Hello and welcome to another episode of Passive Real Estate Investing. I’m your host, Marco Santorelli. Well, today we’re gonna talk about something that I feel is exciting and that is how to pay less tax and make more money using something called cost segregation on your investment properties, on your real estate portfolio. And I know I’ve talked about this a little bit in the past over the years. It’s, believe it or not, it’s been eight years this month since I started this podcast. So it is essentially the eight year anniversary of passive real estate investing. I can’t believe it’s been that long. It feels almost like three or four years to me, but it’s a very successful show. I’m happy to have you as a subscriber and listener. The show is just chock full of great five-star reviews. Oh, actually five-star ratings and great reviews.
I do read all of them, so I appreciate them. And you know, if you have the time, if you have a minute, you know, I, I would greatly appreciate some feedback, like a positive review and even, you know, whether it’s four or five star, I, I’ll take it. But I appreciate everything you guys have provided me and I will continue to do the show and provide you great content and value for as long as I can. But today I just wanna let you know that my guest is gonna talk about an interesting subject, which I think everybody needs to know about everybody. So don’t skip this episode, but what if there is a way to legitimately and legally pay less taxes and make more money, keep more of the money you’re making using something called cost segregation. Now, I, I’m sure that most, if, if not all of you have heard of cost segregation, you might not know what it means or what it is or how it works.
It is not that complicated. But we’re gonna talk about what it is, how it works, the cost of it, how it can help you lower your taxes and make more money, keep more of the money you’re making and some of the ins and outs of it. So that is the topic for today. Stick around. My interview is only about 40, 45 minutes, but it is chock full of great information that I think you will definitely benefit from. So with that, let us go right into our interview with Erik Oliver. And if there are questions about anything that we talk about today, you could reach out to him and his team, or of course our investment counselors here at No Ratta Real Estate Investments. We’re here to help you and we, we’ll always connect you to the right people that we believe will be beneficial in helping you achieve your financial goals. So with that, let us jump right into our interview today.
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Well, it is my honor to introduce and welcome to the show Erik Oliver. He holds a Bachelor of Applied Science and Accounting from Westminster College. Prior to joining Cost Segregation Authority, Erik was the operations manager for a multimillion dollar landscaping company and design firm in Long Island, New York. And I’ve since found out he’s moved back to Salt Lake City. Since heading west and joining Cost Segregation Authority, Erik has been speaking both at the local, regional, and even the national level on the topic of cost segregation, which to a lot of people it might sound like a foreign thing or you know, why am I even interested? But believe me, stick around for this episode. You’ll understand why it’s important to you if you’re planning to invest in real estate or already are investing in real estate. So he brings with him a passion for identifying cost savings and educating real estate owners on the benefits of cost segregation. So with that, Erik, welcome to the show.
Thank you Marco. I’m glad to be here.
Well, it’s good having you on. I haven’t talked about the topic of cost segregation for a while now. I know I’ve touched upon it in years past and that was when, you know, the whole thing with bonus depreciation and the IRS regulations coming out made it a very interesting thing to look at, especially if you’re an a hard asset owner, like a real estate investor because it allowed you to take some really good tax savings faster. So before we jump into all this exciting stuff about saving on taxes, why don’t you take a minute, tell us a little bit more about yourself, cuz my bio is pretty thin about you.
Yeah, no like you said, my name’s Erik Oliver. I’m with a company called Cost Segregation Authority and we work with investors and CPAs across the country or tax preparers across the country helping their clients reduce tax liability by using cost segregation. So we’re kind of a niche accounting firm. My background, my degree is in accounting. I myself am not a cpa but my degree is in accounting. And you know, I was in college trying to figure out how am I gonna get outta college as fast as possible? And I’m like, I don’t like writing papers, I don’t like science, so let’s do math. And so it was either finance or accounting. Ended up with accounting degree, never really used it. Until with this current job I was always in sales prior to this. And when we were living in New York looking to come out west, I came across this company, they were looking to add some folks to their staff and always been interested in investing in real estate.
Like I said, accounting always came somewhat easy or math has always come, numbers have always come somewhat easy to me. And so put the two and two together and ended up here. Have loved it so far. Love working with clients to try and help reduce their tax liability. It’s probably one of the most underutilized deductions that’s out there for real estate investors. A lot of people don’t know about. It’s becoming more and more popular with some of the recent changes, but definitely when I started it was not commonly utilized. And so being able to go out, educate investors, educate CPAs has been great. I really enjoy what I do.
Yeah, no, that’s great Erik. You know, it’s my hope that by the end of this episode people are gonna understand what cost segregation is, how it works, what the benefits are, how can they pursue and implement a cost segregation study in order for them to cut back and save on on the taxes owed or maybe, you know, take some bonus depreciation, which kind of leads to the most basic of questions and where I always like to start. And that is with, you know, a what is question, what is cost segregation and how does it work?
Yeah, no, that’s a great question Marco. So cost segregation really is just accelerated depreciation on your real estate assets. So normally when you purchase a piece of real estate for investment purposes, you either depreciate it over 27 and a half years or 39 years. And so just to make the math easy, let’s use an office suite. Let’s say the suite that I’m in here, if I were to buy this office suite for 390,000, this is a commercial building, therefore it’d be depreciated over 39 years. So essentially I would get a $10,000 write off every year for the next 39 years. I’d take my 390,000, divide it by 39. That gives me a $10,000 write off every year, which is great. That’s why a lot of us get into real estate is for some of the tax breaks that deduction, that $10,000 deduction comes off my taxable income.
