Cost Segregation Techniques You Should Apply

What I’m going to do today is I’m going to bring on someone that I’ve been using in my own real estate investing to help keep my taxes as low as possible. This individual, his name is Eric Oliver. Today we’re going to talk about how you can use cost segregation on your properties—many different types of properties, your residential real estate—to reduce your income taxes. Eric, how are you doing?

Eric: Good. How are you, Clint?

Clint: I’m doing well. You’re the managing director of Cost Seg Authority, right?

Eric: Yeah, correct.

Clint: How did you fall into that position?

Eric: My degree’s in accounting. I’m actually not a CPA myself, but my degree is in accounting, so numbers have always come easy. As an investor, I just kind of fell into it. I actually did cost segregation on one of my properties and realized the value of it. I realized it was an underutilized resource out there, so I kind of fell into it that way.

Clint: Wow. All right. We’ve been talking about this. I’m sure some people watching right now are going, what the hell is Clint talking about a cost seg? Can you explain to people what cost segregation is and how it works?

Eric: Sure. Cost segregation, really, is just accelerated depreciation. We all get into real estate and one of the benefits of getting into real estate is being able to depreciate our assets. Residential assets typically depreciate over 27½ years, for commercial it’s over 39 years. Cost segregation is just accelerating those deductions instead of taking 1/27 over the next 27½ years. What if I could get 30% of those deductions in year one?

The way it’s done is through a cost segregation study. We’re basically segregating your purchase price into different buckets. You’ve got your 5-year, 7-year, and 15-year assets. The IRS, for example, says carpet should be depreciated over 5 years instead of 27½ years, which makes sense, Clint. Carpet doesn’t last 27½ years. Doing a cost seg, we put these out, or we allocate those costs into different buckets, which allows us to front load essentially our depreciation and take the deductions much sooner than 27½ or 39 years.

Clint: To break this down, because you’re at this higher level, what we’re saying is that when you look at a house, everyone just says, oh, it’s just a property. It’s one structure. You depreciate it over 27 years. It’s all on the same schedule. But in reality, there are things in your house that wear out much sooner. It’s like a car. Your car may last for 30 years, but the tires need to be replaced in five. The oil needs to be changed every year. Your transmission is going to go out. So you’re taking those individual components, you’re saying rather, the fact that this thing could last 30 years, let’s look at what the reality is, then speed up the deductions for people.

Eric: Yup, that’s exactly right. When you’re thinking about buying a house, for example, or let’s say a residential rental, single family, you’re not just buying the walls and the land. You’re also buying some appliances, some countertops and cabinets. Again, the IRS says that stuff doesn’t last 27½ years. So by allocating cost to those different categories, it allows you to accelerate those deductions.

Clint: Let’s get into some real numbers here. Examples of what this means to the viewer right now, who’s a real estate investor, and they have residential real estate. Because I think some people have heard about this in the commercial context, but for my client or people who watch this on my channel, residential is big. I mean, I have a lot of residential. How does that work? Can you give me an example of that?

Eric: Yeah. There’s kind of a misconception out there that in the past, cost segregation was only for really large commercial properties. A couple of reasons for that. One is, the fees were a lot higher. You’re talking $20,000 to get one of these studies done so you better have a million dollar asset to absorb those costs.

Nowadays, with some of the laws that have been passed, there’s something called bonus depreciation that was part of the Tax Cuts and Jobs Act that really put what we do on steroids. The benefits are bigger, the fees are less, and now it absolutely applies to folks who own residential rentals.

Just to give you a quick example, let’s say you buy a $200,000 single family home. You take the land value out of that because land is not depreciable. Let’s say 20%, so you’re at $160,000 on a depreciable basis. A typical cost segregation study is going to land somewhere around 30% segregation, which means you’re going to have a $45,000 deduction in year one. You take that times your tax bracket. If you’re in a 30% tax bracket times $45,000, that’s a $15,000 tax savings in year one on a study that might cost you $2,200 to complete the study.

