Avoid Paying Taxes (Legally) with THIS Rental Tax Loophole

Summary

Real Estate Rookie Podcast Episode Summary

Title: Avoid Paying Taxes (Legally) with THIS Rental Tax Loophole
Host/Author: BiggerPockets
Release Date: February 10, 2025
Episode Focus: Understanding Cost Segregation as a Legal Tax Strategy for Real Estate Investors

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Introduction

In this episode of the Real Estate Rookie podcast, hosts Ashley Kerr and Tony J. Robinson delve into the intricacies of cost segregation, a powerful tax strategy that allows real estate investors to legally minimize their tax liabilities. Joining them is expert Sean Graham, who provides an in-depth explanation of cost segregation studies, their benefits, and their application for both novice and seasoned investors.

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What is Cost Segregation?

Sean Graham begins by demystifying the concept of cost segregation:

[00:40] Sean: "A cost segregation study is really a way to accelerate the depreciation on your real estate. So the IRS requires you to depreciate rental investment properties over 30 or 40 years using straight-line depreciation. A cost segregation study helps you accelerate this depreciation, allowing you to reap the financial benefits upfront rather than waiting decades."

Key Points:

• Depreciation: The IRS allows real estate investors to depreciate properties, which reduces taxable income.
• Straight-Line Depreciation: Typically spread over 27.5 years for residential properties.
• Accelerated Depreciation: Cost segregation reallocates property costs into shorter-lived categories, enhancing immediate tax benefits.

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Importance for Rookie Investors

Ashley Kerr emphasizes the relevance of cost segregation for new investors:

[03:48] Sean: "Even if you're just getting your first deal or have a modest portfolio, a cost segregation study can significantly increase your cash flow by accelerating depreciation deductions."

Key Takeaways:

• Cost segregation is not exclusive to large-scale investors.
• New investors can benefit by increasing their immediate cash flow and reducing taxable income.

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Application Differences: Long-term vs. Short-term Rentals

Tony J. Robinson seeks clarity on how cost segregation applies differently to various types of rental properties:

[07:04] Sean: "For residential properties, standard depreciation is 27.5 years. With a cost segregation study, we reallocate costs into 5, 15, or even shorter year categories, allowing for accelerated depreciation and greater upfront tax benefits."

Differences Highlighted:

• Long-term Rentals: Typically treated as passive income; depreciation offsets rental income.
• Short-term Rentals ("Short-term Rental Loophole"): When meeting specific criteria (e.g., average rental period ≤7 days, material participation), these can be classified as active businesses, allowing depreciation to offset active income like W-2 wages.

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Bonus Depreciation Explained

Sean elaborates on the concept of bonus depreciation and its evolution:

[22:53] Sean: "Bonus depreciation allows you to immediately expense assets with a life of less than 20 years. From 2018 through 2022, we had 100% bonus depreciation, which means you could write off these assets entirely in the first year. This percentage is decreasing each year, currently at 40% for 2025."

Key Insights:

• Eligibility: Assets with a lifespan of less than 20 years qualify.
• Depreciation Rates: Decreasing from 100% (2018-2022) to 40% (2025).
• Strategic Timing: Investing earlier maximizes the bonus depreciation benefits before rates decline.

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Process and Timing of Cost Segregation Studies

Ashley inquires about the logistical aspects of implementing cost segregation:

[19:35] Sean: "It's best to conduct a cost segregation study soon after purchasing the property, especially after any capital improvements. The average timeline is about six weeks, and it's crucial to have the study before filing your taxes to ensure the benefits are accurately captured."

Process Steps:

1. Initial Estimate: Provide property details, photos, and financial information.
2. Detailed Study: Qualified engineers assess and categorize property components.
3. Final Report: Delivered within approximately six weeks, ready for tax filing.

Timing Considerations:

• Year-End Planning: Often completed before the end of the fiscal year.
• Catch-Up Studies (Form 3115): Applicable for properties held over multiple years without prior cost segregation.

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Case Studies and Real-World Applications

Sean shares practical examples illustrating the impact of cost segregation:

[33:51] Sean: "One client, high-income earners, invested $1 million in two short-term rentals. A cost segregation study generated approximately $300,000 in year-one depreciation, resulting in over $100,000 in tax savings."

Another example includes house hacking:

[36:26] Sean: "By conducting cost segregation on a three-unit property in Chicago, Sean could accelerate depreciation on rental units, significantly reducing taxable income and enhancing cash flow."

