Cost Segregation Explained: The Real Estate Tax Strategy Most Investors Miss

Cody Crabb (00:00)
Okay.

Jason C Melillo (00:00)
And that’s where

real estate investing becomes powerful for somebody who’s just starting out. Because if they’re looking for a way to offset their W-2 income, it’s hard to do that, you know, if you have passive losses, because you’re not allowed to offset the two. So by doing this Airbnb strategy and getting the deductions from Cost Segregation, right, by accelerating depreciation, basically front loading that depreciation,

If you create a $50,000 loss from that Airbnb activity, now you can offset that against your regular wages. And if you think about, okay, a 25 % tax rate, that’s $12,500 in savings.

Cody Crabb (00:39)
Hmm.

Hello and welcome back to the Real Estate Pros podcast by Investor Fuel. I’m your host, Cody Crabb. Today I’m talking to Jason Melillo. He’s the CEO of KBKG, a firm that helps businesses and real estate investors save money on taxes. So today we’re going to talk about Cost Segregation, tax strategy, and how investors can use tax savings to improve their cashflow. Jason, thanks so much for joining us today. I appreciate it.

Jason C Melillo (02:41)
That’s my pleasure, good afternoon.

Cody Crabb (02:43)
So for someone that’s kind of coming into this and they maybe aren’t a hundred percent sure what I just said Can you kind of me in plain English? what is it? What is it that someone would come to you for and into your company for?

Jason C Melillo (02:58)
We can help companies in a variety of different ways. think since this is a real estate focused podcast, we’ll stick to those real estate strategies that we can help people with the most. And the backbone of what we can provide people in real estate is something called a Cost Segregation study. And let me kind of break that down and explain what it is. When we own real estate that we have rental income associated with, we’re allowed to take certain deductions against that rental income.

Cody Crabb (03:06)
Probably, yeah, probably wise, yeah.

Jason C Melillo (03:26)
income, maybe mortgage interest, property taxes, insurance. But we’re also allowed to take depreciation. And for people who are new to this, depreciation is just a systematic charge of your original purchase price against your expense. It’s a non-cash deduction that the government allows you to take. And the significance of that is

Cody Crabb (03:30)
Mm-hmm.

Jason C Melillo (03:49)
larger that I can make that deduction sooner, the better off I am. So if I have taxable income and I’m getting to depreciate against that taxable income, more depreciation sooner is a benefit to me because I can reduce my tax today and not worry about it until 20 years from now or 25 years from now or 15 years from now. So that’s what

does. It effectively front loads the deduction of depreciation.

for real estate investors.

Cody Crabb (04:22)
Gotcha. Yeah. think, and I think something you mentioned there was you can help people kind of in any of any level to kind of get this under control. So, you know, for example, obviously everybody can imagine a scenario where you have a massive portfolio and therefore need to have, you know, lots of help with the tax part of it, but how could someone kind of on the low end also benefit just as much? mean, I mentioned the W2 angle before, just as an example.

Jason C Melillo (05:35)
Sure, so ⁓ the way that a Cost Segregation study is done, there’s a couple of different approaches, but typically there’s something called an engineered study where we actually have an engineer go out and look at the property and think of it more like what an appraiser does for a commercial appraisal or something like that. ⁓ We actually have a software tool that we built for the…

lower cost properties because it used to be that segment of the marketplace was ignored because it was too costly for a property that was under a million dollar purchase price. So we built our software costsegregation.com to allow somebody who purchases a property to be able to utilize Cost Segregation in their in

rental portfolio or any single family residence that they’re renting out cost effectively. Now, let’s talk about how the strategy works. ⁓ If I have a rental property with a long-term renter on it and I have taxable income associated with that, it’s in my best interest to reduce that taxable income and Cost Segregation by front-loading depreciation allows me to do that. ⁓

Cody Crabb (06:46)
Hmm.

Jason C Melillo (06:47)
And that’s a passive activity. That’s a tax word that we’ll use. I think it’s important to know that when we have income, we have potential for passive income, which is things like real estate where I just, I don’t, not really involved in it. I just have it out there. And active income where it’s my W-2 income.

and I have a business that I’m actively involved in and I’m managing and I’m spending all my time in it, that’s active. The government says that we can’t offset passive losses against active income.

