Ep 189 – How to Utilize a Cost Segregation Study WITHOUT Being a Real Estate Professional
Many investors tune out immediately when people start talking about cost segregation studies because they aren’t a real estate professional. What’s the point of learning about them when your full time job means you can’t use it to offset your active income?
Zach Lemaster and Adam Schroeder talk with Steve Trussell, Rent to Retirement’s resident cost segregation expert, about how cost segregations can be utilized by the average investor, as well as why, if you’re going to do it, sooner is better than later.
Get in touch with Steve by CLICKING HERE
Transcript:
Adam
Hey, Rent to Retires. It’s Adam Schroeder here with another episode. Joined as usual by the founder and CEO of Rent to Retirement, Zach Lemaster. And today we are going to talk about taxes. We’re gonna talk about cost segregation. We’re gonna talk about all the things that, uh, you don’t think about whenever you first start investing in real estate. And that is, uh, with, uh, Mr. Steve Trussell. Steve, thanks for joining us today.
Steve
Thank you for having me.
Adam
Absolutely. So, I know we’ve done other, um, episodes with you talking about cost savings before, uh, people have heard Zach talk about cost savings ’cause he loves them. Uh, he lives and breathes by ’em. But tell us a little bit, just in general, remind people what a cost segregation study actually is.
Steve
Okay. It’s basically, it’s segregating the asset. And what that means is t typically a residential is 27 and a half year depreciation cycle in commercials 39 years. So obviously all of those parts and pieces of the real estate don’t, or last less than 39 or 27 and a half years. So you have the building or the, as one of the components, which is your longer life. But a lot of the, the components inside the, the property like carpeting, lighting, uh, things that expire in shorter periods of time, it’ll last as long. We can bring 20 to 30% of that forward into a cost segregation study. Our engineers break down the building, rebuild it, basically, and segregate the five and 15 year property. 15 year property is what’s outside your parking lots, your driveways, your landscape, things like that. Your sprinkler systems, five years, what’s inside the carpet, you know, the things like that inside the building.
Steve
So we segregate that 20 to 20 to 30% of that comes forward. Uh, and with bonus depreciation, which came about it was July of 2017, you, uh, up through December 20, December 31, 22, you can bring a hundred percent of that forward and use it in the current year, the current tax year. You can do that all the way up until you file your taxes for that year. So if you’re in 22, if you’re, if you’ve extended your 22, you, you’re still eligible until you file your taxes. As long as the report is done prior to filing taxes and starting in 23, that bonus goes to 80%. Next year goes to 60, then 40, 20, and then it goes away. Uh, that doesn’t mean cost segregation is not a a, a benefit. You still would want to want to separate your asset into five and 15 year categories and have a shorter life or part of the building part of the property.
Zach
Alright, so we’re, we’re getting immediately granular and uh, I’m, I’m gonna back up a little bit just for, for people that are like, well, I’m never heard of EG. Or like, what, what did Steve, what the hell did Steve just say <laugh>? So, um, uh, let’s, let’s back up a little bit and don’t let me forget. One thing I wanna talk about today is people that have properties that they’ve owned previously, that they want to explore accelerated depreciation on that. I think it is super essential to don’t, Adam, don’t let me forget that one, but will not be forgotten. Okay. So, um, let’s just start at depreciation and I’m gonna paraphrase for you Steve, and try to simplify things for the audience. Tell me if I’m incorrect here at all, but depreciation, what is that? Basically depreciation means property is a physical asset. We’re actually talking about the improvement on when, when you have real estate, you have land and you have a house.
Zach
3 | 03:56
We’re talking about the actual improvement, the house on the land. Um, and so basically the improvement is, is a depreciating asset just like a vehicle, like it wears out over time. Um, even though it goes up in value, um, the government allows us to basically take tax deductions off of that and, and re we will reduce our, our tax basis or reduce our income on that by taking an expense on the property. Actually, you are required to per our i r s guidelines, this is not an optional thing. You’re required to take depreciation, but basically what you’re saying is I have a hundred thousand dollars house, that’s a residential rental. Um, it’s depreciates over 27 and a half years. Who know, who knows who came up with that number, but there it is. So, um, a hundred thousand dollars house divided by, and we’re not sec sectioning out land in this to be complicated. Usually land is a minimal portion, but a hundred thousand dollars house divided by 27 and a half years, it’s like 3,300 per year, whatever it is that you can reduce, say you had $5,000 of income on that property, you reduce your tax basis by three, 3,300. So you’re basically reducing your income. Um, and then on commercial property, because it’s built differently, it has and has different components to it, it has things that last longer. So the depreciation is 39 years. Did I do a good summary of that? Anything you wanna add to depreciation?
Steve
No. That, that, that’s right. That’s correct. You take the land out, land is usually 15%, depending on where it is, it fits in, you know, LA Jolla, California, it’s probably 25%, but typically across the United States, 15% land is typically what, what we would use. Yeah. You take the balance of it, which is attributed to the building or the structure, and then you depreciate over the life, residential or commercial.