Benefits Highlighted:

• Tax Savings: Immediate reduction in taxable income.
• Cash Flow Enhancement: More funds available for reinvestment or other financial goals.
• Flexibility: Applicable to various property types and investment strategies.

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Implications for Financing and Depreciation Recapture

The discussion addresses concerns about how cost segregation affects loan approvals and potential tax implications upon selling properties:

[37:47] Tony: "After implementing cost segregation across our portfolio, we haven't had a federal tax bill since, and lenders have been accommodating by adding depreciation back into our income calculations."

Key Points:

• Loan Approvals: Lenders typically recognize depreciation as a non-cash expense, allowing investors to qualify for larger loans despite reduced taxable income.
• Depreciation Recapture: When selling a property, investors may need to pay taxes on the accelerated depreciation, though strategies like 1031 exchanges can defer these taxes.

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Tips for Hiring Cost Segregation Professionals

Sean provides guidance on selecting the right experts for conducting cost segregation studies:

[39:05] Sean: "Ensure the firm performs detailed engineering-based studies and has qualified engineers. Quality and communication are paramount to obtaining accurate and IRS-compliant results."

Hiring Tips:

• Qualifications: Look for firms with certified engineers and tax professionals.
• Reputation: Seek companies with proven track records and transparent processes.
• Communication: Choose providers who offer clear explanations and ongoing support throughout the process.

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Conclusion

The episode wraps up with actionable advice for listeners interested in leveraging cost segregation:

• Identify Eligibility: Assess whether your properties qualify for cost segregation and bonus depreciation benefits.
• Engage Experts: Partner with reputable firms like Sean Graham's Maven Cost Segregation to conduct thorough studies.
• Strategic Planning: Integrate cost segregation into your long-term investment strategy to maximize tax savings and enhance cash flow.

Sean emphasizes the dual benefit of cost segregation in reducing tax liabilities and increasing investment returns, making it a vital tool for both new and experienced real estate investors.

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Notable Quotes:

• Sean Graham [00:40]: "A cost segregation study is really a way to accelerate the depreciation on your real estate... you're getting the majority of the benefits upfront."
• Sean Graham [22:53]: "Bonus depreciation allows you to immediately expense assets with a life of less than 20 years... it is currently 40% for 2025."
• Tony J. Robinson [37:47]: "We haven't had a federal tax bill since we did all of our cost segregation studies... there's a massive amount of tax benefit you can generate."

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Additional Resources:

For those interested in exploring cost segregation further, Sean Graham is developing a comprehensive guide available at biggerpockets.com/resources. This resource will cover everything from material participation to real estate professional status and the nuances between straight-line and accelerated depreciation.

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Transcript

[Ashley Kerr]

There's a number one tax loophole out there that if you don't know about it, then you're leaving money on the table.

[Tony J. Robinson]

I've personally been able to legally avoid paying taxes using this one strategy.

[Sean Graham]

And we'll go over what a cost.

[Tony J. Robinson]

Segregation is, who qualifies, and how to complete one to keep more money in your pocket.

[Ashley Kerr]

This is the Real Estate Rookie Podcast. I'm Ashley Kerr.

[Tony J. Robinson]

And I'm Tony J. Robinson. And welcome to the Real Estate Rookie Podcast.

[Sean Graham]

Today we have Sean Graham as our guest expert on cost segregation studies.

[Tony J. Robinson]

Sean, welcome to the show.

[Sean]

Thank you. Thanks, Tony. Thanks, Ashley, for having me.

[Ashley Kerr]

Yeah, Sean, let's get started with what a cost segregation is.

[Sean]

A cost segregation study is really, is a way to accelerate the depreciation on your real estate. So the irs, they require you to depreciate rental, like investment properties that you have. Right. Typically you do this over straight line depreciation. You do it over 30 or 40 years to get a cost study that helps you accelerate this depreciation. So if you take a step back, like you look at it overall cost segregation, like you're going to get the same amount of depreciation over the, like the 30 or 40 years, but instead of waiting like time value money, instead of waiting for that money down the road, you're getting the majority of the benefits upfront. Does that make sense?

[Tony J. Robinson]

Yeah. And I guess, let me, let me ask Sean, for some of our rookie rookies in the audience, we talk about depreciation of real estate, but it's somewhat confusing because we know that properties appreciate over time. So can you just even all the way down to the basics, break down. What do we mean when we say depreciation of an asset?

