SPEAKER_01 0:00

Welcome to the Real Estate Explainer Podcast, where we talk about anything and everything real estate. I'm your host, Brian Kickswell. Today we're going to be talking to Luke Weathers about cost segregation. Let's jump right into the episode.

SPEAKER_00 0:14

I'm Luke Weathers from Atlanta. I've been a realtor almost 14 years now. I love real estate, love helping people buy and sell real estate. I also love the investing side. We own a few investment properties ourselves, my wife and I. So that's a little bit about me. I'm a second generation realtor.

SPEAKER_01 0:31

And what type of real estate do you sell?

SPEAKER_00 0:33

Most of it is residential. 95% is residential. Perfect.

SPEAKER_01 0:37

And we'll just go ahead and jump in. Today's session is going to be a little bit different. It's a QA session. So question and answers. A few of the things that I want to cover are both just general questions that clients have when it comes to cost segregation, and then also some mistakes that clients make when it comes to cost segregation. So I want to treat this more like a what do you call it, like a client call? Sure. Cool. So I'll let you jump in.

SPEAKER_00 1:02

Tell me a little bit more. I know I've done some call segregations before with you, and I'm going to do some more, but I would love to be able to give my clients an idea of what is the basic overarching idea of call segregation.

SPEAKER_01 1:14

Cost segregation is we're breaking properties down into their individual cost components. So what I do when I'm looking at a property, whether it's a residential property or a strip mall or a restaurant, the first thing that I'm going to do is I'm going to walk the site. So I'm really looking to see what type of site improvements are in the property. So think landscaping, your trees, think grass, drink any shrubbery, really any items that the owner or the builder would have built or installed on the property. If it's got a 200-year oak tree, then I'm not looking at that. But if it's got some ornamental trees, it's got some landscaping that they brought in, the landscaping is going to be a short life asset. It's a 15-year asset per the IRS. Same thing with any of the site fencing, your site driveways, roads, swimming pools, tennis courts, all of that is outside of the footprint of the building itself. So instead of having a 27 and a half year depreciation schedule on a residential property or 39 years on commercial property, it's going to have a 15-year tax life. So you're depreciating that asset much faster over 15 years. And then on the interior of the property, we're looking for anything that doesn't have to do with, let's call it the maintenance and operation of the building itself. So your decorative lighting, your removable flooring covers, maybe crown molding, think about in restaurants, you're going to see the lighting, the decorative lighting, you're going to see maybe some noise canceling systems that they've installed, maybe speakers, surveillance cameras, all of those items are five-year assets. So instead of depreciating them over, like I said, a straight line method, you're pulling them forward. And because of bonus depreciation, if you wanted to, you could pull all of those items into the first year of ownership. So you're taking all of those short life assets in year number one. So it's a powerful way to accelerate depreciation to either offset taxable income, or sorry, not taxable income, but either active income or passive income. So that's what we're doing. We're breaking the building into its individual cost components.

SPEAKER_00 3:30

Cool. So tell me a little bit in terms of residential versus commercial. Is there much difference? Are you doing the exact same thing just for a residential home versus a commercial building?

SPEAKER_01 3:41

We are. So think it's construction cost estimating essentially, is what we're doing. We're going in and we're trying to identify the cost of the assets that are in the building. And then what we're doing is we're allocating it to whatever the purchase price was or the cost basis of it. So if you bought a residential property for a million dollars, everything is getting squeezed into that million dollar basis.

SPEAKER_00 4:06

Okay. So do you have any idea or any thoughts, I should say, on if someone says, hey, is it really worth it for me to do a residential, maybe a $300,000, $400,000, $500,000 home?

SPEAKER_01 4:16

Yeah, maybe about five or 10 years ago, the answer would have been no. Okay. Uh cost segregation studies historically have been very expensive because you have to have an engineer engineer the study getting all the data, doing site inspections. It just was expensive. But nowadays, we can do residential studies for under $1,000 or right around $1,000, depending on where the property is located. So the first thing that I recommend on a smaller residential property is just to get a free estimate of benefit. It is a little bit of a heavy lift on my side because what I'm having my team do is I'm having them go and pull county records, look at what do we think the land allocation is going to be, because you've got to back out the land allocation. And then you have your basis for the property, and then we'll work up that estimate of benefit and then take it back to your financial advisor, your CPA, whoever it is. And then if you see that the return on investment's there, then absolutely move forward. Typically, we're seeing at least 10x return or 10 times your return on investment.

SPEAKER_00 5:22

Cool. Okay, tell me a little bit about if we were doing residential, does it matter in terms of the age of the house or even in commercial?