Zach
Yep. Sometimes. And then sometimes in the, in the Midwest, you can have land that’s even significantly cheaper, less than Yes. You know, 5% sometimes. So, uh, you get more depreciation in that case, right. Which a lot of people don’t think about, but mm-hmm. <affirmative>, um, that’s another benefit of Midwest. So, um, okay. So that’s, that’s depreciation and something you’re required to take, uh, you know, on an annual basis. And that’s why, that’s what allows us one of these big things that allows us to have tax-free income. ’cause we have a, a positively cash flow property that’s appreciating over time, but it’s being in the eyes of the i r s is being looked at as a depreciating depreciating asset. And you can recycle depreciation, we’ll talk about that as as well, um, on properties. You can use it multiple times. But let’s, uh, let’s, so the cost tax study, what that basically is, is it says you are having an actual study done of evaluating, I know when, when, um, you’re doing them for my properties.
Zach
This is an actual engineer that’s giving a detailed report of all the things in the house or the, the building that are not gonna last 27 and a half years, or in commercial 39 years. I mean, pretty much everything inside the walls right is not gonna last. Right? And so basically what you’re doing is you’re taking a portion of that call 30% and you’re taking accelerated depreciation. And so the, the cost segregation study, it’s a report that is a breakdown of all those items, um, that you are accelerating in the de in, in depreciation. You’re not, it’s not obviously gonna last 39 years. You could not do this and have those go over 39 years, or you can be a creative investor to accelerate those. And what, what is called bonus depreciation is taking all of that, um, say you get a list of 30% of the items that are not gonna last 39 years and taking that all in in year one.
Zach
So you take a 30% deduction in your, your, you take 30% of your depreciation in year one. The rest of the 70% of depreciation you would take over the normal 39 years. However, the reason you would do that, like why would someone do this, is because it allows them to decrease their tax basis this year and take depreciation this year. And so what you can do if you’re a real estate pro is like offset your income from all these different sources. It doesn’t matter what the source is, but you’re using that depreciation to offset your taxable liability, um, to reduce your taxable income this year. Like for instance, we’re doing this personally because we’re buying enough, what we’re doing, our strategy is to buy enough real estate to offset our active income from all sources. So we create a loss every single year that carries forward. So if you don’t use this in year one, it carries forward, um, year after year. But the reason we do that is so we don’t pay, you know, the, the money and taxes that we would otherwise to then go out and reinvest and earn income on that. So that’s kind of the idea behind doing an accelerated depreciation is, is that correct Steve, or anything else you wanna add to that?
Steve
That’s correct. Well, the one thing to add to it, if you can’t use it all, then you can carry forward until you can use it. So, uh, t typically with your cash flow, if you’re in a really good cash flowing market, sometimes you’re 39 or your 27 half year is not enough to offset your income so you have a gain. So with cost segregation, you most always will offset your income from the, from the asset from that property. And then if you’re a real estate pro, like you mentioned, you can use your W two or your other income if you qualify for that to to, to offset that income as well.
Zach
And just one other note about depreciation to understand depreciation is recapture, okay? So when you sell the property, you pay it back again, you are required by the RS to take it. In fact, like they, if you don’t take it, they factor your taxes in as if you did take it and penalize you, right? So, um, I mean you you you should be taking it and you have to take it. Um, but you pay pay back. It’s happen
Adam
One way or another,
Zach
Right? And so that’s an important thing of having the right c p on your team, right? But, uh, so when you sell the asset, you have to pay it back. The alternative would be to, you can carry it forward and 10 31 exchange. It like kind of the, the big picture goal here of people that are building exceptional wealth into real estate is they’re doing exactly this, uh, is they’re taking, they’re buying all these assets, they’re doing accelerated depreciation and then they are holding those assets for a long period of time. And when they do sell them, they are 10 31 exchanging and paying it forward, like moving it forward. ’cause eventually you can basically in perpetuity forever, uh, pass forward depreciation, right? You can’t, the idea
Steve
It is now in 10 31, 10 31, you are gonna reduce your basis in the new asset by, by some of the recapture that you pick up in the old asset. But it’s still a worthwhile way to to, to transfer the asset to a new asset through 10 31 exchange for sure.
Zach
So we won’t get super detailed on that, but I think that’s just one thing to kind of clarify, um, on, on the depreciation. So Adam, I I keep jumping off here and I obviously, this is my, my topic here, so,
Adam
So I don’t want people to just pass this episode over because they heard the word real estate professional and they aren’t real estate professionals because if we’re being honest, most investors are not real estate professionals. When people think of cost segregation, they think about real estate professionals. But as we were discussing before we got started, you do not have to be a real estate professional to take cost segregation studies in your properties. Correct. And if so, if not, when does it make sense for people to do it?
Steve
Well, to me it always does. It always makes sense because you’re, you’re going, you have cashflow from your, your, uh, uh, your asset and, and if it’s exceeding your depreciation, you’re gonna be paying tax on that. And one of the benefits of real estate investing is the tax benefit from through depreciation. You don’t pay if you do a property, you don’t pay income on your income tax on your gains. So it’s always good to have it. I mean, you can also take it against your capital gains of your passive losses as well if you sell outside of the 10 31. So, uh, if you have multiple properties, so it, it always makes sense. I mean, you, you’ll always get your depreciation over the 27 and a half or the 39 year life, but if you got a five and 15 year, uh, asset as part of that com, as part of the asset, you should be taking advantage of that.