Clint: Wow.

Eric: It definitely applies to the smaller investor, those who are investing in single family rental at this stage.

Clint: What you just said, that’s one property. But if I had five properties, now we’re $225,000 in deductions. Those are real numbers now that we’re looking at as far as what you can be writing off.

Eric: Absolutely. Like I mentioned, the bonus depreciation, we’re creating deductions now that people can’t utilize. One of the nice things is that if you can’t utilize those deductions, they do carry forward. You never lose them. The deductions are just so massive right now, with the tax law the way it is.

It’s all part of the Tax Cuts and Jobs Act, like I mentioned, with Trump, and as you guys know, he’s a real estate investor. He doesn’t want to show his tax return for the reason he’s not paying any taxes. It’s because he owns real estate. He’s doing cost segregation. He’s offsetting his income by doing cost segregation and creating these massive deductions on his real estate that offsets the income.

Clint: A question I get a lot from individuals is, do you have to buy the property brand new to take advantage of this? Can I have owned it for 3 years or even 10 years?

Eric: The nice thing is the IRS actually allows you to go back and do a study you’ve owned, in prior years that have been on previous tax returns without amending any tax returns. There’s a form, a 3115 tax form. Basically, that form tells the IRS, hey, I’ve been taking my straight line deductions over the last three or four years, I’m now accelerating those deductions. The difference between those two numbers is you get to drop on your current tax return without amending any returns.

Oftentimes, like you were talking about the single family rentals, those are great candidates if you’ve owned it for four or five years, because you’re getting four or five years worth of missed depreciation, and dropping it on your current tax return without, like I said, having to amend anything.

Clint: So you’re going back and you’re saying, hey, for the past five years, I’ve been screwing it up because I didn’t know Eric. I will take all that now.

Eric: That’s exactly right. It’s funny because actually, on that tax form we check a box. It says impermissible method to permissible, which basically is telling the IRS I’ve been doing it wrong and I want to fix it now. The IRS isn’t going to tell you you’re doing it wrong and say, hey, you haven’t been taking enough depreciation. They’re not going to come tell you that. It’s essentially what you’re doing. You’re depreciating your carpet, for example, over 27½ years, and the IRS says that’s a 5-year asset. You’re basically fixing your depreciation by submitting that form. Like I said, the nice thing is it allows you to do that without having to amend any returns.

Clint: Yeah. I’ve seen several comments from CPAs, tax attorneys, and read articles, where they take the position. You’re required to do this on your residential real estate, because those are different depreciable assets. You can’t take them over 27½ years, and you shouldn’t be doing it.

Eric: Absolutely. Like I said, you’re doing it wrong if you’re just taking a building and depreciating the whole thing over 27½ or 39 years. Technically, that’s wrong because when you bought that asset, you bought carpet, you bought auxiliary lighting, you bought a driveway, you bought landscaping. All that stuff should be depreciated over the correct asset life. That’s what a cost segregation study does is put those into the correct asset life and enhance that allows you to accelerate those deductions.

Clint: Now, I just heard some of the things that you guys look at when you’re going through that in order to create these deductions. You talked about the components. I heard you say landscaping, carpet. How about countertops?

Eric: Countertops. Yup.

Clint: Okay. What are some of the other ones that we will look at?

Eric: Your five-year assets are a lot of your interior stuff. Things like countertops, cabinets, flooring, window coverings. Interestingly enough, the electrical going to your appliances. A lot of times people think well, my washer and dryer is a five-year asset, but when you have a cost segregation study, then we actually take the electrical work going into your laundry room, because the only reason you’ve got electrical work going into your laundry room is for a five-year asset. The IRS says, well, that electrical work can be associated with that five-year asset and you can depreciate that electrical work over five years.