[Sean]

Yeah, so the, the IRS like really likes real estate. Right. It's kind of the backbone of the economy of small businesses. And so they want you to keep reinvesting in real estate. They want to buy, buy real estate, buy more real estate. This is where people live, this is where small businesses are. So they allow special tax breaks for real estate investors. And that could be somebody who's in real estate full time or somebody who just maybe you're a doctor, you just have your practice there, but you're buying real estate. So the IRS gives depreciation benefits, meaning depreciation expenses. So it's kind of this phantom expense. You take this expense which lowers your taxable income. Now it's not actually a cash flow expense. Right. So like, let's just say you have a $275,000 depreciable basis on a rental property. So you depreciate this $10,000 every single year without a cost segregation study, right? Just straight line, this is not $10,000 that's coming out of your bank account, right? It's just an expense that the IRS lets you take on your taxes, which lowers your taxable income by $10,000 each year. So the IRS is doing this to incentivize you to invest in real estate, right? It's a cash flow benefit to you. It saves you taxes. Now with a cost segregation study, it's really the same thing, but we're accelerating that depreciation so we're not waiting a super long time to get all the benefits. It's the time value money. So if I said, Tony, like if I could give you a dollar today or if I could give you a dollar in 30 or 40 years, what would you rather have? And you'd say, well, I'd rather have the dollar today, right? Because a dollar today is worth more than a dollar in 40 years. So that's what a cost segregation study is about. Depreciation's always been there and during certain years, like it benefits you more than others with bonus depreciation. But Overall it's the IRS's way to incentivize people to keep investing in the real estate market.

[Ashley Kerr]

John, why is this important for a rookie investor? Maybe they are just getting their first deal or they only have one deal. Is this even applicable to them?

[Sean]

Totally, yes. So I get that question a lot, right? Because when you think of cost segregation study, you think, okay, well this is for big time real estate investors or people buying commercial buildings. But that's not really true. You know, there's different benefits if you are in real estate full time or you're a real estate professional. But even if you're not, there's a lot of benefits to it. So for example, I house hacked a building. So I bought a building myself, right? Just as an example. 3 unit building, bought it for about half a million dollars. This building, it cash flows about $2,000 a month. And then I'm paying down principal of another thousand dollars a month. So every single month I'm profiting about $3,000, right? Over the course of the year, that's $36,000 in profit. The IRS doesn't look at principal as an expense. That's part of your profit. So if I don't do a cost segregation study, right, Then I just do straight line depreciation, I'm going to get depreciation of somewhere around $18,000 every single year. Well, that leaves me with $18,000 left right out of that 36,000, that's just going to be profit. It's going to be taxed at my ordinary tax rate every single year. Right. So with a cost segregation study, I can front load a lot of that depreciation to the current year. And not only will it offset like for this year, it'll actually whatever I have left. So let's say, you know, I'm able to front load a $150,000. Well, it'll offset that, that, you know, $36,000 for next, for this year, but also for the next four years and going forward.

[Tony J. Robinson]

And it just kind of keeps rolling. And Sean, I just want to. I think that's a really important thing for people to understand when it comes to the cost tag because the. There's this rollover, right? It's almost like, you know, when you used to have your cell phone in the early 2000s, you had these rollover minutes. Like you get all these minutes in one month. You didn't use them. They rolled over to the next month. Very similar thing with the cost where you can create all of this tax benefit and if you don't use it this year, it's still there for you to use in the next year. But I just want to go back to one thing you said earlier, Sean, because I really want to make sure that the rookie audience understands. But you, you said the. Basically the irs, the government is incentivizing us to buy real estate. And one of the ways that they do that is by allowing us to create these phantom expenses. So there's no money out of pocket with depreciation. But it is still something that we get to claim on our tax return as an expense that then lowers our taxable income, reducing the amount of money we have to spend in taxes. That is a major, major reason for a lot of people to get into. Into real estate investing. So it's a point that I just really want to make sure that, that rookies understand. Now Sean, I know that there is a difference between how cost sex can be applied depending on the asset class. Like, you know, I do a lot of short term rentals, so I know there's a slightly different way that the tax benefits apply there. Long term rentals, commercial property. So can you maybe, let's just maybe start with, with maybe the two most basic that Rickies are focused on. But a traditional single family long term rental versus a traditional single family short term rental. How is the cost seg maybe applied differently in those situations, I guess.