Steve
Well, what we do in, in all situations, we, we do an estimate of benefit to tell you what your property would look like. And it’s usually a conservative estimate because I don’t want to give you a large number and then come back with a smaller, rather do just the opposite of that. So, but that allows you to take a look at that, take a look at the cost of the study, get with your C P A and see if it makes sense for you to do that nine times outta 10. It it does, sometimes it may not. It depends on your personal situation, but the estimate gives you a guideline along with the cost, the price of the study to decide if it makes sense for you.
Zach
Do you charge people to do estimates?
Steve
No. No, not at all. Okay. And I’ll turn those around in a few days. And it is just that, it’s an estimate
Zach
I have to ask you because you’ve always given me estimates, but I’ve also always paid for them. So <laugh>, I for, I don’t know
Steve
If you do, you actually, you pay for the study. Now the estimate you don’t, once you look at it, once someone looks at the estimate, they look at the cost and if they like what they see and there’s a benefit to them, then we engage in the study and then that’s when they, they they pay Steve what
Zach
Is, he knows
Adam
You’re gonna just go ahead and do it. So you don’t even bother with the estimate part. It’s just Yeah, we’re
Zach
Gonna do it. Yeah, that that is true. Um, and, and I’ll share a little bit about what, what I’m doing. I don’t wanna be too personal giveaway all financial information. Uh, my wife wouldn’t like that. But I mean, I, I do wanna be somewhat of an open book on, on what we’re personally doing, uh, which has has been, I mean, quite a lot. Would you agree, Steve? Like we’ve been pretty aggressive.
Steve
You have? Yes.
Zach
Um, so I mean we’re, we’re creating millions of dollars of losses every single year by doing just
Steve
Last year you did. Yeah, for sure. But last year was a, on those four properties was, was a gigantic loss for you. So
Zach
And so we’re carrying that forward. So probably our income for the next two or three years is probably already set offset by properties we’ve bought in the past. And we will continue to buy this year too. Because another thing to be conscious of is like, this is a time sensitive thing. You can still do cost segregations and, and um, do things with depreciation. But what we talked about with the bonus depreciation, like last year in 2022 was last year we could do a hundred percent. So just number wise, if you have a hundred thousand dollars property, you get 30%, I think on most of your estimates, Steve, you come in between 22 to 28% on your estimate. Right. But on all of our studies, I think our average study were between 35 to, we’ve had some over 40%, um, last year we did
Steve
For sure. Yes.
Zach
Yeah. So what we’re doing, so basically if you take that study, you can take a hundred percent of that 40% off of, you know, as an accelerated depreciation in year one. But now this year, 2023 is 80%, next year goes to 60%. So this is a time sensitive thing. Like if you’re gonna do this, you should think about doing it rather soon or this year. Um, because now this year we can take 80% of whatever your study comes back at 40%. So you can take 80% of the 40% of the a hundred thousand dollars property without getting too complicated. But it’s still attractive to do. It still makes sense to do. And it’s not like you’re losing any depreciation, right? If you’re taking, um, a percentage of it, you’re whatever you don’t take, you’re accelerated, you’re still getting normal depreciation like you would anyways. Correct.
Zach
But here’s a couple things just we’ve talked about this in detail on other videos that we can link to, but just understand one is that sometimes short-term rentals, there’s what we call the short-term rental loophole where you don’t necessarily have to be an act, you don’t have to be a real estate pro. But if you’re actively managing that property and involved in it, you potentially, you, you should be able to take accelerated depreciation on those assets and also do cal study. And the second thing to understand too, um, which the first time I heard about this, I was like, what this, this is like how do we not know more about this? ’cause this applies to a lot of people. I don’t quote me on the numbers here, Adam, maybe you remember more than I do. But if you earn, I think it’s $150,000 or under, and I believe that could be joint jointly.
Zach
Um, you can take, you do not have to be a real estate professional and you can take accelerated depreciation, you can take against your active up. I think it’s up to $25,000 of active losses if either of you guys know more details on that. Like please state that. But basically that means if you have one rental property and you make $150,000 or or less, you can take a depreciation year. One of I think up to $25,000 without having to do like, without having to be a real estate. This large real estate professional. That’s, that alone is a huge benefit if you, if you fall within that category. Do you guys, can you <crosstalk>,
Adam
We talked about that, I believe with Amanda Han if they wanna go back and
Zach
A few times. Yeah, yeah. So we’ll link to that. But I don’t know, Steve, do you have any other We don’t, I don’t wanna spend a lot of time on that, but it’s just something to be aware of. If you’re $150,000 or under, like, you should be taking probably, in my opinion, I’m not a C P A or attorney, but you should be taking additional depreciation, um, if you’re paying taxes, right? Yeah.
Steve
In my opinion, as I said, if you own real estate, you should always do a cost irrigation study because you can use it in this instance like you just discussed. And, and you may have a really high cash flowing property like your, your short-term rentals in Colorado. Those, those will exceed, uh, the normal cash flow on, on a piece of property. And so if you have a high, high cash flowing property, I mean, it certainly makes sense to do that, to zero your, or maybe not zero, but at least wipe out a lot of the income.