Same thing when you think about multifamily. Think of how many appliances. How much of the condo going into the unit is for personal property, things like ceiling fans, garbage disposals, washers and dryers, dishwashers. When you start allocating that electrical work plus the things like washers and dryers, it makes a huge difference.

Clint: Oh yeah, those add up. The thing about this that I hope people understand is that when we’re talking about creating these losses, they’re going to flow down on your tax return. They’re going to be typically passive losses that you can use to offset your passive income that comes from your rents, from all your properties.

If you qualify as a real estate professional, or even the short-term rental game, you can actually take these losses. If you meet the qualifications, material participation—you can watch my videos on that; at the end of the video here, I’ll have links to those—then you can use these losses to offset your active income as well. Correct?

Eric: Correct. It’s a great opportunity. We see that a lot with professionals. We work with a lot of dentists or doctors. They’ve got high W-2 income, but they don’t really classify themselves as real estate professionals. Oftentimes, they’ll either have their spouse qualify and manage the properties, or they’ll get into the short-term rentals, like you mentioned. All of a sudden, we do a cost segregation study on it and we create a $300,000 deduction that goes to offset their W-2 doctor income.

Clint: What I tell people is that it becomes your down payment. I mean, you put money in to buy this property, the IRS is giving you the money right back, like properties for free then.

Eric: It is, especially if you leverage it with debt. I ran some analysis the other day for a client who was looking at some syndication, and they wanted to share with their investor. If you give us $100,000 to put towards this asset, I think it was about $117,000 of depreciation. They were getting back more than what they were putting into the project because they were leveraging it with debt. Like you said, with the tax law, the way it is now, you’re oftentimes getting your down payment back or a good portion of it back by doing the cost segregation.

Clint: That’s what I like about this technique is because there are a lot of nuances. For example, before we started, we were discussing one of my clients, who has zero taxable income because he has so much real estate. It wipes him off. He’s like his own Trump, $30 million in real estate. But I brought up the fact that you still may want to do cost segregation and he said, well, why? I’m just going to create more deductions that I can’t use. But then you and I were talking about, yeah, but as I told him, when you sell that one of those properties, like you said, you’re going to sell in the future. If you’re carrying forward $300,000 in losses, when you sell that property, you have $300,000 in gain, tax free, right?

Eric: Yup. That carry forward loss that you’ve got will unlock with up to the amount of the gain, and can be used to offset those capital gains taxes.

Clint: That’s like doing a 1031 then. It’s kind of like, why wouldn’t you do this?

Eric: A great question. There are not a lot of reasons why you wouldn’t. One of the reasons is, if you are in a passive loss issue where you’re not a real estate professional, or you’ve got a huge carry forward that you’ve already got, then it doesn’t make sense, obviously, to do a cost segregation study.

Other than that, I can’t think of a reason why you wouldn’t want your deduction now, especially when you think about inflation, like give me my dollar today. My dollar today is worth more than $1 tomorrow with the current rate of inflation, let alone 27½ years from now. So give me my deductions today, as opposed to letting the IRS hold on to those.

Clint: Your dollar on January 1st was worth more than it is today.

Eric: Right.

Clint: One of the things that really intrigued me when you and I were talking last week, was that partial asset disposition, PAD or maybe the acronym for it. Can you explain that? Because when I started talking to some of my clients about this, their eyes just got this big. They were just shocked to hear how they could really accelerate their deductions when they’re buying a property that they intend to do some rehab work on.

Eric: The partial asset disposition is especially for multifamily when you’re constantly updating carpet or countertops. Basically what it is when you do a cost segregation study, we’re going to put all those different assets. We’re going to line item all those different assets. When you dispose of your countertops, for example, and you’ve only had it for three years but they’re a five-year asset, you have remaining book value that you can write off in the current year as an expense. You’re basically telling the IRS, hey, I’m retiring this asset and it has zero value now.

You get to write that off as an expense. Then you take the cost of your new countertops and you add that as a line item. It’ll say leasehold improvement, what-have-you. Add that as a line item on your depreciation schedule. If you don’t do cost segregation, it’s really hard to pull those things out that you dispose of.