So that’s an important consideration. We want to make sure that we’re matching out these different types of income. So if we have passive income, we can have passive losses. That’s what Cost Segregation allows someone to do, to take that real estate income and create real estate deductions that can create a loss. So if I have two properties, one of them is making money and the other one is losing money.

I can offset those two and net them for tax purposes. And this is where Cost Segregation comes into play and how it’s powerful. Now, there’s a certain way that you can take some types of rental properties, short-term rentals. So think about your Airbnb and your VRBO where the average length of stay is seven days or less. That becomes an active trader business. So now it’s treated just like W-2 income.

Cody Crabb (07:57)
Hmm.

Jason C Melillo (08:23)
have a W-2 income, husband and wife, and they go out and they buy a property that they turn into a Airbnb type rental and that creates losses. They can now deduct those losses against their ordinary W-2 income.

Cody Crabb (08:43)
I

Okay.

Jason C Melillo (08:43)
And that’s where

real estate investing becomes powerful for somebody who’s just starting out. Because if they’re looking for a way to offset their W-2 income, it’s hard to do that, you know, if you have passive losses, because you’re not allowed to offset the two. So by doing this Airbnb strategy and getting the deductions from Cost Segregation, right, by accelerating depreciation, basically front loading that depreciation,

If you create a $50,000 loss from that Airbnb activity, now you can offset that against your regular wages. And if you think about, okay, a 25 % tax rate, that’s $12,500 in savings.

Cody Crabb (09:23)
Hmm.

Jason C Melillo (09:30)
And I picked that number arbitrarily just as a low percentage to help illustrate that it can be real meaningful.

Cody Crabb (09:37)
Yeah, think, can you give me kind of a, let me give it like, it would be helpful to, let me say this all again, cause that was just gibberish. So give me an example, like what is like a good green light for someone? Like what level does someone have to be at to actually start to get some benefit out of this? Is this something that like lowest level investors can take advantage of? I’m talking about Cost Segregation specifically.

⁓ Is that something that the lowest level investors can benefit from or is that something more that you have to only take advantage of at a higher level?

Jason C Melillo (10:42)
It covers the gamut. we can start with a single family rental that maybe is a $200,000 purchase price all the way up to billion dollar properties. So it covers everything in between. So where you might not opt to do it is if somebody has little to no taxable income, then there’s no point in doing it today. But maybe next year.

you look at it again and their tax situation may be different. And the beauty of the Cost Segregation strategy is it can be done at any time. It doesn’t require amending a tax return. So I can choose to do it this year or I can defer and do it next year or the following year.

Cody Crabb (11:21)
⁓ see, yeah, that’s good. Yeah.

Jason C Melillo (11:30)
And there’s an additional form that would be required to be filed, but this kind of stuff is done all the time. And it’s a really flexible and valuable tool because it kind of enables you to pick and choose when to do it. And maybe you have multiple properties and you choose to do one of those properties this year.

Cody Crabb (11:51)
Mmm.

Jason C Melillo (11:52)
the next year you do a different property. And so from a tax planning strategy, working with your tax preparer, your tax advisor, ⁓ you can pick and choose when is the best time for you to employ this strategy.

Cody Crabb (12:07)
Yeah, think that’s a great way to explain it. as far as I’m aware, there’s also some kind of retroactive ⁓ kind of properties here too. Can you kind of go into that a little bit? Like how far back does that work?

Jason C Melillo (12:20)
Yeah, absolutely.

Well, as long as you’ve owned the property. So just when I said you can pick and choose when to do it, even if you had a property that you’ve owned for 10 years, let’s say, you can actually do a Cost Segregation study today and apply the catch up depreciation that you could have taken over the last 10 years, but didn’t in the current year. So a lot of times when somebody has taxable event, let’s say I own two properties.

Cody Crabb (12:44)
you

Jason C Melillo (12:53)
I’ve held them both for the same amount of time. I’m going to sell one of those properties and recognize a gain. I’m not going to do a tax-free exchange. I have other plans for that money. So I’m going to recognize a gain. I can do the Cost Segregation study on my other property and I can utilize that loss to offset against the gain from the second property, provided that they’re both similar properties, they’re rental properties.

