621: Cost Segregation Real Estate Tax Strategies

SHOW NOTES FOR EPISODE 621: COST SEGREGATION REAL ESTATE STRATEGIES

The good news is that real estate is selling at record profits.  The bad news is you have to pay taxes on those profits.  In today’s podcast, real estate investor and cost segregation expert Erik Oliver shares how unique tax reduction strategies are saving investors tens of thousands of dollars on single family homes through large multifamily properties.

What You Will Learn

• The definition of cost segregation
• How cost segregation can be applied to single family homes through commercial buildings
• What “bonus depreciation” is and how you can depreciate 100% of an asset
• How to calculate if cost segregation will work for you
• Two key reasons why cost segregation can significantly reduce your taxes
• Why all new construction projects should use cost segregation

About Our Guest

Erik Oliver

Erik Oliver holds a Bachelor of Applied Science in Accounting from Westminster College.  Prior to joining Cost Segregation Authority, Erik was an Operations Manager for a multi-million dollar landscaping and design firm in Long Island, NY.  Since heading west and joining Cost Segregation Authority, Erik has been speaking at local, regional, and national events.  He brings with him a passion for identifying cost savings and educating commercial real estate owners on the benefits of cost segregation.

More About Erik

• Erik is from Salt Lake City
• His background is in accounting
• He got his college degree in accounting
• Got a job in business development
• Lived in Virginia and Long Island, NY
• Returned to Salt Lake and got a job with Cost Segregation Authority where he could use his accounting knowledge
• He saw cost segregation as very underutilized in the marketplace
• Part of his job is to travel around the country to teach both CPAs and investors on the benefits of cost segregation
• He loves his job

Definition of Cost Segregation

• Cost segregation tries to accelerate your depreciation on your real estate assets
• When you buy, for example, a fourplex multifamily property, you normally get to depreciate that over 27.5 years
  • If you paid $275,000 for the property, you would get (roughly) a $10,000 write off every year for the next 27.5 years against your income
  • If your income is $100,000, instead of being taxed on the $100,000, you are only taxed on $90,000 because you have this $10,000 paper loss (which is depreciation)
• The goal of cost segregation is to accelerate that depreciation
• With cost segregation, instead of taking 1/27th every year, for the next 27 years, you can front-load the depreciation in the early years to get a bigger portion of that depreciation and less in  future years because you may not own that asset for 27 years
• The reasons why an investor might opt for a cost segregation approach include:
  • The time value of money
  • Inflation hedge
• How it works
  • An engineering based study is conducted
  • For example, you buy a fourplex
    • You’re not just buying the walls and the land, you’re buying…
      • The driveway
      • Countertops
      • Cabinets
      • Appliances
      • All of these items can be segregated out from your purchase price and be put into shorter-term assets or different “buckets”
  • The IRS says carpets should be depreciated over 5 years, not 27.5 years
    • The problem is, when you buy that $275,000 fourplex, you don’t know how much of the carpets can be attributed to the $275,000 purchase price
    • What his company does is to go to that property and “segregate out the costs” of those items to those different buckets, which then, allows them to accelerate those deductions
  • Normally, when you buy a building, for example, at $275,000, your CPA will just take the entire building price and put it on a 27.5 year depreciation schedule
    • When you’ve done a cost segregation study, instead of just having one asset on there that says “building,” you will have additional line items like:
      • carpet
      • appliances
      • concrete for driveway and sidewalk
    • Buy breaking those items out, you have a new depreciation schedule that has all these line items broken out, with the attributable cost, based on what you paid for it
    • A cost segregation company will take that $275,000 purchase price and and put it into the individual buckets.
      • They will provide a detailed report on:
        • How much you paid for the carpet
        • How much you paid for the cabinets and countertops
        • All the different components
      • They use a costing/modeling software that ascribes costs to those various segregated items
      • You may see, for example, that out of the $275,000 for the building purchase price…
        • $20,000 was for cabinets
        • $5,000 was for the countertops
        • $10,000 was for the flooring
    • They only segregate things out that have different IRS-designated depreciation schedules
      • For example, the IRS states that everything in a bathroom has a 27.5 year depreciation
        • Therefore, toilets, bathtubs, vanities, etc. all have that depreciation rate

New Construction

• It makes a lot of sense to do cost segregation early on with all new construction properties
• If you get an invoice once it’s completed and the invoice is not very detailed out
  • For example, an invoice says you paid $100,000 for finished carpentry, and it could be door casings or crown molding
    • Both are treated differently from an IRS tax perspective
      • Door casings should be depreciated over 27.5 years
      • Crown molding can be depreciated over a shorter period
• If a good cost segregation company can get the invoices early enough in that remodeling or construction process, they can…
  • Identify what materials are being used
  • Make sure they are broken out on the invoice properly
  • Then, they can maximize the deductions they can create when they do on the cost segregation study

Is Cost Segregation Only for Big Commercial Properties?