So let’s say I make a hundred thousand dollars a year, instead of being taxed on a hundred thousand, I’ve got this $10,000 depreciation expense that I get to reduce my taxable income by which is great, but what if I don’t plan on holding the building for 39 years? Maybe I’m gonna, you know, invest in it for five years and sell it or I want my deductions now versus spreading them out evenly over 39 years. And the way you do that is through an engineering based study where a cost segregation firm will come in and identify all the different components of your building. So if I were to buy this office suite, I’m not just buying the land and the walls, I’m buying the parking lot, I’m buying the window coverings, I’m buying the flooring, I’m buying the television. There’s all these different components that make up that real estate.
And cost segregation is just segregating those components into different asset lives for the reason of being able to depreciate them faster. So again, the IRS says carpet only lasts five years, not 39 years. So carpet should be depreciated over five years, not 39. The problem is that when I buy this building for 390,000, my C P A or my tax preparer, they don’t know the value of the carpet. They don’t know the value of the parking lot, they just know that I bought all of this stuff for 390,000. And so they’ve put it on the books as one lump sum of assets all depreciated over 39 years. And so cost segregation again comes in. I identifies those short-term assets that we can segregate according to the IRS provisions, puts a value to those assets. That way our CPA or our tax preparer can depreciate them over the correct useful life, which then front loads that depreciation.
I, I think that was a great choice of words front loading the depreciation. So it’s still de depreciation whether you take it over 27 and a half years or 39 years. It’s just you’re slicing and dicing the real estate that you just purchased or or already own and categorizing the different parts that make up that real estate or the improvements on the land. Yep. And then putting each of those categories on different depreciation schedules, which could be as short as three to five to seven years versus the 27 and a half or the 39 years. Correct.
Yep. You got it.
Right. Okay. So front loading, I love that term. I never heard it said that way, but you’re essentially accelerating your depreciation and taking it upfront and then applying that towards whatever your tax impact is at the time. And I guess if you don’t use it all up, I assume that you can carry forward some of that depreciation or maybe all of it to gains in future years. Is that true?
Yeah, yeah. You never lose it. So when you accelerate your depreciation, just like you said, let’s say we do a cost sake study and I create a $200,000 deduction. If I only have a hundred thousand of income, I wipe out all of that income, pay no tax on it, then I have a hundred thousand left over that just carries forward into next year and wipes out my first a hundred thousand of income next year. So yeah, you never lose it, which is great. It carries forward indefinitely. Now what you don’t wanna do is, let’s say you make $10,000 a year of income, you don’t wanna pay to have a cost segregation study done cause we’re gonna create a $200,000 deduction. But if you only make 10,000 of income, it’s gonna take you 20 years to utilize this 200,000. In that case, it just makes sense to take your standard deduction, right?
Don’t pay us to accelerate it if on the back end you’re gonna turn around and decelerate it or it’s gonna take you 20 years to utilize those deductions. So it’s kind of a balancing act. It all depends on, you wanna use depreciation and cost segregation to manage your tax brackets. And so it’s really a conversation that not only you need to have with us, but also with your tax preparer to say, okay, what tax bracket am I in this year? What does my income look like this year? What other deductions do I have? What carry, you know, maybe I have stuff carrying forward from last year that I, I need to utilize before I use this cost study. So it’s a matter of using, like I said, depreciation or these deductions to manage your tax bracket in order to maximize your tax savings.
Yeah. You kind of started to answer a question I wanted to ask you at some point that was, when should cost segregation be considered for a property? Or I guess you could say if I have a portfolio of properties, when should I consider that? I mean, I want you to answer that question, but I’m also thinking in my mind, why wouldn’t you want to do a cost segregation study if you’re gonna be able to carry it forward? And I guess part B of that question is if you have multiple properties that you can or mar multiple sources of income, can you not apply the depreciation you get from the cost segregation study towards a all of your aggregate income sources?
That’s a great question. So I’ll give you a real life example. I am a W employee or W2 employee here at Costa Authority. My wife is in the school district. She’s a in the school system. And so she’s a W2 employee. So, and we have some investment properties on the side. If I were to do a Costa study on my investment properties, I could not use those deductions to offset my W2 income cuz you’ve got what we call passive income versus active income. So my W2 income is my active income, my real estate is considered passive income cause I just do it on the side. So those cost segregation deductions from my real estate, they can only be used to offset passive income. So when my properties start making money or their cash flowing, or maybe I sell an asset and I have a a big capital gain, that’s when I’m gonna want to utilize my cost segregation studies.
But let’s say I’m just making a little bit of cashflow every year. I’m making $10,000, you know, over the course of a year on my two real estate properties, it doesn’t make sense to create a hundred or $200,000 deduction if I can’t use that to offset my W2 income. So there’s a couple ways around that. Marco. One is becoming a real estate professional for tax purposes. So unfortunately me and my wife are both W2 employees, but let’s say my wife goes part-time or she quits her job at the school district if she be starts to manage my properties or manage our properties, if she manages those and meets two tests, one is you’ve got to spend 750 hours a year doing real estate, which is about 14 and a half hours a week and you’ve gotta spend 51% of your working time doing real estate.