[Sean]

Tony, you brought up a good point too. Like when you just said like, you know, what is this depreciation? So this is just the IRS's way for you to let you write off the wear and tear every single year, right? Even though that wear and tear might not actually have a real cash flow expense, but that's what depreciation is. So for residential properties, the standard depreciation amount is 27 and a half years, right? Just straight line depreciation. Now, with a cost seg study, we reallocate part of that, part of the, you know, we do an engineering study and we say, hey, IRS, like not everything takes 27 and a half years to depreciate. Some of it can be five years, some of it can be 15 years. Right? Some of it, a big portion of it we're gonna do in year one. It's gonna be through bonus depreciation. We'll write it off in year one. And so that's the benefit of it. Now, there are a couple different ways that a person who's not in real estate can also use this depreciation not only to offset the passive income from the real estate, but also offset the active income as well. Meaning, Tony, if you're in real estate just part time, right? Or actually, like you're working a full time W2, but you have this rental property, well, you can use the depreciation to offset other passive income, but you can't use it to offset your W2 income. Now, the exceptions to that are if you or your spouse qualify for real estate professional status, meaning, like you're in real estate basically full time, you're doing it more than anybody, anything, any other job, it's 750 hours. But then it says, then the IRS says, well, you're a real estate professional. This isn't just a passive activity for you. This is active. And so you actually get to use these losses to offset your W2. So sometimes high income earners will have a spouse who maybe manages real estate full time, manages their real estate portfolio, and they'll take that depreciation. They'll be able to take that depreciation and use it to offset the other spouse's W2 income, right? So huge benefits really lowers that income. Now back to your question. You said, what's the difference between like, long term and short term, right? So let's just talk residential. So we're just talking rental properties or small multifamily. And that's generally as the IRS looks at it, they look at long term rentals as a passive activity. So hey, IRS is just deemed to be passive by, you know, from a tax standpoint, there's an exception where you don't have to qualify for real estate professional status. And that's sometimes referred to as the short term rental loophole. Right. So short term rental loophole, short term rental strategy, however you want to term it. But the point is, if you meet certain requirements with a short term rental, like you have an average rental period of seven days or less, you materially participate it, meaning you're putting in it's at least 100 hours more than, or more than in more than anybody else, or at least 500 hours. There's different material participation rules. It's not a personal residence. Like you're not using it as your personal residence for more than two weeks. Right. Then you can qualify for short term rental loophole where the IRS says this is actually an active business, you're managing it. And so you get to use the depreciation losses and the losses in general. Right. From, from the property and use it to offset your active income. So it's a really big strategy, especially with high income earners such as doctors or attorneys, which helps them offset that type of income.

[Tony J. Robinson]

Yeah, and Sean, like a great explanation. I just want to, I want to recap all that for the rookies to make sure that they're tracking. So basically, if you buy a single family home, whether you intend to short term rented or long term rent it, you can still perform a cost segregation study which then allows you to accelerate that depreciation from 27 and a half years down to some shorter timeframe depending on what's inside of that report that's generated. But the only way to then take those losses generated by the cost seg and apply them against your actual W2 income, not just the rental income from the property, but your W2 income or any other active income is either A, you have to qualify as a real estate professional or B, you have to materially participate in a short term rental. Am I, am I understanding that process correctly there?

[Sean]

Generally, yes, that is, that is correct. Generally speaking, you want real estate professional status or short term rental loophole in order to use those depreciation losses to offset other active income, such as W2 income.

[Ashley Kerr]

Well, Sean, we're going to take a quick break, but when we come back, we're going to find out more about doing a cost segregation study. Before we go into the break though, I want everyone to check out biggerpockets.com/conference. It's time for BPCON, which is going to be in Las Vegas. Build your network and unlock the next level of your investing journey. When we come back, we are going through the actual process of how to do a cost seg with Sean. We'll be right back.

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[Ashley Kerr]

Okay, now let's get back into the show and if you want to learn more information about this, Sean, you are actually creating a resource for Biggerpockets. It can be [e-mail] resources and this is going to be a guide for rookie investors on how to actually do a cost segment study who you need to know, what you need to do and how it actually works. Is there anything I'm missing that will be included in that?