• When cost segregation first began, it was geared more for larger commercial buildings (hotels, casinos, etc.) for two reasons:
  • The costs of these studies was $10,000-15,000 each
    • You would have to have significant tax savings to shell out that kind of money for it to make financial sense
  • The results aren’t as good as they are now
    • There was a tax law change that occurred at the end of 2017 called the Tax Cuts and Jobs Act
      • The Act mentioned something called “Bonus Depreciation”
        • It takes cost segregation and “puts it on steroids'”
          • For example, instead of depreciation of carpet over 5 years, you can take the depreciation all in the first year
        • But take note, bonus depreciation starts to phase out in 2023
          • Anything bought between September 27, 2017 and the end of 2022, is eligible for 100% bonus depreciation
          • Anything bought in 2023, drops to 80% bonus depreciation
          • Then it will drop 20% less each year until 2027 when there will be no more bonus depreciation
    • This made cost segregation feasible for a lot more investors because the tax savings was more significant
• As a result, Erik’s company does cost segregation studies for single family rental homes up through apartment buildings and large office complexes
• Erik’s company wants to see their clients achieve at least a 7 to 10X return on your investment
  • So, if his company charges $2,500 for the cost segregation study, for example, they want you to save at least $20,000 savings in taxes on the back-end
  • Any thing above $120,000 purchase price of the building minus the land value, (depending on the part of the country and the land value), can have opportunities for cost segregation

Biggest Mistakes People Make in Trying to Utilize Cost Segregation

• Not getting an estimate
• Most cost segregation companies will give you a free benefit Analysis
  • They look at the property and let you know what your expected tax savings would be
• Most investors don’t know about this or their CPA never told them
• If you own real estate and you’re paying taxes, definitely look into cost segregation because you may be able to save significant tax dollars
• It’s extremely important, as you begin to grow your real estate portfolio, to make sure that you have a good, solid CPA who understands real estate investing – not just a tax preparer
  • Someone who will sit with you quarterly to talk tax strategies
  • Someone who will help you so you can have more money to put back into real estate
  • Having a tax advisor in your corner who can work with your cost segregation people and is advising you in a manner that helps you grow your wealth

Investor Success Story with Cost Segregation

• There was a gentleman who worked with Erik from Louisiana
• He had bought two large single family homes right next to each other
• He wanted to turn them into Residential Assisted Living
• When he bought the homes, both had tenants
  • One had 3 months left on their lease
  • The other had 6 months left on their lease
• His plan was to let their leases expire, renovate the homes for assisted living and convert them to RAL facilities
• But, because they both had tenants in place, technically they were considered “in service” or “in use” the moment he signed the escrow papers
• Erik and team did a cost segregation study on his original purchase and put values on everything (countertops, cabinets, flooring, appliances, etc.)
• Once the tenants’ leases expired, he was able to go in and do extensive renovations – adding more bedrooms and bathrooms
• Then, Erik and team did a second or supplement CS study to identify all the things that could be accelerated on his rehab
• The new owner was able to accelerate the appreciation on two sets of cabinets, two sets of flooring, etc. for each of the homes
• His savings, as a result, was substantial
  • Because the places were “in service” when he bought it, he was able to accelerate depreciation on the items that were there and the items that replaced the other items
  • The owner was able to take a “partial asset disposition” which means, when he removed the original cabinets, to replace them, he was able to write-off the remaining book value as an expense and he never had to recapture that depreciation
  • In essence, he was able to do a “two for one” depreciation

Advice for Old Dawgs Looking at Real Estate Investing to Help Them in Their Retirement Years

• If you are an investor, you can get a good portion of your investment properties down payments back within the first year
• For example, if you bought a million dollar asset by putting 20% down, you’re coming out-of-pocket $200,000
  • If they do a cost segregation study on the full million, they generally segregate around 30%
  • This means you are going to have a $300,000 write-off in the first year, which will help offset the $200,000 down payment
  • If you take the $300,000 times your tax bracket (let’s say at 30%), that could be a $90,000 deduction tax savings
  • Out of your $200,000 down payment, you could be getting $90,000 back in tax savings just by doing a cost segregation study
  • Being able to leverage debt is huge, especially in the current provisions around depreciation

Current Business

• When Erik started his job, working with real estate investors and cost segregation tax strategies, he didn’t own any real estate
• But working day-to-day with real estate investors has helped him see the tremendous tax advantages of real estate
• We all have to pay taxes and the tax code is written to incentivize people to do certain things and to drive initiatives
• As a result, he has started investing in real estate and is now growing his own portfolio and build long-term wealth

Using Depreciation Recapture BEFORE You Sell

• When you sell an asset, you have to pay two types of tax:
  • Capital gains tax
  • Recapture tax on the depreciation you have taken
• He has been talking about taking as much of the depreciation as you can now
  • But people ask him, “Won’t I just have to just pay that all back when I sell the asset?”
  • His answer is, “No.  Not really.”
    • What happens is that you take the deduction against your ordinary income of, say 37%
    • And when you sell that asset, you’re paying it back at 25% max (often at even less than that – depending if you have capital gains at 15-20%)
    • So, you save the spread
    • Take your deduction at a high rate and pay back a portion of it at a lower rate, at a future date, and save the spread
• If you don’t do cost segregation and you buy a $500,000 asset and 5 years later, you sell it at a million dollars
  • When you settle up with the IRS, you tell them everything doubled in value
    • Your walls, dirty carpets, etc. have doubled in value
  • But, with cost segregation, you will not pay as much tax as you would have, if you had not done it
    • You’re not selling your carpet for more than you paid for it

Rap-It-Up

• Favorite real estate book: Tax-Free Wealth by Tom Wheelwright
• Favorite business book: Good to Great by Jim Collins
• Most valuable web site for success (other than your own): IRS.gov
• Favorite app: RepTracker.com
• Favorite quote: “It’s not what you make but what you keep.”
• If you lost everything – all your assets – and had to start all over, knowing what you already know, and you only had $1,000, what would you do to re-launch your real estate investing business? You can make $200,000 a year doing “Internet Arbitrage.” You can go to your local department store and buy stuff on sale and sell it online for significantly higher than you pay for it. I know a guy who goes to a lot of garage sales and he has an app that tells you what things are selling for on eBay. He would take the $1,000 and go garage saleing!”

I Will Ask You How People Can Reach you

• Web site: CostSegAuthority.com

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