Zach
So to simplify Adam’s question, when does it make sense to do it? Pretty much if you have, if you have any taxable income, right? If you have cashflow on the property that, um, exceeds your expenses and your write-offs, if you have capital gains, like if you, if you have taxable, um, liability on the property, you can offset that. I mean, regardless of real estate pro, I mean there’s, this is now we’re just talking about the property. So it doesn’t matter, you can still accelerate depreciation on on that Yes. If you have taxable income on it.
Steve
Yes, correct.
Adam
Now Steve, when it comes to these, let’s say, you know, that a hundred thousand dollars house, let’s say I want $15,000 this year, but I don’t wanna accelerate, accelerate everything. Is this something you can take piecemeal or does it have to be, you know, all in one go, you know, oh, 30% was depreciable, so we have to accelerate this now? Or can it be like, you know what, I just need 15 grand and write off and I’ll take the rest over the next 26 and a half.
Steve
Well, the study is the study and it’s gonna, it is gonna break down the asset and create the, the accelerated depreciation regardless. So you can’t do a partial study, you do the whole study, but then you take the 15 this year and you carry forward the balance of it to the, to the future years.
Zach
Yeah, it would make sense, I think, um, in my mind to just do it. Like why would you not? Because then it’s going to carry forward year after year. Like you’re still taking it, it’s just a matter of Yeah, I’m,
Adam
I’m mostly just thinking like if I’m buying something and I think I’m gonna hold this two to three years and I don’t wanna have to recapture all of it in the 10 31 exchange, but if I could just get, you know, 15% of this for the next two years to offset my taxes, that’d be great. I didn’t know if, if that was a possibility or not.
Steve
It, it’s not because the study is a study, but I will say if you’re gonna sell in the, let’s say a year to two years, probably wouldn’t recommend. I don’t turn, turn away any business. But I probably wouldn’t recommend you.
Zach
That was gonna be my question. When does this not make sense? We talked about when it does
Steve
Three, three years or more, you know, three years is kind of borderline as well. So that’s part of what the, the estimate’s about you take a look at that and then what are your plans for your property? If you’re gonna hold it for a while, which I I hold mine then, then I think it makes sense to do it. But if you’re going, you know, want to, you’re gonna turn it a year or two, uh, to, into something else, I would wait until you finally get something that you’re gonna hold for a while.
Zach
So if you don’t have income, and you may not know this until after the fact, right, but or until you’re starting to prep your, your tax structure. So if you don’t have taxable liability on the property, if you already have a significant loss, um, or if you’re gonna flip it and not hold it for, for a period of time, which most of our investors are buy and hold investors, we, we know that that’s how you build wealth in real estate over time is you hold real estate and you do exactly what we’re talking about today. Um, right. This you, that’s, that’s kind of like the long term key to like, without overcomplicating it, maximizing the tax efficiencies and holding real estate over time is that that’s the recipe for success. But those would be the two scenarios. Okay? So if you don’t have taxable income on it, or you’re flipping it, maybe this doesn’t make sense, what does it cost that study cost, Steve, what does that typically cost on different assets
Steve
On a residential? Uh, it is pretty simple. Anything under $500,000 is $1,500. Um, if if it’s on residential under half million dollars when you get into the four or $5 million, $2 million, those are all based on each individual. But they’re gonna run from, you know, I hate to throw a number out here because I need to look at the property first, what type it is and so forth. But they’re gonna be in the thousands, not not 10, those tens of thousands, but it depends. If it’s a five or 10 million property, it might be $12,000. And, and that’s just a kind of a number outta the air. I don’t have anything in front of me to, to uh, uh, quote that. So I hate to throw the numbers out there and people that have expectations that aren’t realistic, uh, uh, that’s why we do the estimate. We do the estimate. That’s what you
Zach
Charge, right? And you give, you provide that in the estimate that these are generally so under $500,000 flat $1,500 Yes. Cost. Um, and this is, uh, I think this is important to, I mean, you, you or who I use, I personally use for, for my studies as, as you know and have for years. But, um, I’ve, I’ve heard of many cost segregation companies out there that that will charge people, you know, three to $5,000 for just a single family house. Now that, that is a tax write off to the, the study itself. Um, but still that, that seems a little bit overkill. So <laugh>, I think that’s much more reasonable. Is
Steve
It, it wouldn’t make sense. There’s there at a half million dollars and under to pay that kind of money for a study. I mean, I would never do that. It doesn’t make any sense to do that. I mean I, I I, that’s why we try to price these as reasonable as we can. So you can do the residential, the smaller residentials and, and if someone’s got a house that even, you know, 60 or 70,000, you know, then there are a few of those still out there. Not very many. But if, if there are, it may or may not make sense. Again, that’s why we do the estimate to take a look at what, what kind of benefit are we gonna get? How can you use it and take a look? What’s my cost and what’s my benefit? Does it make sense? And then you and your c p a can make that decision based on your personal plans, what you plan to do, hold it or sell it or, or whatever you wanna do with it.