[Sean]

No, I'm super excited about creating that resource for Biggerpockets. I'm in the forums a lot talking to people about depreciation and cost segregation and taxes. But it's going to be I think cost segregation 101 and it'll be in the resource guide and just kind of touch on a little bit of everything from material participation to short term rental status or short term rental loophole, real estate professional status and just how the difference between straight line depreciation and accelerated depreciation and how that works.

[Ashley Kerr]

Now Sean, we didn't talk about flipping at all. Is this something that would work with flipping a property?

[Sean]

Short answer is no. The reason is, is that the IRS looks at flipping as inventory. So it's not, you're not investing in real estate as, you know, a long term, long term asset or as a real investment. You are flipping inventory. So they do not allow depreciation on it and it just wouldn't be beneficial for, for flipping.

[Tony J. Robinson]

Sean, just one quick follow up question to that. At what duration of ownership does it kind of transition from long term, you know, rental to, to flipping? So or maybe even short term rental to flipping. Right. Let's say I buy a property, I renovate it, I hold it for six months. During that six month time frame I'm short term renting it and then I sell it afterwards. Could I cost like it at that point? Like how, how do you make that distinction?

[Sean]

So I think the IRS looks at a lot of things as what's your intention when you go, go in upfront, right. So if your intention is to flip this property then they're not going to want you to take the, the depreciation, right. If that's your intention upfront. But if you buy a property, you do a cost segregation study and then you end up selling it a year later. Like that's fine. There's nothing, nothing wrong with, with doing that. Now. It's not going to be beneficial for you if you just have it for one tax season, right? So like, okay, you bought it at the end of 2024, you file your, file your taxes and then you, you sell it. Well, there's something called depreciation recapture. So the IRS says you have to pay your taxes. Right. This is really a deferral strategy, meaning it's not a permanent tax savings. But they want you to pay your taxes eventually. Now if you take the proceeds and you 1031 exchange or you know, you have other depreciation from another property to offset it, which we can dive into that more if you guys want, that could help offset that. But overall, like especially if you have the, the you buy it and you sell it in the same year, well then there's no point in doing a cost segregation study because it would just, it would just be a wash. Right? Like you can't take the losses on the property that you, you no longer have. Right. You're selling this, this property. So if you have it for a year, it's not, you're going to have to pay like pay the depreciation recapture the following year. So it could defer it for a year if the losses like really help you offset it. Right. Right. Now that's good. But overall depreciation is for long term investments. That's the intention behind it.

[Ashley Kerr]

Sean, what if you don't sell the property? What if you purchase this property and your goal is within three to five years, you're going to rent it out until that time and then you're going to make it your family vacation home as your second home. Is there some kind of limit on how long you actually have to have it as a rental before you can turn it into your second home or your vacation home?

[Sean]

That's a good question. So I don't think that there's a limit as to how long you can have it again. Like it kind of goes back to intention. Like if you're going to buy it in December just to qualify for the short term rental loophole. Right. And then you're never going to rent it out again after December. Right. It's just going to be your family vacation after that. Well, that could raise a red flag. Like in the case that you did get audited, there'd be a lot of question marks about that. So again, it comes back to what's your intention up front? If you decide to use the short term rental strategy or you want to buy real estate and you know, accelerate the depreciation, then that should be your intention of what you're doing with the property. Now the IRS does have a personal use limit of 14 days or less. So like you could go take vacation at this property for two weeks and that's okay. And it can still be this, you know, investment property for, for you. But if you're going to go stay there for months at a time, well then this isn't really an investment property to them. This is a personal residence or a second home vacation home that you also happen to rent out.

[Tony J. Robinson]

So what about from, from a timing perspective, Sean, like when does it actually make sense to do the cost seg? Is it have got to do it immediately after purchasing? Do I have to wait a certain time after I own the property? How do you time out when to do the cost?

[Sean]