Oftentimes the big ones are for example, a roof. When we do a cost segregation study, we put a value to that roof. You may not have the roof for the full life of the asset. We replace our roofs quite often. When you replace the roof, there’s still a remaining book value that you get to write off as an expense in the current year. That’s a big deduction. You get to write that off. No recapture and then you start depreciating your new roof starting the day that you put the new roof on.

We see depreciation schedules all the time, where they just have the building, then underneath that it says, roof $100,000, improvements $200,000. Well, in that building, you’re still depreciating the old roof. The old roof is gone. It’s disposed of, so you should write that off as an expense. It’s an added benefit of having the cost segregation study that is having these line items so that when you dispose of them, you can write them off and take advantage of those deductions.

Clint: Well, not only do you get to write that off, you also get to write off the cost of the demolition of that asset as well. I understand.

Eric: Correct.

Clint: Say I didn’t know about this. Last year, I did some of this work. I bought a property and I realized I needed to put on a new roof. I remodeled the kitchen and took out all the cabinets and the countertops. My CPA didn’t do it, can I go back and capture this?

Eric: On the partial asset disposition, you probably can’t. It’s a little bit harder. It has to be expensed in the year that you dispose of it. If you disposed of it last year and you didn’t expense it last year, it’s going to be hard to go back and take advantage of that. And definitely could go back and still do the cost segregation, but the partial asset disposition is a little trickier in previous years.

Clint: Okay. What I should be then looking at is if, say I bought a house, it’s 18 years old, and I know that I’m going to have to rehab it. Get rid of the roof and stuff like that. I’ve only owned it for three months. I go in, I start doing this work. Does that qualify?

Eric: Yeah. The big thing for the partial asset disposition is putting it into service. We always recommend, if you’re in that situation, buy the asset. You may already have tenants in there when you bought it, let their lease run up. Once they’re out, those three months that they were in there, the property was in-service, you were using it for its intended use or purpose. So you get to depreciate the old cabinets that were in there.

We put a value on those. Three months later when their lease is up, they leave. You put the new cabinets in. You write off the remaining basis of the old cabinets, then you get to do a cost segregation or accelerated depreciation on the new cabinets. You’re getting two sets of cabinets by putting that building into service. Now if you buy it and it’s vacant, and then you go in, put in new cabinets, no, that doesn’t work, but always try to get the asset into service before your renovations and have a cost segregation study done in order to maximize these deductions.

Clint: Okay, so I’m curious as to how you interpret in-service. The way I interpret in-service is that I’ve listed that property for rent. As long as I can show that I’m actively trying to rent out the property, even though I don’t have anyone in the property that’s in-service. I determined that no one wants to rent my property because it’s got problems, then I go in to do it. Would you say that would qualify? Would you feel comfortable there?

Eric: I would feel comfortable there. We see all different types. It’s kind of a gray area that all CPAs have their own interpretation of that law. My understanding of the law is if it’s available for its intended use or purpose. It doesn’t mean you have to have renters there. If it’s available for rent but you just can’t rent it out, you’ve listed it, you’ve got people out there trying to find renters but you can’t, I would agree with you. That is technically in-service.

Clint: Yeah, and you just have to be able to back it up and show if you were audited that yes, you were trying to rent it. I had one person come to me. They said, well, I don’t want anybody to come in. It’s going to screw up my remodel so I’m going to list this property for $18,000 a month. The average rental is $1500 in that area.

Eric: That’s not going to fly. The IRS is always looking at what is your intent? If you can back up that intent with documentation, you show that you had it listed, you have a listing agent or something along those lines, I think you’re fine. It has to be within reason, I should say.

Clint: Absolutely. Are there any problems when it comes to holding properties in LLCs and going through a cost seg?