Zach
So if you <crosstalk> another
Steve
Thing, another thing to, to, to discuss you, you’re talking about, I just wanna get into it for a minute. If, if you’ve got that window between July of 2017 and December 31st, 2022, so we’re in the 80% now ’cause we’re in 2023. But it, it, it’s based on the date in service. So if you bought it in 2018 and haven’t done a EC study, you you can still do that. It’s based on when you put it in, placed in service, not when we did the study. So people that have properties they’ve owned for a few years, they should take advantage of the a hundred percent. ’cause that doesn’t go away for them. It’s still there because they bought prior, they bought between that window of July of 2017 and December 31st, 2022, they still get the a hundred percent bonus.
Zach
Can we talk about that a little bit more in, in detail? Detail? Can you run through an example though? Because, so basically what you’re saying is that if someone that bought a property and, and the reason it’s 2017 is because this was and part of the, um, 2017 tax tax act that was put into play, but, um, okay, so someone bought a property in later part of 2017 or 2018 or 2019, whatever the case is, and they’ve just been taking normal depreciation on it. They haven’t taken accelerated depreciation. Maybe, you know, this is the first year that they’re really wanting to be aggressive and try to qualify for repro and, and offset some of their active income because they previously didn’t qualify. I mean, what does that, what does that look like? Does that mean because I bought a property in 2019, does that mean I have to go back and amend 2019 taxes? Am I just doing a study this year? Yeah. Like how does that work? Can you, can you clarify more? Well,
Steve
Without jumping into the weeds of it’s being the accountant, basically there’s a form called 31 15, which is changing accounting methods. You don’t have to amend your return ’cause you’re gonna take it this year or 2022 or 2023, but you’re gonna get the a hundred percent benefit because it went in service prior to 2023 and after July of 2017. So you don’t have, you’re not amending prior returns, you’re just going to take the benefit on this return. And they, it is called a change in accounting methods, which, which the C P A should be familiar with. It’s a form 31 15 we’ve done it on, on, uh, some of your stuff, Zach, that you’d purchased before We, that you before we did the, if you buy it now in 2023 or 2022 and it’s not on the depreciation schedule already, then there’s nothing to change. But if you’ve had a property for five or six years and you’ve got an active depreciation schedule, we’re gonna change that depreciation schedule your C p a files, the 31 15 with your taxes to changing accounting methods for that particular property. Make sense?
Adam
Yeah. So
Zach
It’s still an option. Yeah.
Steve
Yes.
Adam
So even though, you know, your five year schedule’s essentially done on those ones that you bought five years ago, you can still bring it forward.
Steve
Yeah. Because you, those remember are on a 27 and a half or 39 year schedule. Yeah. So they we’re gonna bring, even without bonus, if you bought it five years ago, that five year is gonna catch up to a hundred percent immediately without bonus depreciation. So if you bought something in 2016, for example, or early 2017, what is that six years? All your five year depreciation is gonna be bonused anyway because we’re gonna catch all of that up from 2016 to now.
Adam
Interesting. And so just in general, you know, a couple years from now, assuming it goes back to zero, does your five year stuff just depreciate 20% every year and your fifteens roughly 6% every year. Um, and that’s kind of how it moves forward as opposed to the bonus depreciation.
Steve
Yeah, you, you’ll just reclassify the asset and you’ll have, let, let, let’s just divide it down. Let’s say it’s 25%, let’s use 12 point a 5% for the 15 and 12 point a half percent for the five you’re gonna be, you’re gonna shorten that to five year and 15 year life, which gives you more depreciation annually in that case. Now hopefully they renew this and go back and keep it active, but we’ll see what happens. It’s up to Congress to do that. You know, it’s, uh, depends on who’s there.
Adam
<laugh>, has there been any discussion about it? I mean, I, I mean I, I know that it’s phasing out, but I haven’t heard any, uh, rumblings about renew.
Steve
You get opinions, but, you know, no, I, I wouldn’t, uh, just opinions from everybody that thinks it may just like, opinions about interest rates or anything else, you know, um, <crosstalk> also of an older property. If you think about it, if you bought a property in 2018 with all this crazy inflation we’ve had on real estate, for example, you’re, and your, and in increase in rents, the cash flow on those properties are probably pretty good today with what you’ve purchased for what you bought it for, plus the interest rate, you’re probably paying on it as well. So doing a cost thing on that, just offset this gain you’re gonna have on your cash flow, which should be substantial. Uh, I would think ba based on those factors.