So if she was still working at the school 20 hours a week, she would have to do 21 hours a week doing real estate. If she could meet that, then we could file a joint tax return, call her a real estate professional for tax purposes. Which basically means you’re telling the IRS that either you or your spouse does real estate for a living. That changes the rules. Now our, all of our income, excuse me, all of our deductions, whether they’re from real estate or anything else, become active and they can be used to offset my active income. So you’ll see that a lot Marco with like high W2 earners where maybe, you know, somebody is a doctor and the spouse gets, is fortunate enough to stay home and the spouse manages their rental properties. Well the spouse becomes the real estate professional. They do a cost X study on those rental properties and they use those deductions to offset the doctor income.
That’s one way around it. The other way is they call it a short term loophole. I hate to use the word loophole cause that sounds like you’re doing something in the gray area, right? Right. It’s actually not a loophole, but and this is what we did. We ended up doing, my wife and I, because we needed the deductions. If you invest in a short term rental, like an Airbnb VRBO type property, if the average stay is less than seven days and you or me I can show material participation in the management of that property, there’s seven different tests to show material participation. You only have to meet one of those tests, then you can use those deductions to offset your W2 income. Doesn’t work on long-term rentals, only short-term rentals, but basically you’re saying you’re setting it up almost like a hotel business versus a piece of real estate.
But you have to meet those criteria. Average day has to be less than seven days. You’ve gotta show material participation and it gets treated a little bit differently. So now at the end of last year, I bought an Airbnb property, did a ache study on it, created a massive deduction that basically got me in a refund check about my down payment. So I put 80,000 down on a property and I got about 80,000 back on my tax return. So basically I was gonna come out of pocket $80,000 either way, either give it to the IRS or in my case I’m like, well I don’t want to give it to the irs. I’m gonna go buy a short-term asset and Airbnb, even if it only cash flows a little bit, I just saved $80,000 in taxes and now I’ve got a revenue generating property that we’ll appreciate over time and creates a little cash flow. So those are kind of the two ways around that active versus passive income.
Nice. That’s, that’s a great consideration and that’s a great strategy actually to take your tax savings and apply it to a, an income producing asset. I mean that’s brilliant.
Yeah.
I love it. So I’m not sure if you, you know, answered the question, you know, when should someone consider Oh yes, <laugh>.
Yeah no, just when, when should, so again, you wanna use it to manage your tax brackets. It’s not a matter of if, it’s usually a matter of when. Right. you know, if you don’t have any, if you’re not a W excuse me, if you’re not a real estate professional for your tax purposes and you don’t show a lot of passive income, then it doesn’t make sense to do a cost sake study. You’re just gonna hold onto it until you need those deductions and you’ll do it at that point. The IRS fortunately allows us, you don’t have to do it in the first year. You buy the property, you can kind of pick and choose. It’s one of the few tools that I’m aware of, few deductions that I’m aware of that you can pick and choose when you use that deduction. So usually you’re gonna wanna do the cost segregation in a year that you have high income or in a year that you’ve sold an asset and have a large capital gain. And and the asset needs to be have of a, what they call a depreciable basis of about 250,000 or more. So that’s your purchase price minus your land value equals your depreciable basis. Mm-Hmm <affirmative>. But usually your depreciable basis needs to be north of about 250,000 in order for it to be a good candidate for cost segregation.
Can that 250,000 apply to more than one property? In other words, you have multiple properties that are less than the 250,000, but you can aggregate that.
You can, but typically financially it doesn’t make sense because remember you gotta pay to have the study done. So yes, if you have a hundred thousand dollars property, you can do cost segregation, you might save 3000 in taxes. But if the study costs you 3000 to get done, then it’s just a wash. So it works on all size properties, but there’s just a break even point where it makes sense to pay for a study. You wanna make sure that your tax savings is obviously more than what it would cost you to get the study done
And the savings that you’re talking about. I just wanna be clear, you’re applying that towards passive income. If you’re not a real estate professional, you don’t want to consider that against your active income. Right? You wanna look at saving on your passive income. If you have a windfall year or if you have a large capital gain windfall in a particular year, that’s when you look at cost segregation.
Absolutely. Yep. If you’ve got revenue generating properties, they’re creating cash flow. You know, let’s say I make, you know, X amount of my W2 job and then I’ve got my real estate that’s making $80,000 every year, I don’t wanna pay tax on that 80,000. That’s when I wanna do a cost segregation study to offset that 80,000 of, of passive income.
And how long can you carry that forward If you do cost segregation on one or more properties and you have, you know, these deductions that you don’t use up, how long can you carry it forward?
Yeah, it carries forward indefinitely, which is great. You don’t ever lose it. Okay. It carries forward indefinitely. But one thing you want to keep in mind, and this again is something you would talk to your tax strategist about or your wealth advisor, but it doesn’t always make sense to wipe out all of your income to use your de your depreciation deductions to wipe out your income down to zero. And the reason for that is our income is taxed at different levels. You know, you move up in tax brackets as your income goes up, you wanna use these deductions to offset the income in those higher tax brackets, the 37%, the 35%. But I don’t wanna wipe my income out to zero because now I’m using the deductions to offset income that might only be taxed at 12%. I’m using up all my deductions. So next year when I’m in that 37% tax bracket, I don’t have as much of a deduction to use against that 37% taxable income.