It's funny, December often seems to be like a very busy month for us. And I think because that's because people start thinking, hey, I have to get it done before year end. Which is not necessarily true, but it is very helpful. So your tax CPA needs the cost segregation study in time to file taxes. So if you have any business taxes, right, you're on a March 15 deadline, you need the cost segregation study ahead of that. Our average timeline is about six weeks. So you don't have to do it in the year. You can do it, you know, when you're filing taxes or before then. But you need to give your tax EPA enough time to file. That being said, you bring up an interesting point which is there, there's something called A3115 which is a look back study is a catch up in depreciation so that we have customers who, they didn't know about cost segregation, they didn't know about accelerated depreciation, they've had properties for several years, you know, four or five years, whatever it may be. And we have to go back, we do a cost segregation study and we say, hey irs, like all this depreciation was missed because they were using was technically the incorrect method of depreciation, which is just straight line. We corrected it through a cost seg study and this is the correct amount of depreciation. And so that difference, we can actually take that difference and apply it to the current year so we don't have to go back and refile five years of taxes, but rather we can say hey irs, he missed all this depreciation, he's going to take it in the current year and that's allowed. So that's called the change in change in accounting method. Now overall, what I would recommend, I'd recommend getting the cost study pretty Much done after, after you close the property knowing, you know, and if you have any capital expenditures or maybe you're going to, you're going to buy the property, you're going to rehab it and then you'll rent it out, you're doing the brrrr method. We'll get the cost segregation study done after you finish those capital expenditures.

[Tony J. Robinson]

And Sean, you, you, what you outlined is pretty much what happened to us. So we bought several Airbnbs in 2020. You know, we were self managing all of them so we qualified for material participation. But we didn't do any cost segregation studies during that year because at the time I was new to this, didn't really know what was going on. I don't even think we did any in 2021. I believe it was 2022. And at that point we were up to, I don't know, 20 Airbnbs. So we had a decent portfolio and then we just did like a massive cost segregation study across almost the entire portfolio and then we were able to apply that to that year's income even though those properties have been put into service, you know, in 2020 and 2021. So you're absolutely right that you know, even if you don't necessarily do it today, you can still get that tax benefit at some point in the future. One thing we didn't talk about though, Sean, and we touched on it briefly, but it's bonus depreciation. And that was I think a really big driver of interest in the short term rental space. In addition to, you know, rates are super low, revenues are really high, but the bonus depreciation. So can you just quickly explain what bonus depreciate because it was 100% bonus depreciation. So what exactly does that mean? And then I have one follow up question after that as well.

[Sean]

Sure. So I think sometimes bonus depreciation gets a little bit confused. Right. And that's because it doesn't apply to everything. For the entire depreciation, depreciable asset or depreciable basis. It applies to anything that has less than a 20 year life. So when we, I like to break it down like this. So you have your structural components of an investment property which is typically over 27 and a half years or 39 years, that always is just straight line depreciation. We break out site improvements like things like sidewalk fencing, landscaping, parking lot, and that goes into 15 year life. 15 year life, less than 20 years is eligible for bonus depreciation. We also get internal like non structural components, maybe kitchen cabinets Laminate flooring, maybe certain types of lighting or carpet. And we categorize that into five year life, also less than 20 years. So it's eligible for bonus depreciation. Short term rentals, furniture, furniture goes into seven year life. So we take everything that's less than 20 years, five, seven, 15 year life, and we can apply bonus depreciation towards that. So that means instead of the stuff that we recategorized into five years, instead of straight line depreciating it over five years or using makers to depreciate it, we are able to take whatever the bonus rules are for that current year and we're able to apply that percentage and get that percent in year one. So from 2018, end of 2017, really all the way through it was 2022, we had 100% bonus depreciation. That means that anything that was recategorized into a shorter lifespan, we could take that and just write it completely off in year one. 2023, it went down to 80%. So you know, again, if you have something in five year life, let's just say $100,000 that was moved into five year life, you could take $80,000, expense it in year one, and then the remaining 20,000 would still be depreciated over five years. So that's what it is, it's going down. Bonus depreciation is going down by 20% each year. So for 2025, currently, right, it is 40% bonus depreciation. However, there's a decent chance that an act will pass and 100 bonus depreciation will, will come back around.

[Tony J. Robinson]

Hopefully. We're, we're all hoping for that at least as much. Right. But I guess let me ask one follow up question, Sean, because you talked about bonus appreciation going from 100% to 80% to 60% now sitting at 40%. But let's say that I bought a property, put it into service in, you know, 2021 bonus depreciation. So 100%, I met the requirement for material participation. If I put that on my taxes, now I'm filing in 2025 for tax year 2024. Do I get the 100% bonus depreciation of 2020 when it was put into service and when I met material participation requirements, or do I get the 60% that was available in 2024? How does it, how does it decide which benefit you get?