Zach
So that falls into the classification of yeah, if you like, when does it make sense? And if you have positive cashflow, you’re paying taxes on, uh, you know, maybe this is one way to, to combat that. Um, but generally speaking, I believe on new construction, you, you do get more attractive, uh, cost segregation study, right? You get more depreciated. Is that, I I feel like that’s
Steve
<crosstalk> No, not necessarily. No. It just depends on the type of building and the structure. ’cause it, it, they’re all built, you know, kind of the same way, you know, go, like something built in the twenties maybe it’s different, but I mean, they’re probably built pretty close to the, you know, the, the same way. Uh, so I would think new construction versus existing is probably gonna be in the same category close to it. If you take a look at yours last year, Zach, those were not new construction and the, the numbers came back really nice on those. I mean, and just 40% probably. No, I won’t even to count on 40%. If we can get there, we will. Uh, but, uh, I’d say probably just acro run of the mill, 25 to 35 is probably a, maybe an average of 30 is a good number to try to count on. And, ’cause I don’t want somebody to think I’m getting 40, we come back at 27%, which is still good. But I I I, I don’t wanna set unrealistic expectations for folks. They can
Zach
Well run us, run us through a numeric example. Maybe let’s do this. I was gonna pull up a report. I just found one of the recent reports from this last year, but then I realized it was 74 pages long <laugh>. Um, and I thought that maybe that that’d just be, obviously I’m not the one read, like this is what the engineer, um, produced that all I’m import, all I’m paying attention to is like, what is the depreciable amount? And then here you go, c p a, um, scroll is
Adam
The last page. <laugh>.
Zach
Yeah. So, uh, that would probably be just, uh, people’s eyes would glaze over if we looked at that, but I may, let’s, let’s use an example. Let’s, let’s go through a real world example from our inventory sheet, Adam. Let’s choose one. Uh, let’s choose a new construction in Florida. I, I do think new construction, you’d get a little bit better of a, uh, there’s just, you know, it’s branding construction based on, as you mentioned, the, the, how it’s built. But you get like a full appreciable value there. Um, let’s, let’s choose a property on, on our inventory list, Adam, and go through what we would expect numbers, just, just so someone can have something tangible, conceptualize, like, would this actually make sense for me? And then we’ll even go through and say, okay, how much of an actual, let’s say assume they’re taking the active depreciation on it, um, as a real estate pro, what are they, like, what does that mean for their tax liability?
Steve
Okay.
Adam
All right. So here’s, here’s one we have, it’s a new build in Lehigh. It’s three 20 two’s 300 and call it 320,000 rents. 26 50. So let’s see. So now we go down to our,
Zach
Those are some nice interior photos. I think I wanna buy one of those. Adam <laugh>.
Adam
All right, so what I’ll do, what all do you need here, Steve?
Steve
Well, I’m gonna look at the, the, the, the total cost, what, what, what it sells for on the, so, so if they ed it for 3 21 9, we’re going use that. We’re gonna take 15% for land. Typically. Let,
Zach
Let me ask real quick. If we know that land is not 15%, like if 15% is an assumption, if you don’t, but if land land is less than that, then you do wanna take land. Like you do want to take less than that, right? Yeah, we
Steve
Just wanna justify it. I’ve not say I, I’ll usually go to the CAD and see what the CAD shows. Uh, if it’s new construction, they don’t have a ratio between land and value. Uh, but if they do, I take a look at their ratio because in this case, they may have it on the, on the, if it’s a couple years old, maybe they’ve got it on the rolls that
Zach
This lot is $15,000. So let’s, that’s
Steve
What we’d use then. If they paid 15,000, we we do something to document, we’d use 15,000 in that. Alright,
Zach
3 | 29:51
So three we’ll call it, we’ll just do
Adam
Say 300. Yeah. For the improvement.
Zach
Well, let’s, let’s do it exactly as we can. So let’s say 3, 3 22 is a purchase price. Okay? Right. And, and because we’re, we want to be, you know, as specific, a little bit of variance can make a big difference in the grand scheme of things. So 3 22, um, minus 15,000 mm-hmm.
Steve
<affirmative>.
Zach
And that’s, that’s 3 0 7. 3 0 7,
Steve
Yeah.
Zach
Okay. So that’s, that’s the improvement value. And so you would, what would you expect your study to come in as an estimate on this
Steve
Estimate? Probably 70,000. So 25% of that would be 75,000. So I, I, I’d use 70 to be conservative, and I’m hoping we come back at closer to 90 when, when we do the final study. But let, let’s use even 70,000, um, uh, of, of accelerated depreciation. That, and you’re gonna take 80% of that since that’s 56,000 you’re gonna get this year. And if you take 70 from 300, you’ve got two 30 left. So you’re getting, uh, two 30, right about 27.5. You’re still getting 8,300, roughly $8,400 a year in your normal 27 half year depreciation going forward.
Zach
Yeah. That’s, that’s important for people to realize. It’s just like how powerful normal depreciation is. Like Yeah. Eight. And just in that scenario, like if, if you just took 3 22 and divided it by 27.5, well, I guess I, I did that incorrectly ’cause I needed to do not the, I needed to do 3, 3 7, 3 0 7.
Steve
So you’re,
Adam
You’re lowering your yearly depreciation by about $3,000 to save $56,000 this year
Steve
From 11 to about 84. Yeah. You normally get about 11,000, now you’re getting 84, 8400.