If one was my home and the other was a rental, I wouldn’t be able to do that. But if they’re both rental properties, I would be able to do that.

Cody Crabb (13:24)
So apart from Cost Segregation, what are some other things that you would tell real estate investors that they should absolutely be taking advantage of? If they’re not, then they really should be.

Jason C Melillo (13:34)
Well, so the tax code is really well positioned for people who own and invest in real estate. I think the real estate lobby is very strong. So taxpayers who invest in real estate can actually go their whole life without having to pay tax if they plan properly.

One of the strategies that exist is the 1031 exchange and that is the like kind exchange. So if we want to sell one piece of real estate property and invest in another real estate property, we’re allowed to do that if we follow special rules. When we sell the property, we use somebody called an accommodator and they hold the proceeds from the sale, the property we’re selling. And as long as we identify the property within a certain period

time and closing the replacement property in a certain period of time, we can defer that gain into the new property and not have to pay any tax. ⁓ So there’s an expression in real estate swap till you drop. A lot of real estate investors will continue swapping their properties. This property has run its course. I want to trade into a bigger property or a different type of property. I can do that and then I hold that property for another 10 years and then

Cody Crabb (14:35)
Hmm.

Jason C Melillo (14:55)
and

I do a deferred exchange, like kind exchange into another property and hold it for 10 years. Meanwhile, I’m doing Cost Segregation on my increased basis each time. So I’m able to deduct that depreciation against the income that I’m generating. So in theory, I could go all that time without having to pay taxable income. And then when someone dies,

⁓ The government allows their heirs to get something called a step-up in basis and what that means is when we buy a property For a hundred thousand dollars. That’s our basis

And when we depreciate that down, it reduces our basis. And so our base could be zero at some point. Theoretically, land we can’t depreciate. So we have to allocate a certain portion of our purchase price to land. that portion that we have that is building related, when someone dies and they’ve held the property forever and that building value is zero, and let’s say it went from 100,000 when they bought it 30 years ago, it’s now worth $2 million.

Their heirs have a zero basis the day before the person passes away. And the day they pass away, the day after, it now steps up to the fair market value, which is $2 million. And the heirs get to depreciate that $2 million.

and they could do a Cost Segregation study on that $2 million and reduce income significantly on a prospective basis. So that’s where I’m saying that that property owner may not have paid taxes along the way. They may not have paid taxes when they exchanged the property. And when they died, they never had to pay tax on the fact that that building was now worth $2 million.

Cody Crabb (16:58)
Hmm.

Jason C Melillo (17:23)
and they changed it out three or four times and now their heirs are going to get a $2 million asset that they can depreciate and take deductions against the income. ⁓ So real estate is a very, powerful investment and

Cody Crabb (17:33)
Hmm.

Jason C Melillo (17:38)
You know, I’ve had a former colleague that used to say, it’s not what you make, it’s what you keep. So Cost Segregation allows for you to keep more of your money without having to pay it over to the government.

Cody Crabb (17:45)
There you go, yeah.

Yeah, I think anyone that had had a job as a teenager and got their first paycheck and they kind of had done the math in their head and then they looked at that number would probably agree with that because that’s that is a shocking moment that pretty much everyone has. Well, this has been really helpful. So I’d love to know kind of what are some things that you see that people make mistakes on that you kind of have to start on the early side. The reason I ask this is because I know that, like you said, the you know,

you can go back and claim for things for years, like for years, as long as you’ve owned the building and things like that. But I’d love to know kind of, are there strategies that don’t work that way that you kind of need to set up in advance in order to take advantage of them?

Jason C Melillo (18:35)
Well, for real estate in particular, the couple of things that you want to make sure that you’re doing properly, there’s ways to fix almost everything. But I think about the land building allocation. So when we think about an investment property that we buy, we have to divide that into two components to start with. The building.

and the land. The land we don’t get to depreciate. So the building we depreciate, it’s in our best interest, it’s in the taxpayer’s best interest to maximize the amount that they have in building as opposed to land. And if someone uses the wrong land value, something that’s too high, then they’re going to miss out on depreciation deductions that they could have against the taxable income.

