 1031 exchange.

[00:15:45] Vekevia Tillman-Jones: Cynthia, one of the things that you mentioned for clients to ask their tax professional that's very important is when they, if they don't qualify for, let's say, real estate professional status that the IRS allows, which allows them to be able to offset ordinary income, take these passes off losses against ordinary income.

[00:16:02] Cynthia Meyer: Yeah. And most real estate investors don't qualify for that unless they're, they're managing properties full time.

[00:16:07] Vekevia Tillman-Jones: Or have a spouse who's not working, and something like that. So, if they don't qualify and it stays passive, that means that you might not- you might take all of this accelerated depreciation, and not even really be able to fully benefit from a full loss,

[00:16:22] Cynthia Meyer: not in a single tax year anyway. The losses would carried forward. Yeah.

[00:16:26] Vekevia Tillman-Jones: And when they get ready to sell, right? Yeah. Or get rid of the property. So that's important.

[00:16:30] Cynthia Meyer: Yeah. And so we commonly see this in our client base with Real Life Planning. We commonly see people doing this where one of the spouses who are married filing jointly, and one of the spouses works professionally in real estate and manages the couple's rental properties. And so maybe we've got somebody that's a real estate agent or in construction or a developer or something like that, and one spouse is working in real estate, maybe they're property manager, right? And they're managing the family doors, if you will. And then the other spouse is a high income earner in some capacity, either with salary or stock options, or they have a high earning business. That kind of combination of the real estate professional and the high earning spouse can be very tax efficient on under the current tax law. But again, it's not for everybody and you absolutely gotta get some professional advice. We've also seen it occasionally with people who have short term rentals and they've moved their short term rentals onto Schedule C, for example. And then that's active income or losses that can offset active gains. And of course I'm preaching to the choir here because we agree about this, but there was so much to talk to your tax advisor about before you would ever commit to a strategy here.

[00:17:45] Vekevia Tillman-Jones: Okay. Something that sometimes comes, that clients will bring up is just how much should they expect to actually pay for a cost segregation analysis?

[00:17:54] Cynthia Meyer: Oh gosh. It could be for, for a small little rental, it could just be a couple thousand, right? 1,500, $2,000 maybe. I would say that for a large commercial building, like an apartment building, we could be talking about 10, 20, $30,000 depending on how big the property is. Possibly even more if it's really huge, complex. Somebody should expect to spend in the multiple thousands of dollars and, maybe for a million dollar fourplex, for example, you might, you could spend like $7,000 or $8,000. Good question. What other questions have your clients been asking, Vekevia?

[00:18:33] Vekevia Tillman-Jones: I have clients who have multiple properties, T hey've done cost segregation analysis on all of the different properties. They more so just felt unsure when it comes time to say, maybe one of the properties is on underperforming; one or more of the properties. Is that a good property then to go and then sell? Did the cost segregation analysis change anything with regards to the performance of the property? I've had that come up.

[00:18:57] Cynthia Meyer: Yeah. No, not really. Remember, depreciation is a paper expense. It doesn't change the amount of money that you have in your business checking account, right? So, depreciation shelters net cash flow from real estate income, which is, you know why people say real estate cash, we talk about cash flow as opposed to income, right? Because we're taking a depreciation expense for the wear and use of the property over time. I would say that in general, we would coach clients who are considering doing a cost segregation study with a passive loss strategy, if they qualify for this. We would encourage them to just commit to the idea that unless it's an emergency, they're going to 1031 exchange when they're ready to sell that property. They're going to do a tax deferred 1031 exchange and they're going to kick the can down the road on recognizing that income and recapturing depreciation. And they're just going to roll that- everything into the next property.

[00:19:56] Vekevia Tillman-Jones: And I can imagine especially when you're thinking about, I know that I'm going to do a 1031 exchange on this property later on. And this isn't directly a cost segregation question, but it's more, am I okay then with potentially a smaller profit margin each year on that property? Between the income that I'm receiving it and the cost that it has. But I know the benefit later on with the 1031 exchange that I get to, you know, kick the tax issue down the road. Perhaps I look at that property a little bit differently every year up until I 1031 exchange it.

[00:20:26] Cynthia Meyer: So the whole should I 1031 or not 1031? That's probably subject for a different podcast, but the, just think of it in general, the goal of a strategic 1031 exchange, higher cash flow, more doors, or simplification. So I say simplification in the case of somebody maybe who's looking to get out of the day-to-day business of being a rental property owner, and maybe they're going to 1031 exchange into a Delaware statutory trust or something like that or into a triple net lease, right? Which has less active participation. But again, that's another, that's a whole other topic. I do want to talk a little bit about the other use of accelerated depreciation and we saw this a lot with people buying cars in their business that met certain criteria, right? And then taking depreciation right upfront and then going to like selling that car after two or three years and not realizing that they were going to, even though the car has lost value, right? That they were going to be paying taxes on that recaptured accelerating depreciation. Not a real estate thing, but if you were somebody who has taken accelerated depreciation for some kind of business property, that's not real estate, right? Definitely talk to your tax advisor before you sell it again. Selling before that depreciable period would have been up, right? Can bring you unexpected taxes.

[00:22:05] Vekevia Tillman-Jones: Oh, Cynthia, that is such a good point because all over social media are posts from people who say, and they likely are, very savvy tax professionals tooting a horn on the side of, hey, especially when bonus depreciation was at a hundred percent in the first year, really getting people to purchase a property. You can just appreciate this whole thing in year one. But nobody ever spoke about the other side of it. About what happens if you sell,

[00:22:27] Cynthia Meyer: Yes. Yes. So, the bonus depreciation ability to take a hundred percent bonus depreciation has gone down a little bit every year through the- up for consideration in the current examination of the Tax Cuts and Jobs Act. We don't know what's going to happen but in any case, if you took bonus depreciation on any kind of personal property or excuse me, if you took bonus depreciation on any kind of business property or on your rental real estate, gotta talk to a tax advisor before make a contract to sell.

[00:23:00] Vekevia, thank you so much. This has been really helpful.

[00:23:03] Vekevia Tillman-Jones: Yes, absolutely.  

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