Zach
So $11,000 depreciation per year. That’s huge, right? Mm-hmm. <affirmative>, that’s, that’s pretty dramatic. Like depreciation is a big, big deal here. Um, and mm-hmm. <affirmative> for someone who hasn’t calculated that out, like the first time I saw like, oh, this is, this is a loss I’m taking every single year, but, okay, so in this case, $70,000, you take 80% of that you said, which was 56,000. Uh, I’m, I’m trusting your math here, Steve. So $56,000 of a lost year. One, that means if you made 56, if you bought this one property, you still get the rest in the normal depreciation schedule. But you could take a, if you bought this property this year and rented it out, you could take $56,000 in accelerated losses against, against your active income. Let’s assume you’re in the 37% tax bracket. Let’s assume you live in a state that doesn’t have any state income tax. If you do have state income tax and you factor that in, but $56,000, um, you know, let’s assume you’re at 37% tax bracket, that’s an actual tax savings that you would otherwise pay of over $20,000. Am I doing my math right here?
Steve
Roughly?
Zach
Mm-hmm. <affirmative>. So that means that you can either, like by doing accelerated depreciation and a cost like study by buying this property, you have an actual tangible year one tax savings of over $20,000 that could be an additional down payment on another house, which it should be. And now you’re actually, instead of giving it to Uncle Sam, pick you actually earning a return on that investment and buying another investment that then has another, uh, taxable benefit to it. Right? I mean, is this how, this is how people build wealth in this compounds really quickly, is why paying less taxes, investing that money, and, you know, building more taxable, um, losses here, or acquiring more taxable losses that compounds time and time again. But Adam, what was the down payment on this property? I just wanna put this in perspective.
Adam
Uh, it was right around 80.
Zach
Okay. So you reduce that. That’s, but that’s, if you’re putting 25% down Yeah, we had,
Adam
Yeah, we have everything at 25% now. So,
Zach
So let’s just assume 3 22 at 0.2 20%, that’s $64,000. You can reduce, like you basically, if you ran an accelerated depreciation, if you bought this house with 65 K out of pocket using 20% down, you almost get 30% of that back immediately, like year one if you did accelerated depreciation mm-hmm. <affirmative>, um, just, just from, from doing that, right? But that’s, this is, this is big stuff to think about. And I mean, for stuff we’re personally doing,
Steve
Yeah, it comes down to each individual situation. I mean, that’s why we’d like to get the C p A involved so they can take a look at their tax planning and you know, what their income looks like if they’re under the one 50, where they could take 25 towards their, uh, ordinary income as well. Or if they own multiple properties and they can qualify as a real estate professional that, that they can use it against all of it against their W two income, which is huge.
Zach
Just clarify for me, I know you mentioned this, I probably missed it though. So if someone bought a house last year in 2022 or 2021 when bonus depreciation was still at a hundred percent this year it’s at 80. If they do the study this year, are they taking it at 80% or is it,
Steve
If they bought it in 2022, they’re taking it at a hundred percent. ’cause it’s the date it goes into service. And if they haven’t filed their 22 taxes and they’re on extension like I am, uh, I always am, I do it every year on extension. I I you have until October 15th, as long as the study’s done prior to October 15th, you’re, you’re able to, uh, take, take it for 2022.
Adam
Is there a limit to how far back you can go? I mean, I know in the terms of the bonus it’s 2017, but, you know, is there a limit to when you can actually bring your study in? I mean, if you’ve had something that for 10, 11 years, like
Steve
Yeah, there, there, there’s sort of, imagine if you’ve had a 15 plus years, it may or may not make sense because you’ve already taken, you know, basically over half your depreciation on a 27 minute year and you’re not quite there on a 39 year. But, so it just depends. That’s where the estimate really comes into play. Could we take into account what you’ve taken from your depreciation schedule, see what’s remaining and how much can we bring forward? And then does that make sense based on the cost of the study? So by and large, if you’ve had a 15 years plus, it may or may not make sense to do it.
Zach
And so in my mind it’s kinda like, why would you not get an estimate at least to know what your options are, right? Yeah. I mean that’s,
Steve
That’s where it starts. Yes. And then
Zach
You can work with your C P A to see with like the impact would be, but yeah, if you have, if you own property and you have taxable income on those, on those properties, maybe it, this might be something to, to consider, to consider doing. Um, and if I understand it correctly on like a, with a lot of like the commercial assets or these larger assets, like there is a specific study with the, you’re actually walking the property for each one of those. Um, but sometimes on like the sub $500,000 single family, I, I believe Steve, it’s just where you, you kind of take some data gathered from the sale, like you’re not actually walking the property. Is that, is that accurate? Like, you want me do that?
Steve
We do that through an empirical modeling, uh, program. We take all the thousands of cost segregations that have been done over the years. We model that property against that and it’s defendable before the i r s to be able to defend that. Uh, that’s the basis we use to come up with the accelerated components of the, the property.
Zach
Have you ever had to defend one of these to the I R s?
Steve
I haven’t. Uh, in my, my time in the business, I haven’t had one yet. Uh, and a lot of people think that this is some sort of a gimmick that causes the i r s. It’s a red flag where they they flag your return and they wanna audit you. It, it’s, it’s, as long as you follow the IRS guideline guidelines there, there’s, it’s, it’s no different than any other tax strategy that you use. ’cause it, it’s allowed by the i r s to use this on your real, real on your properties that you own. So th there, there’s, I haven’t had one, but, uh, the engineers that I work with, they’ve had some and never lo never had anything, any issues. If you do it right, there’s not any issues. If you try to take a piece of property and say it’s 60% of it’s coming forward this year, I think you’re in in for some trouble. But as, as long as you’re doing it proper and doing it right, and that’s why it’s important that you do an engineered study and, and, and not just try to do that yourself. And I guess people could, and I’ve heard of people doing that where they just go take and divide the property up the way they wanna divide it up. And I think you’re asking for trouble if you do that.