So that’s something that we would just want to make sure that if, and the more significant the purchase price, the more it matters, right? But if you have a good land value, so a lot of times people will get an appraisal on the land, or when they get an appraisal for their, if they’re getting a bank loan, they get an appraisal for the bank loan, you can ask the appraiser, hey, just be sure and give me a separate value for the land.

When you ask up front, there’s very little extra cost, if any. But if you wait until after the fact, now you might have to pay another appraiser to go out and do a land value.

Cody Crabb (20:11)
Yeah. See, yeah. And that’s why I like,

I like digging into those things specifically just because like sometimes it’s just, yeah. You’re like, just, if I had just known that six months ago, then I could have, yeah. So that’s, that’s great. does anything else come to mind in that sort of arena?

Jason C Melillo (20:17)
That’s a potential mistake, yeah.

you know, the, the thing I will say is sometimes if someone is in a passive investment and they can’t utilize losses against.

the income today, if they did a Cost Segregation study, it wouldn’t provide an immediate benefit for them until they have passive income to offset it. So I would just say, be careful about that. you do your own taxes, just make sure that you know that you have taxable income from your real estate activities. If you’re working with a tax professional, just make sure you’re talking to them about it. Do I have passive taxable income?

or depending on the type of investment, if it’s a short-term rental, then I can actually use it against, assuming I meet certain other criteria, I always have to give that caveat out there. But I can offset that against other ordinary income. So sometimes Cost Segregation might not have an immediate benefit if I’m a passive taxpayer and I can’t offset other passive income. So we just want to make sure that we’re looking at that before we actually jump in the water and pay for the service.

Cody Crabb (21:37)
Yeah, this has been great. Yeah, I think this is stuff that everybody needs to know. It’s very in the weeds, but the weeds is sometimes where the money is. So I think…

Jason C Melillo (21:46)
Unfortunately, yeah, we can’t get

out of the weeds with this kind of stuff because it is very weedy.

Cody Crabb (21:52)
Yeah, very much. So yeah, there’s no such thing as doing this in a way that isn’t in the weeds. Well, this is like I said, this has been super helpful. And one last question I’d have is, so if somebody is working with one with a tax professional, what would you say would be a good question to ask them if they if you have it yet? You mentioned a couple already, but I just would be curious if there if another again, another one comes to mind.

Jason C Melillo (22:14)
think if they own property, just ask their tax professional, would I benefit from a Cost Segregation study? And if the tax professional says, I don’t know, or what is that, maybe gets a second opinion, because you’re probably not working with somebody that knows real estate.

Cody Crabb (22:32)
Yeah, maybe you should

find someone who has a little bit more of an inkling about it. Because I mean, I’m no genius and even I have, I’m aware of this. if someone’s doing your taxes and you have enough real estate to even ask about this, certainly, yeah, I think that makes a lot of sense to follow up on that. ⁓

Well, again, thanks so much for this. If someone wants to reach out to you or find out more about what you do, work with your company or something like that, who should they be, first of all, and where can they find you online?

Jason C Melillo (23:03)
First of all, anyone who invests in real estate should probably at least know who we are and evaluate whether or not there’s something we can do to help you. ⁓ And where they can find me, they can find me at either kbkg.com.

Cody Crabb (23:13)
⁓ huh.

Jason C Melillo (23:19)
or costsegregation.com. That’s our software website for performing Cost Segregation services on smaller properties. They can also find me at LinkedIn, Jason Melillo if your listeners do have properties that they need help with and they want to go check out costsegregation.com, we’ll give a discount to your listeners with the promo code IFC2026.

Yeah.

Cody Crabb (23:44)
fantastic. Yeah, that’s I

love a good promo code. So, yeah, it’s much appreciated. We’ll that down in the in the show notes as well. ⁓ Yeah, but thanks again. think anybody that anybody should be a little more aware of their tech situation. There’s always more you can do. So so I always I encourage everybody to do that and check out your website. Jason, thanks one more time for giving us some of your time today and listeners, you as well. If any if any of you.

Jason C Melillo (23:50)
Perfect.

Cody Crabb (24:08)
heard something today that helped you out, go ahead and give us a like, subscribe, follow all the things so you don’t miss more great conversations like this. And we’ll see you for now. Jason, thanks again and we’ll catch you later.

Jason C Melillo (24:19)
Yeah, thanks. This was fun.