So again, you wanna use it to manage, in some cases, you know, it makes sense to bring yourself down to zero, but oftentimes we just want to use these deductions to strategically get you out of those higher tax brackets into something. You know, I don’t mind paying, you know, 12% on 80,000, I just don’t wanna pay 37% on 500,000 because that’s gonna kill me. Right? And so getting yourself out of those higher tax brackets into those lower saving some of that depreciation to use next year when you’re in the higher tax brackets is really kind of the the strategy you wanna look at.
So does that mean that you can take some of the cost segregation or depreciation and apply it in a particular year? You don’t have to take the whole amount. You can carry forward some of the amount to future years.
You can’t necessarily pick and choose like, like let’s say I make 80,000 this year and I do a cost eight study and it creates a $200,000 deduction. I can’t say I only want to take 60 this year and I wanna take, you know, 40 next year and and so on. But there are strategies like if you have a portfolio of properties, maybe you only do one or two of them this year, you don’t do all of them this year. You do one or two of ’em to give you enough deduction to get you outta that higher tax bracket and then you do one or two next year, one or two the following year as opposed to just doing the whole portfolio, creating this massive deduction and just carrying it forward forever. It might make sense just to pay for one or two studies every year.
There is some strategy also involved with something that you’d mentioned called bonus depreciation, where bonus depreciation, if you have an asset that qualifies for bonus depreciation, there are different levers that you can use to dictate how big your deduction is in a current year. For example, you can opt out of bonus depreciation by class life, meaning you can take, if we do a cost egg study, we we create five, seven, and 15 year buckets. You can say I don’t want to take bonus on my five year, I don’t wanna take bonus on my seven year, but I do want to take bonus on my 15. And it gives you some room to, what’s the right word? I don’t wanna say manipulate cause that doesn’t sound right either. It’s all legal <laugh>. It gives you the ability to strategize on how big your deduction is. Again, maybe you don’t take bonus on everything, doesn’t create a massive deduction in year one. You wanna spread that deduction out over the first five years. There’s different tools that allows you to do that.
Interesting. Okay. Yeah, I like the flexibility of it. Yeah. So maybe this is an obvious question, but what types of properties are actually eligible for cost segregation? You mentioned commercial residential, but does that imply that everything qualifies or certain things don’t?
Any revenue generating property? So a lot of times people will ask, Hey, does my primary residence qualify? No it doesn’t. But if you have a, if you have a duplex and you live in half and you rent out the other half, then we can certainly do cost segregation on the other half. We’ve done it on basement apartments. Land doesn’t qualify land if you’re investing in land, land is non depreciable. So you don’t get to do cost segregation on land, but any revenue generating real property. So again, everything from condos to single family homes, duplexes, commercial storage units, trailer parks, anything that’s generating revenue that allows you to take depreciation, you can accelerate it.
Yeah. Interesting. Okay. So I decide that I wanna move forward with the cost segregation study. What is the process of conducting one?
Yeah, so most cost segregation companies out there will provide a free analysis to start. So you would call us and say, Hey, I’ve got a tax problem. I own some real estate. I think I might be able to save some money by doing cost segregation. Can you run some initial numbers? We’ll ask for a little bit of information. You know, when did you buy the property? How much did you pay for it? What’s the address? Et cetera. We gather a little bit of information and we’ll run a pre-analysis to say, okay, conservatively on this property we’re gonna save X amount of tax dollars. Your fee to get the study done is gonna be X amount. And then we want to get your C P A on the phone to confirm, I shouldn’t say your cpa, your tax preparer, whether it’s a CPA or an EA or an account or what have you.
We’ll get them on the phone to say, okay, tax preparer, here’s how much of a deduction we think we can create. Can the client utilize this deduction? Again, there may be things like passive loss limitations where it’s passive income versus active income. There may be things that we don’t know about, like maybe you made a charitable contribution last year and you still have some of that that you need to use up this year. So we just wanna make sure that yes we can create the deduction, but that doesn’t necessarily mean that’s gonna translate into a tax savings for you that first year. So once we run the analysis, we get the tax preparer on the phone, we confirm, yes, this is definitely gonna save you some money. Once that’s done, the IRS does require that we do a site visit on each of these properties.
So once you’ve signed up with a cost segregation company, the first thing they’ll do is schedule a site visit. One of the great things that came outta Covid is we can now do a lot of these site visits virtually. We don’t have to go out to the property. Prior to Covid, we were sending our engineers all over the country, but now we can actually do a lot of these site visits virtually through a video conferencing app or for the larger projects. We definitely send somebody out once that site visit’s complete, they look at the property, they identify the assets that are there, we come back, we put values to all those assets and then our deliverable back to you and your tax preparer is about a 40 to 50 page report has everything line Itemed has the value of everything. Your CPA is probably gonna skip the first 49 pages. They’re gonna go to the last page, which is our revised depreciation schedule. They upload that into their tax software that says, okay, there’s you know, $7,432 worth of flooring, there’s $8,000 worth of parking lot. All those things are line itemed. They upload that into their tax software and that’s how the gain, or that’s how the deduction, excuse me, is realized for the investor.
So they’re just taking the depreciation based on a schedule on each of those line items that they’re plugging into their software. So for them it’s really just taking the breakdown of that one hunk of real estate into all those pieces of real estate and improvements and depreciating those accordingly.
Yep, yep. Normally on a depreciation schedule, there’s two lines. It’ll say building a million dollars land 200,000. Yeah. All we’re doing is taking that one line that says building and breaking it up into different buckets. I see. So instead of it saying building now it’s gonna say parking lot and appliances and countertops we’re just breaking that one line up. Exactly.