Eric: No, not at all. The entity structure doesn’t affect the cost seg one bit. We do the cost segregation study at the entity level. Typically if you’ve got partners, it’ll all flow through the K-1s onto your personal tax return. The entity structure doesn’t affect the cost.

Clint: How many of these do you do a year?

Eric: We do a couple of thousands every year. We stay busy. We do work in all 50 states, so we’re traveling quite a bit. The tax law, like I mentioned earlier, puts this stuff on steroids. If you’re paying taxes and you own real estate, you should definitely have a cost segregation company look at it.

Most companies will do a free benefit analysis where they look at your property and say, hey, we expect to get you this much additional deduction. Here’s what our fee would be. Do you want to do it before you ever engage? If you’re paying taxes and you’re in real estate, definitely look at possibly getting some cost segregation work done, because it’s a huge, huge deduction that’s available to you if you’re aware of it and take advantage of it.

Clint: We were talking about the bonus depreciation earlier. This is an opportunity for you to compress all that down and take it in year one. But there’s a timeframe on that, is there not?

Eric: Yeah, there is. The bonus depreciation right now is 100%. What that means, Clint, for the viewers is basically those 5-, 7-, and 15-year assets, instead of depreciating my landscaping over 15 years, I get to take 100% of that in year one, which is just crazy. You’re taking your 5-, 7-, and 15-year assets all in year one.

Now, the 100% bonus does phase out at the end of next year. Any properties purchased after December 31st of 2022, are no longer eligible for 100% bonus. Under the current law, they are still eligible for 80% bonus, then it phases out 20% every year until it’s down to zero.

There’s definitely a time crunch on this. Like I said, in order to be eligible for bonus, you have to have purchased your properties between September 27th of 2017 and December 31st of 2022. Then you’re eligible for a 100% bonus.

Clint: If you purchased them in 2016, you can still do a CASA, you can still pick up the deductions, you just don’t get the bonus.With what’s going on with the Senate Finance Committee with the current administration, and the House, the way it sits, these things can be taken away from us. That is why I’ve been telling my clients hey, you ought to seriously consider taking advantage of this while there’s that opportunity. Stack up those losses this year. Carry them forward because they may not be available next year or the year after if they go in and they try to tinker with this and change it. Would you agree or disagree with that?

Eric: Yeah, I absolutely agree. There’s a lot of uncertainty with the current political climate in terms of taxes, especially those that affect real estate investors. Take advantage of these deductions while they’re available. Like you said, in the books, you never lose them. If you end up not using them this year and you can’t absorb those deductions this year, they carry forward indefinitely.

Cost segregation is one of the few things that you can be really strategic about in terms of when you utilize those deductions. A lot of deductions, you have to use the year that the expense occurs, but cost segregation, you keep these in your back pocket and just use them as needed to offset those high income years.

Clint: I always suggest people do it because there’s such a distaste for Trump out there and hate for the man, they figure, oh, he’s going to benefit from these things. We can’t let him have anything that leaves that office. They probably want to get rid of it all. So anyway, I wouldn’t seriously consider it.

Eric: Absolutely.

Clint: All right. Well, hey, I’m going to put a link in the show notes for anyone who’s interested. In this way, they can contact you all and look at preparing a cost seg on the properties. You guys are doing evaluation before you go through all that, correct?

Eric: Absolutely. We don’t want to engage anybody if they’re not going to save significant tax dollars. We’ll run an initial benefit analysis to give you an idea of your potential tax savings, let you know when our fee would be to do the study, then you can work with your CPA from that point to determine if it makes sense or not. We’re happy to jump on a call with your CPA to walk through it. Yeah, absolutely.

Clint: That’s great. I have several clients that, after they worked with you, they came back and they said, Clint, this was the best thing. I wish I would have known about this earlier. So thanks for taking the time.

Eric: Absolutely. Thanks for the time.

Clint: All right Eric. Take care.

Eric: Thanks, Clint. Take care. Bye-bye.