[Sean]

That's a great question. It's based on the placed in service date. So if it was placed in service in 2020, well then you'll get 100% bonus depreciation even if you're doing a Form 3115 where you're going back and you're doing the catch up because you didn't do a cost segregation study before. Other cool thing is that maybe in 2020 you weren't a real estate professional, right? So you couldn't have used it against your active income. But you are a real estate professional now. We're in 2024. You are. Well, not only do you get to go back and get that 100% bonus depreciation, get the difference between whatever you took via straight line and what you could have taken with a cost seg study, but you can also use the real estate professional status in 2024 to offset active income. So people will get strategic with this. You'll even see people who, they don't do a cost seg study and then they wait until they have a large, like they have a big capital gain, right? And then they use all of the depreciation, accelerated depreciation through a 3115, a catch up study, right, from prior years and they get the study done in the current year and they use that, all that catch up depreciation to offset the capital gains from maybe a sale of a different property. Does that make sense?

[Ashley Kerr]

Sean, my question is, okay, I'm ready. I want to do this. I'm interested in it. I think my property would apply to this. What do I need to bring you? When you're having a cost seg study, what do you need from the investor to actually do it?

[Sean]

It's not that like we put together estimates, right? Estimates are free of charge. It's just, hey, this is really a quote to say we're going to tell you what we think approximately what you'll get in the depreciation every single year from a cost segregation study. And this is how much it would cost you. Now in order to get that estimate, we need an address, we need pictures, we need the date you started renting or an in service date. We need, we can estimate a land value, right? If you don't have it or if there's public publicly available property tax assessment info, we could use that to get a prorated percent for land. And you know, if you, if you could send us over like the Zillow link or the rental link, like that helps a ton. So all of like that information that basically. Oh, and if you have any capital expenditures, you know, let us know about those. But if we get that basic, basic information, we can put together A pretty good act, you know, accurate estimate on what the benefits would be, how much it would cost and from there we would, you know, engage with you. After that we need a little bit more information. We need the closing statement. If you took depreciation in prior years, right, like you were doing straight line, we'd want to take a look at the depreciation schedule. We want to send somebody on site to actually get photographs. We do have an option for like, you know, for small residential where we don't send somebody on site that's like a little bit less expensive. But there's just different things that we would need to do really overall, not that complicated. Most of the stuff that, you know, you would have from just being a rental property investor.

[Ashley Kerr]

Anyways, we're going to take one more quick break and then we're going to be back with Sean for more. While we take a quick break, make sure you head over to the real estate rookie YouTube. We are releasing a new Ricky resource video on an unit information sheet. This has been our most asked for request of any checklist or template. So you need to have one of these for your rentals. So go to Real estate rookie on YouTube to be able to get that download. We will be right back after this.

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[Ashley Kerr]

Okay, welcome back from our break. We are here with Sean who has been teaching us everything we need to know about doing a cost cost Segregation study. So Sean, do you have any examples for us of maybe case studies or how someone has benefited from having a cost segum?

[Sean]

Sure, I, I could name several examples. But just start with one that comes to mind recently. And this was somebody who he. His household like, like him and his wife. The he and his wife were high W2 income earners. They ended up inheriting some money and the way they used that money I thought was pretty good. So they went and they bought two short term rental properties, put a down payment on it, leveraged it, got a loan, did some rehab and created two Airbnbs or short term rentals. We did a cost segregation studies on those, right. And I think they spent about a million dollars in real estate acquisitions overall between these two properties. And we created, using a cost segregation study about $300,000 of year one depreciation. So at a high 30 plus income, you know, percent tax rate bracket that was over 300 or over $100,000 in tax impact that it saves them if they don't need it, if they don't use all $300,000 in depreciation this year, it'll just roll forward into the next year and help them offset the income for next year. So that was just a really good example. I brought up the house hacking thing earlier too because I've house hacked multiple times. I know this is a lot of the listeners, they probably house hack themselves or have. But an example would be a house hacked a three flat three unit and this was in Chicago and I rented out a. I rented out two units. I lived in one unit. Well, the two units that I rented out, right. We're able to do a cost study and start Excel, start accelerating the depreciation on those two units. After I stayed in the property for a year, two years and moved out, we're able to then place the third unit into service and start rent and start accelerating the depreciation on that. So again, even without the real estate professional status still helps offset all the profits that you get from your rental property and going forward. And if you are able to get the real estate professional status, well then it can also help if help you offset your W2 income or if you're not right, you don't have any active income because your real estate professional status, but maybe your spouse does, we can help offset that income and going forward.