Yeah. Each with their own depreciation schedule instead of the 27.5 years.
You got it.
Got it. That’s interesting. So are now, are there, are there limitations or restrictions on cost segregation now that you can explain what it is and how it works? Are, are there limitations or is it just wide open to any income producing real estate?
No, it’s really wide open. There are some, we haven’t really touched on bonus depreciation. Maybe now’s a good time cause that is starting to phase out. Yeah, let’s talk about that. Yeah, so bonus depreciation is a tool that the government uses to stimulate the economy. So bonus depreciation’s been around for a number of years and if the economy’s not doing well, the government says let’s increase the bonus percentage. And what that means is if you go buy a million dollar bulldozer and at the time you buy that bulldozer bonus depreciation is at 50%, that means you get to depreciate 50% of that million dollars in the first year. Or you get a $500,000 write off in the first year. So you can see how that would stimulate somebody to go out and buy something at the end of the year. Right. We all go rush to buy stuff at the end of the year cause we need the deductions.
Bonus depreciation just enhances those deductions. Well back at the, let’s see, 2017 with the Tax Cuts and Jobs Act, a few things changed. As you guys know, Trump was our president then Trump owns a lot of real estate and a few things changed. One is, at the time it was 50% bonus and Trump changed that to a hundred percent bonus. So any assets bought between 9 27 of 17, so September 27th of 17 and 12, 31 of 2022, the end of last year are eligible for a hundred percent bonus. But those assets have to have a useful life of 20 years or less to be eligible. So you have to have a, cus if you buy a real estate, you have to have a cost study cuz otherwise your building is a 39 year asset that’s not less than the 20 years. So it doesn’t qualify for bonus.
But if you take that 39 year asset, break it up into five, seven, and 15 year buckets, those three buckets all qualify for bonus. And now you get to take 100% of those deductions in the first year if you need to. And we usually segregate Marco around 30% of an asset. So if you buy a million dollar asset, we segregate our 30%, that’s a $300,000 in those shorter asset life buckets. And if you get 100% of those in the first year, you know, you buy a million dollar asset, you’re getting a $300,000 write off all in year one versus if you don’t do cost ag, you’re getting one 39th of a million as a deduction versus 300,000. So that’s bonus depreciation. There are some limits around that. Bonus depreciation does start to phase out here in 2023. It actually drops to 80% bonus. So we would take 80% of whatever we find in those three buckets, write it off in the first year, the leftover 20% gets spread out either over the next four years, the next six years or the next 14 years.
You know, your five, seven, and 15 years assets. So you take 80% year one, the other 20% spreads out over years two through four. So but cost segregation, I mean that’s a, I don’t want to call that a limitation cuz cost segregation. We were doing cost segregation before bonus was even around or bonus even applied. And so, you know, it still makes sense to accelerate things from 39 years or 27 and a half to five even if you don’t get bonus. But when you take bonus now it just puts those numbers on steroids and creates massive deductions.
So in 2023 you can take 80% as a bonus depreciation, correct? Correct. Yep. Next year it drops to what?
60% and then 40%, 20% and then zero. So in 2027 it’ll be down to zero or until we get a new administration or until they changed the law, which they’ve actually, the ways and means committee in Washington just made a proposal to extend the a hundred percent bonus into 2025. So again, remember they use that to stimulate the economy. So if the economy’s not doing well, they’ll say, Hey, let’s incentivize people. Right. But giving ’em these bigger deductions to go out and buy stuff. And so there may be an opportunity that we hear before the end of the year that bonus depreciation gets extended through 2025. So that would be best case.
Interesting. Well, things are always changing. Yes. <laugh>. So now I’m sitting here listening to you thinking about, you know, whether I should pursue a cost segregation study or not. So what factors should I consider in making that decision?
Yeah, so the, the big factors are one, what is your taxable income? What tax bracket are you in? And then what type of assets do you own? When I say type of assets, are they, do they have a depreciable basis of 250,000 or greater? So if you’ve bought some investors, they’ll go buy an $80,000 home they’ll fix it up and then they may hold onto it for a few years. That $80,000 home, it could, you could do cost segregation on it, but it probably doesn’t make sense financially because you might save three or $4,000 in taxes, but it might cost you three or 4,000 for the study to get done. So it’s just a wash. So what you want to consider is, do I have properties that I’ve owned that I paid more than 250,000 for number one. Number two, what tax bracket am I in? Am I in a, you know, higher tax bracket, lower tax bracket? And then number three is can I absorb these deductions, you know, can do I have passive income that can be used to offset these passive deductions. Those are kind of the three criteria to look for.
Well let me throw a quick hypothetical at you. I know there’s a lot of what ifs. You know, what if you have an income over a certain amount, what if you know you have other assets to depreciate? What if you are a real estate professional or not? But oversimplification here, here’s a hypothetical. Sure. What if I’m an investor that has, let’s say 10 properties in my real estate portfolio and these properties are worth in the range of 150 to $200,000 each. Is that person with that portfolio a candidate to consider cost segregation?
