Why doctors, dentists and lawyers should consider utilizing cost segregation with their real estate investments to save money on their income taxes.
I do a lot of work with doctors, dentists and lawyers when it comes to cost segregation. For nearly all of them, it’s a passive income investment. There are times though when they own the building(s) that they run their operating business out of – i.e. self rental. At that point they often can take advantage of “grouping.” In that case, cost segregation is a grand slam as they can use the depreciation from their real estate to offset their operating business income. It’s massive. Sometimes I run into situations where the doctor, dentist or lawyer or some other high income W-2 earner own a short-term rental like an Airbnb or VRBO and their spouse is running the operation. At that point they might also be able to utilize the depreciation generated from cost segregation to offset their high W-2 income. (BTW, as with all of these things…this is not tax advice. Please consult your own tax advisor regarding these strategies). I will publish information in a future blog post about high W-2 earners owning and operating short-term rentals.
But let’s get back to owning real estate as a passive income investment for these highly compensated professionals. If they own residential real estate investments (rental homes, duplexes, triplexes, quads, apartments etc) or if they own commercial real estate of any kind and IF they earn a profit at the end of the year, they will owe federal income taxes at their marginal rate. More often than not that rate is 32, 35, or 37%.
Let’s say they own a few buildings and when all is said and done, at the end of the year, they have a net profit of $10,000. They expect their investment to grow in future years if not through the purchase of additional units or buildings, then through rent growth. The $10,000 in net profit is after all expenses, debt service and normal straight line depreciation. If they pay taxes at a 35% rate, they would owe the IRS $3,500 for the year. Next year it would likely be more as their net profit grows. A cost segregation study would eliminate this $3,500 tax obligation for the year and would likely wipe out future income tax liabilities on their real estate investments for years to come. How could this be you ask? The magic of increased accumulated depreciation expense / i.e. bonus depreciation or accelerated depreciation creating a large loss carryforward.
Let’s say in the scenario above, one of the properties you own is a $500,000 duplex and the land is worth $100,000 which is not depreciable. So $400,000 is your cost / basis that can be depreciated. A cost segregation study will identify and separate the 5, 15 and 27.5 year property. Often this might be between 20-25% of the building cost or basis. Given that information, you will likely see an $80,000 – $100,000 depreciation expense. If you purchased the building and put it into service between Sept. 27, 2017 and Dec. 31, 2022, it qualifies for 100% bonus depreciation meaning you can take all of that $80-$100k in depreciation in one year. (At this point bonus depreciation starts to phase out – for buildings put into servince in 2023, they will qualify for 80% bonus depreciation…in 2024 it goes to 60% etc). So let’s say it’s $80,000 in depreciation. You had a $10,000 net profit and were going to owe $3,500 to the IRS that year and likely every year going forward. By doing the study, you would not have any taxes owed this year. You’d have a $70,000 loss carry forward which you would utilize in future years. In this scenario, you may have eliminated your tax liability for the next 6-7 years. A cost segregation study for a building like this might cost $3,500 or so. You might also have to file an IRS Change of Accounting Form 3115. (If you’ve owned the property for at least one tax year, you will have to file this form). The 3115 let’s the IRS know you’re going from straight line to accelerated depreciation. We draft those typically for about $750 and your tax advisor would sign off on it.
Let’s review…you have $4,250 into the study and 3115 draft. (You’ll probably have some additional fees from your tax advisor as they have to fill out the 3115 information document so we can draft that form). So maybe your tax advisor is going to charge you another $500. So you’re all in at about $4,750 +/-. That’s a business write off for you so it’s really costing you a net of $3,087.50 roughly. That’s less than what you were originally going to have to pay the IRS when we started. The $80,000 in depreciation expense that you’ll get, ends up saving you about $28,000 in federal income taxes ($80,000 x. .35). That’s a 9 to 1 return or 900% return on your investment. You likely wiped out your tax liability for years to come and you can use that money to reinvest, put in the bank, take a trip etc. It’s your money. You can do with it what you want.
If you’d like to learn more or get a quote for your building, please just reach out and I’d be happy to discuss. We alway recommend you also talk with your tax advisor. Once you get a quote from us, please have your tax professional review it to make sure they are on board and that you can in fact utilize the depreciation expense we generate with cost segregation.