[Ashley Kerr]

Tony, you mentioned you did a cost seg on all of your properties at one point in time. How was your experience with this? Was it something you found was an easy process? Was it really expensive. Did it end up being a success and you saved money in your taxes?

[Tony J. Robinson]

It was like almost stupidly easy for me as like the person getting the segregation study done, the cost done, because we. We sent, like Sean mentioned, all the details about the property over to the cost company that we used. They did everything virtually with, you know, properties that we did renovations on. We gave them scope of work, you know, updated photos, things like that. They did it all virtually and within, you know, a couple of weeks had all of our cost segregation studies back to us. And my CPA was coordinating with the cost that company. So I was just kind of like on CC for all of this. And then my CPA was like, okay, cool. This year we're going to use this one, this one and this one. We'll save some of some of these other ones for next year. And we did that, I want to say, in 2023. And we haven't had a federal tax bill since. So, you know, I'm not a cpa. I don't know all the math that's gone into that or how it's worked, but we literally have not had a federal tax bill since we did all of our cost segregation studies. So when you do it, and obviously our portfolio is a little bit bigger, we have more expensive property. So, you know, I think that helped us a ton. But to Sean's point, when you do this the right way, there's a massive amount of tax benefit you can generate to offset that active income.

[Ashley Kerr]

Yeah. One follow up which I guess can be geared towards both of you is I remember years and years ago when we went to go get our construction loan on our property and there was the farm equipment depreciation, and when we went to the bank to get our construction loan, they added the depreciation back into our income so that it actually made what was on the tax return. Our income was actually higher. They added the depreciation back in because it's not a realized loss. Does that happen too when you do the cost seg. So, like, Tony, if you didn't have to pay taxes and you know, you showed not enough income when you've gone to get loans on properties, has that actually affected your ability to get approved for financing at all?

[Tony J. Robinson]

At least the lenders that I work with, they're like, well aware of cost segregation studies and they've been able to add that depreciation back in, so it hasn't negatively impacted us and our ability to purchase future properties.

[Sean]

Right. Commercial lenders in general, they know, they understand depreciation and so it's not. They don't count it as an actual expense. And so they add it back to your, to your income. So it's not uncommon to have zero taxable income but still be able to qualify for an investment property loan.

[Ashley Kerr]

The best of both worlds.

[Sean]

Exactly. The best of both the world. So you got it.

[Ashley Kerr]

Okay, Sean, I guess real quick, before we wrap up here, when someone is looking to hire someone to do a cost seg, what are some questions they should be asking or, you know, how should you be able to determine who's going to do a good cost seg study and what's a good resource for that?

[Sean]

Yeah, so I think obviously this is, this is what I do. My company is Maven Cost. Maven Cost Segregation. So it's maven cost. Seg.com is my website. Uh, but I would just ask, you know, ask for an estimate. Ask what kind of study they're doing. Is it detailed engineering? What, what does it look like? Get an estimate. There's a lot of people who, I think they, they're just looking for the highest number. I wouldn't recommend just looking for the highest number. Right. Because anybody can push anything and just say, hey, we're going to get you the most amount of depreciation, but really build the relationship with somebody who you know like and trust because you want to get a cost segregation study done right and done by qualified engineers. So that's what we try to do. We focus on, one is quality, give quality reports, and two is communication. In the way I approach it, you know, I'm on both sides of the coin. My background's as a tax cpa. That's where I started. But then I became a full time real estate investor myself. And so I get it from both sides. I know what the IRS is looking for and I know what people are looking for from an investment standpoint. And so I bridge those two worlds with this cost segregation firm and that's what I do. But anyways, I'm happy to talk to anybody if they have questions. You know, I'll shoot over my calendar link. If you reach out to me, My email is seanavencosseg.com that's Sean spelled the correct way. S E a N. And yeah, simple as that.

[Ashley Kerr]

Tony, is that how you spell your son's name, too?

[Tony J. Robinson]

My son's name is Sean. We also spell it S E A N. So I thought that woman jumped.

[Sean]

Oh, wow. That was dangerous. That was a dangerous joke. Okay, the correct way. There we go. Tony didn't even know.

[Ashley Kerr]

Well, John, thank you so much for joining us on the real estate rookie podcast. We really appreciate you taking the time to break down what a cost segregation study is, and we learned some new things today, so thank you very much.

[Sean]

Thank you for having me.

[Ashley Kerr]

I'm Ashley, and he's Tony. And we'll see you guys on the next episode of Real Estate Rookie.