Potentially, yes. Definitely worth looking into. So you would want to couple things when the basis or the depreciable basis is less than two 50. If you find yourself in a high tax bracket, number one or you plan on holding the properties long term, then it, it still may make sense to do cost segregation just because in the first year you might only save 5,000. The study might cost you 3000, you might save 5,000 in the first year. But in year two, if you save 4,000 in year three, if you save an additional three, that adds up over time. Now if you, in that same scenario, you mentioned if I have 10 properties, they’re, you know, 150 to 200,000, but I’m in a low tax bracket and I plan on selling some of those properties often in the near future, then you’re probably not a great candidate for cost segregation because remember you get to take these deductions upfront, but it does create a tax situation on the back end where you do have to pay some of this tax back.
That’s typically in the form of either capital gains or recapture tax. So just because you’re saving 5,000 today, if I gotta pay, you know, 2,500 of that back when I sell it and I’m gonna sell it in a year, it might not make sense for me to pay to have a study done just to have that extra cashflow for, you know, less than a year. Yeah. So that’s just one thing you want to consider. But if you’re gonna hold them long term, if you’re in a high tax bracket, it definitely could make sense to, to do cost segregation in that scenario.
I would think that a lot, if not the majority of people listening to this podcast are not in the camp of selling properties in the short term for the sake of selling it. You know, whether just to realize a gain or whatnot. Like if they’re selling, they’re gonna sell because they’re diversifying or upgrading their portfolio, meaning they’re doing a 10 31 exchange, they’re buying more property, they’re growing the size of their portfolio, they’re not selling just for the sake of selling. So if that’s the case, then I guess it sounds like it’s worth taking advantage of cost segregation because they may not be in a situation where they’re gonna have to pay taxes through the recapture of that depreciation. Is that a fair statement or not?
The longer you hold the asset, the bigger your tax savings is over time. So sometimes there can be a tax savings, even if you only hold it over one taxable year on some of the larger assets. But on the smaller assets, you definitely wanna make sure you’re holding it at least past the five year mark in order to maximize your tax savings.
Yeah. Okay. So can cost segregation be applied to new construction properties as well as old properties? Or does it apply the same way across any property any age, whether it’s new construction or not?
It does. So cost aggregation can be done on brand new construction or it can be done on existing buildings. It’s a little different methodology that we use internally on how we do the cost segregation study. For example, if it’s a new construction, new build, you’re gonna send it, you’ll have actual cost of that new build and you’ll send us those costs, we’ll go through those costs, we’ll break ’em up into the right buckets, we’ll handle all the indirect costs. We’ll do it that way. If you were to buy an existing building that let’s say was built in 1980, but it’s new to you this year, we would do a little bit different technique where we, you don’t know the value of the existing carpet, you don’t know the value of the existing parking lot because it’s been in there for a number of years. And so we’ll come in, we’ll do a cost estimate approach or a modeling approach where we will model using some IRS approved software to say, okay, you know, this flooring has been in here for X amount of years, it’s mid-grade carpet and so we’re gonna put a value of X amount per square foot to it and we’ll calculate the value that way.
So yes, you can do it on new construction and existing construction. It’s just changes up the methodology that we use that we use to u to complete the study.
Right. So when the study is done and you’ve got the report and you send it to the client and the client’s obviously sharing that with their tax advisor. Tax strategist, are there any documentation or maintenance requirements or records that are needed to be kept or held or updated after the cost segregation study is done?
There’s not. So even on the cost segregation study now you’re gonna want to keep the study obviously in your files for seven years in case you ever were to get audited. Sure. the the, the report will have all the backup documents you need, but when you do a cost a study, you don’t actually even turn the study in with your tax return. You’re just using a numbers and if the IRS ever questions those numbers, you have backup document to support those numbers. And so there’s no additional paperwork. The only time I sh I shouldn’t say no additional paperwork there. The only time there is additional paperwork is if you were to do a cost segregation study on an asset that you’ve already depreciated on a previous tax return. So one of the nice things about cost segregation is, let’s say I bought two properties back in 2015.
I never did a cost egg study. All of a sudden it’s 2022, I find myself with this big tax bill, I can actually go back and do cost segregation studies on these buildings I bought in 2015, bring all that missed depreciation that I should have been taking over the last seven years. Bring that all forward under the current tax return without ever amending a prior year’s return. There is just one form that you have to fill out. It’s called a 31 15 tax form. It’s basically, it’s called the change in accounting method. But what you’re telling the I R S is, hey, i r s for the last seven years, I’m going, I was depreciating my carpet wrong. I was depreciating over 39 or 27 and a half. I should have been depreciating it over five. So let me make the fix now. Let me change those numbers now. And it creates a large deduction on the current tax return without ever having to amend. So that’s the only time when any additional forms are needed is when you’re doing what we, what we call a look back study where you’re going back on a property that you’ve already had in service. Mm-Hmm <affirmative> and we’re, we’re making the corrections.
I wonder if that raises a red flag with the IRS for an audit <laugh>.
You know, that’s a great question. There’s been studies shown that it doesn’t, it’s the 31 15 is a automatically accepted change in accounting method. So the IRS doesn’t even need to approve it. We send a copy of it off to some IRS office. I think it goes in the basement. I don’t know that anyone ever looks at it, but it doesn’t, we’ve done, we do thousands of those every year and we haven’t seen an increase in audit any more than what a normal audit would take. So just to give you an idea, we’ve done close to 12,000 studies here at our firm. We’ve been involved in 12 audits and not a single one of those audits was triggered by the seg. It was triggered by something else in the return. And then they said, okay, we’re, as we’re going through this the paperwork, we realize you’ve done accelerated depreciation. How did you get to these numbers? And you better have a a backup report. You show ’em the report, they go through it. Oh, I see what you’ve done here. I see what you’ve done here. Perfect. And you move on. So we haven’t had to make any changes to our reports but Right. 31 fifteens don’t typically raise a red flag unless there’s something else in the return.