Adam
So when you, you’re talking about, you know, not doing it yourself, how do you know if you have somebody who’s a legitimate person? I mean, obviously you’ve been doing this, but you know, let’s say I got a cost sex study done a year or two years ago whenever it was, and now I start to wonder, was it done? Maybe they came back at 50% and now I start to wonder, was that wrong? You know, is something wrong there? How do you vet out? Um, cost people
Steve
References is what I do. I, I, I furnish all the references anyone wants to have to talk to, talk to people that I’ve done studies for. Uh, and I, I think, and if someone honestly came back at 50%, that would be suspect to me. Um, I’d, I’d want to actually see some of their studies and talk to some of their clients and, and about what they’ve done over the past, how long they’ve been in business, things of that nature.
Zach
Steve, anything else we need to know about cost segregation? We know that the, the legislation is changing. Um, this is something that could be applicable to anyone regardless if you’re real estate professional or not. Just knowing like what it is and, and how to use it and seeing if it factors into your, to your investment strategy and plan. And, uh, hopefully at this point, if anyone’s been following us by now for even a short period of time, they understand that we’re very passionate about educating people on the tax benefits, right? Of real estate because that is one of the biggest benefits of investing in real estate that know their asset class has. Um,
Steve
That’s why investment in real estate, it’s one of the best investments out there for the tax purposes and the cash flow, the appreciation, all the things that we know, the real estate’s brand even in this market is still, I think, one of the best investments to be involved in. The main thing probably for your, your list of clients that purchased in the past, anyone that has bought since 2000 anyway in the last 10 years, they really should explore this because there’s bonus depreciation. There’s also the person that’s owned it for, for 10, 12 years that, that they’re gonna catch up most of their depreciation even without bonus. So they should take a look at their portfolio and get an estimate on what you have as if it makes sense for you.
Zach
Yeah, I mean if you look at this and, and just, it’s, it’s extremely clear to me, and I know that when I first kind of learned about this years ago, it was like it was a game changer. It’s an eye-opener for me of, of just seeing how the wealthy build wealth in, in real estate and then compound that over year after year. And, uh, it’s, it’s really a combination of taking full advantage of the tax benefits and applying these things. This like doing a cost segregation study in combination with 10 31 just perpetually, you know, is a way to pretty much reinvest your capital. Even if you do sell the property, you have to pay taxes at some point in time in the future, you would’ve had all this time of investing money and earning and, and acquiring more assets and acquiring more tax benefits and earning income on it and reinvesting those and compounding that you would’ve had all that time versus just paying money to, to Uncle Sam that you never see back, right? Yeah.
Steve
Time value of money makes sense. And that’s what cost segregation does for you. You’re able to take that cash today that you normally send out to Washington and, and, and, uh, or wherever you send it to, and then, and you would be able to use the money today, like you mentioned, uh, 20, 30, 20,000 or so that you could use towards a down payment on, on another property.
Zach
And it’s not like I’m anti-government. I don’t want to be paying taxes here, right? Like I, I feel that the taxes are necessary and important and they have their place, but understand that the i r s people, they put these things in place, um, because they want to incentivize economic development, right? Like as real estate investors, we are providing a necessity for people housing and business opportunities or whatever the, what you’re, depending on the asset class that you’re investing in. Like we are adding economic value and adding value to society in general. And we’re incentivized to do that, um, through the I R S X code. And so that’s the way you really should look at this, um, as this is your right and a benefit to you investing in an asset class that betters our society. Yeah. Um, and so I, I think that’s just important to think this isn’t about like, oh, we’re a bunch of, you know, snobby real estate investors to see how we can not, not pay taxes and scapegoat the rules. This is, this is working within the rules and just being an educated investor, but also creating businesses and wealth through that. So I just wanted to end with that. Yeah, it makes sense.
Adam
And someday we’ll have a rent to retirement event where anybody who hasn’t paid taxes because of real estate can get together and just, uh, chuckle together and <laugh> talk, tell, tell tax stories of how
Zach
Copi against the US the government. Uh, yeah.
Adam
Makes sense. Alright, well Steve, thank you so much for joining us today. Really appreciate it. If you want to contact Steve, head over to Rent to Retirement and you’ll see, uh, the meet the team page. Steve’s on there as Zach said, he uses him for his stuff. So you know, you can get ahold of Steve w right through the rent to retirement.com website. Just go to the, uh, meet the team page, uh, if you have any, uh, interest in knowing what markets to invest in in 2023 and would like a copy of Zach’s report, email over to [email protected] and ask for the top 20 markets to invest in, in 2023. And we will get that sent over to you. Please leave us a review on whatever podcast platform you use so other people can see that our show is something that is helping you in your real estate journey. Appreciate the time you’re spending, educating yourself on your real estate journey, and we’ll talk to you on the next episode.
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