Right. Yeah. Cool. Alright, well just two more quick questions and then we can wrap it up. Yeah. I don’t know if this is even a fair question to ask, but when it comes to repair and maintenance expenses, which are just, you know, operating expenses that you have month to month or year to year on your properties, when you do accelerated deductions, whether it’s like bonus depreciation or cost SE study, does that affect in any way how you deduct or take advantage of your repair and maintenance expenses?
It does have an impact. It’s a positive impact. In fact, the way it works is there’s something called a partial asset disposition. So when you just have building on your depreciation schedule, just one line item that says building when you, two years later after owning that building, when you go to replace the roof, you just add the roof to the depreciation schedule. So now your depreciation schedule says building and then underneath that it says roof. What should happen if you’ve had a cuss segregation study done is we’ve taken this building and we’ve separated outta the different assets. So now you have a line item that says roof. So when you replace the new roof, you get to take that old line item off the books, whatever the remaining book value is, you get to expense that in the current year and never pay recapture tax on it.
That’s only if you’ve done a ache study because if you haven’t done a ache study, when you replace the new roof, you have a new roof value of let’s call it a hundred thousand, you don’t know the value of the old roof cuz it’s just stuck in that building line that says building. So what ends up happening is you end up depreciating two buildings along the way at the same time, I’m sorry, not two buildings, two roofs at the same time. Because again, you’ve got one roof stuck in that line that says building and then you’ve got the new roof added there. So now we’re depreciating two roofs at the same time. What should happen is you should take that old roof off the books. If you’ve got it line itemed, you can do that, take it off the books, expense it as a par, what they call a partial asset disposition. You get a huge write off in that year and you pay no recapture tax on it and then you start depreciating the new roof by itself. But that’s one of the benefits of having everything light item ’em, especially on multifamily or residential properties where you’re constantly updating, putting in new flooring, new countertops, a new roof, new windows. When you have everything line itemed, it’s just easy that when you replace one of those items you pull that item off, dispose of it. Right. Put the new one on. So
That’s, that’s really cool actually. That’s really interesting. So if you did a cost seg study and you have the roof item there and you replaced the roof, which is really not an ex a, a repair or maintenance expense, it’s really more of a capital expenditure cuz it’s, it it’s a big ticket item. So you’re saying you could take that, the cost of that roof and plug it back into that line item, replace that line item with the new roof. Now you are depreciating that on what timeline is it back to the 27 and a half or 39 year timeline? Or is it still accelerated on under the whatever, 5, 7, 10 year?
So a roof is always a long-term asset. It’s always part of the building. It’s just when we do our cost x study, we, you know, you buy a million dollar multifamily, we say okay, the roof is worth a hundred thousand. Yeah, well when you’ve, and that’s a 30, excuse me, a 27 and a half year asset. So let’s say you own that roof for half of its useful life, so let’s call it 13 and a half years. Yeah. That roof, after 13 and a half years, it still has half of its book value left. Yeah.
And so when you put the new roof on that old roof, whatever that value of that old roof is, you get to write that off as an expense and take all of that in the current year, even though because you’re retiring that equipment or retiring that roof so you don’t get to depreciate it and you shouldn’t depreciate it anymore. Yeah. And then you put the new roof on and starts depreciating it. So it’s just one of the, one of the great benefits or one of the additional benefits of doing costing is having everything line item so you can take advantage of
Your schedule. Yeah. And I, and I get all that and that’s really cool. But what I’m saying is when you add the new roof into that line item, are you depreciating that based on that accelerated cost segregated schedule? Or does it go back to the the original 39 or 27 and a half year depreciation schedule?
Well, a roof is always 27 and a half or 39 even when we do the cost
Even with cost.
Yeah. So we, we pull out the carpet at five. Got it. You pull out the parking lot at 15, but roof is part of the building. Yeah. So it’s not a short term asset. So it stays in that bucket. The new roof will stay in that bucket, but you get to pull the old one off, so. Okay. Yeah, you don’t ever get to accelerate the depreciation on a roof in that example.
Okay. Last question, just real quick. You can, you know, generalize this one, but how long does it typically take to recoup the cost of doing a cost eg study through the tax savings that it, you know, should or typically will give you?
In most cases it’s just one taxable year, not even a year. So if you were to do your cost eg study in March, file your taxes in April, you’re gonna recover probably tenfold what your fee was to get the study done in that first year. Wow. So we don’t ever want to engage a client to do cost segregation unless they’re gonna get anywhere from a seven to 10 x return on their investment with us. Hmm. So, you know, if we’re charging you 3000 for a study, we want you to save 21,000 on your taxes. So at most, let’s say you call us in May of this year and you don’t file your taxes till April of next year, it might take you 11 months till you actually get that money back. But that would be the longest case that it would take you, it could take you anywhere from a month to 11 months in that case.
Wow. That’s really cool. Well Erik, I appreciate you taking your time today to help educate, educate us on cost segregation. Something that doesn’t sound overly sexy to most people, but when you start to think about the cost savings and the tax savings, it actually gets pretty exciting. So do you have any final thoughts, comments, you wanna leave our audience before I let you tell everybody where they can find you and get more information?
No, really that’s it. You’ve hit it on the head. I mean, cost segregation, taxes in general is not something people always get excited about. But this is the exciting part of cost segregation are our ex exciting part of taxes. One of my clients used the example once of, you know, a lot of us are looking to grow our portfolios, right? And we think that we’re gonna make more money by getting more doors and growing our, which is a one way to gather more income. But the other way is to play defense with the money we already have. And let’s try to, instead of sending a big check to the irs, what if I can keep half of that money every year? So there’s, I’ve had clients where they didn’t add any doors of their portfolio and their income more than doubled because they put together a comprehensive tax strategy to reduce their tax liability.
So it’s a common sports analogy I I’d like to use where you gotta play defense. It’s not how much you earn, it’s how much you keep. And so sometimes we lose focus on go get the next one, go find the next deal. But it’s like, let’s make sure that the existing deals we have, we’re maximizing the tax savings. That’s the first thing. And then the second thing would be make sure as your listeners start to build their portfolio, there’s a huge difference out there from a tax preparer and a tax strategist. And as you build your portfolio, make sure that you have partnered with a tax strategist who understands real estate, who isn’t just doing a tax preparation. You know, tax preparation is you go to h and r block at your local Walmart, you hand them your forms, they process it through their machine and they spit, theres an output.
Tax strategists will meet with you a couple times a year at minimum and say, Hey Marco, what’s in the hopper? What are you buying? What are you selling? What’s your income looking like? What do your deductions look like? What do we need to do? Do we need to buy some more stuff at the end of the year? Do we need to do some cost segregation? You know, they’re putting together a whole comprehensive plan. Now a tax strategist is significantly more expensive than a tax preparer. Yeah. But a tax strategist is gonna pay for themselves tenfold in the amount of money they’re gonna save you in taxes. So sometimes people get sticker shock and they’re like, why am I gonna pay a CPA a thousand bucks to do my taxes? I can go to h and r block and it’s only a hundred dollars or I can do it for free on TurboTax. It’s like you get what you pay for. Yeah. And so definitely as your investors start to build those portfolios, make sure you have a tax strategist in your camp that understands real estate because it’s a huge difference between a tax strategist and a tax preparer.
Yeah. That is great advice. And everybody should really take that to heart. And I will add one thing to what you just said. Not every cpa, in fact, most CPAs are not tax strategists. Right. You know, they understand taxes to some degree and how to balance the books and fill out forms and whatnot. But they don’t have the strategy side of the tax game.
No, you hit it on the head. I I like to use the analogy, your average CPA is a, is your general practitioner in the medical field, they know a little bit about a whole lot. I mean the tax code is thousands of pages. Yeah. So they, they don’t have, and it’s no, no fault of their own. They just don’t have the bandwidth to go deep in a specific category. And so finding somebody who understands real estate, and I’ll preface this saying we don’t do taxes, so this is not self-serving in any way. Don’t call me to do your taxes cause we don’t do any tax returns here at our firm. I just deal with a lot of investors and I see way too often investors leaving thousands, tens of thousands of dollars on the table because they’re like, listen, I can do this. They do TurboTax, they do h and r block I’m like, you know, you’ve got 10 properties in your portfolio, why are you still doing TurboTax? You need to find somebody who understands real estate. Yeah. Understands how depreciation works, and can give you the advice you need. So that’s a, that’s a great point, Marco.
Yeah, very cool. Erik, tell our listeners how they can follow you and get more information about what you guys offer.
Yeah, so the best way to follow me is on LinkedIn. It’s just Erik Oliver, Erik with a K, last name Oliver. As far as getting ahold of us, our website is www.costsegauthority.com. From that website, my contact information’s on there, my cell phone’s on there. You can call me directly. I’m happy to, I try to answer my phone as much as possible. We’d love to be a resource for your listeners. We, like I said, we don’t do tax returns here, but we see a lot of tax returns. We work with a lot of investors and CPAs across the country, so we kind of see the latest and greatest on how people are handling different situations, and we’re happy to advise any way we can. So please use us as a resource and also from that website, if anyone has a property, they would like to get an analysis done. We do a free analysis, we can turn it around in 24 to 48 hours give you an idea of what you can expect on, on, on each of your properties.
Cool. Erik, thanks again. I appreciate you coming on. It’s been very eye opening and enlightening, so thank you.
Oh, you’re welcome. Thanks for having me.
Thank you
Well, I know that it was probably a bit of dry material for some people, but at the end of the day, anywhere that you can save taxes is immediate income in your pocket. Tax savings goes straight through to the bottom line, which means it’s real spendable cash that you can apply right away. So I’m always interested in how to save taxes because tax savings are like getting a pay raise. It’s immediate and it’s real money. So that is it for today. I appreciate you listening. If you have an interest in growing or building a real estate portfolio, just contact my team free strategy session, just talk to my investment counselors and they’re always around and here to help you. Other than that, if you have a question about real estate investing or just wealth creation or even a personal question, just send it over to me at AskMarco@passiverealestateinvesting.com, or go to the website at passiverealestateinvesting.com and click on the Ask Marco link or button that is on the website. Remember to subscribe. If you haven’t done so already, it takes you all of three seconds. And help us spread the word about the show. Tell your friends and family and other people about it. Have them subscribe and of course, leave us a rating and review on iTunes or wherever else you listen to the show. I always read them and I greatly appreciate ’em. So that is it for today. Thank you for listening, and we will see you all on our next episode.
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