SPEAKER_01 5:31

Yeah. So in 2017, they changed the tax laws. And if a property is used when you acquire it, you can still do a cost segregation study on it. You can take the bonus depreciation on the property as well. So when they changed the tax laws, it really opened up the gates for real estate investors, whether they're buying a hundred-year-old property in the Northeast or they're buying a three-year-old property in Arizona. So they can absolutely do a cost segregation study on it. What we have to do then is when I'm looking at the asset, I have to figure out the RC and L D number. So the replacement cost new, less depreciation. So that less depreciation piece is critical because we're trying to figure out the physical or functional obsolescence on that asset, meaning if it's got a, I don't know, old wall radiator that's not being used, then I'm not going to give value to that item. Or if I see that the roof is 15 years old and we know that we have to replace it in the next five years, it's not going to get 100% of the value. We're going to hit it for a depreciation number. So that's how we handle used property.

SPEAKER_00 6:46

Makes sense. Okay, cool. Question I have is does it matter if someone's self-employed, if they're W-2, is it going to make a difference? I know there's benefits to real estate professionals like myself, but what are the benefits to someone that says, hey, I've got a W-2 job?

SPEAKER_01 7:01

Yeah, it's a good question. And I talk to clients about this all the time. And that is absolutely why I recommend getting the estimated benefit up front. There's no cost. Take it back to your tax prepare, review it with them. If it makes sense for your specific scenario, then move forward. The what you're looking at is you have two buckets of income. One is active income, and then the other is passive income. So historically, rental properties have been, it's passive in nature. So all of the income that you're generating from your rental properties is passive. So you would have to have enough passive income for to generate the return on investment that you're really trying to get by doing the cost segregation study, because that passive income is going to be locked in that passive bucket. You're not going to be able to have that income or depreciation, then jump over to the other bucket to offset your active income. So unfortunately for a lot of people, they can't always use all the depreciation that a cost segregation study is providing. But it's not a use it or lose it scenario, meaning if they don't use it in year one and then two years down the road, they sell a property and they've got this passive gain that they have to take care of. Then that depreciation that's sitting on their depreciation schedule may help offset that gain. So for your W-2 employees, it's really important for them to take the estimate back to their CPAs, make sure it makes sense for them, and then move forward. The goal is with real estate investors, it's to generate passive income. So a lot of times on that first year of ownership or a couple of years of ownership, they don't have a lot of passive income gains. Right. But down the road, as their properties start scaling, all of a sudden they do have that, let's call it an income or taxable income issue. And that's where cost segregation study really becomes powerful for your W-2 employees, where it's locked in that passive bucket. You'll hear about short-term rental loopholes or other properties that would help them offset their W-2 income. And when you're looking at the short-term rental loophole, what the loophole really is short-term rentals are treated like a hotel. If you're actively or materially participating in that business activity, then you could potentially use a depreciation loss that I'm providing to help offset other active income. So if you're you have a business activity use. So if you have a short-term rental, let's say you buy a car wash, you buy a restaurant, you buy a strip mall, whatever it is, you just have to make sure that you pass that material participation test. When it comes to strictly residential rentals, anything that's 30 days or greater typically, that almost always falls into the passive bucket unless you qualify as a real estate professional. Now, with that said, you don't need to be a real estate agent or a real estate broker to be a real estate professional. You just have to be in the real property business. And that is a pretty broad term. So I would say look at the IRS guidelines on that, talk to your tax preparer and see if you can qualify as a real estate professional because you may be a contractor, you may remodel homes, and that's your primary source of income. Well, technically, you would be considered a real estate professional if you in fact owned the business. So that's the caveat is you have to own that business. Thanks. What was that? A short question, but long-winded answer.

SPEAKER_00 10:48

No, that's all cool. Um, in terms of the benefits versus the drawbacks, what would you say? Benefits, drawbacks? Because I know there's both.

SPEAKER_01 10:56

Yeah. So the biggest I'd say drawback doing a cost segregation study, which is very real, is depreciation recapture. So you're changing your short life assets from being grouped as a 1250 real property asset to a personal asset, a 1245 asset. And when you switch it to personal property, if you take a gain on the sale of the personal property, you're taxed at ordinary income rates. Whereas if it's a capital gains on a piece of real estate, you're treated much favorably when it comes to taxes. So there's a couple of workarounds there. If you're selling, let's say, your appliances when you sell the property, the appliances aren't, they're not what you paid for them when you acquired the asset.

SPEAKER_00 11:47

Yeah.

SPEAKER_01 11:48

So you want to look at fair market value and then carve that out so that you're not taking a big gain on a refrigerator that's 15 years old. So you really just have to look at the disposition of the asset. Think about the disposition of the asset, meaning what are you going to do with the property when you sell it down the road? And when do you plan on selling it? That's the other piece is depreciation recapture happens whether you do a cost segregation study or not. It's going to get calculated in when you sell that property, when you file your tax returns. So you really want to know what are you going to do? Are you going to do a 1031 exchange? Are you going to do the quote unquote lazy 1031 exchange, which simply means selling the property and then buying another property and doing a cost segregation study on it to offset the potential taxes? So those are the two, or that's really the drawback of doing the cost seg.

SPEAKER_00 12:38

Question for you, and this may be a personal preference. I don't know, but do you typically, if someone says, hey, I'm going to sell this property in the next two years, five years, do you have a cutoff for you that says, you know what, don't, it's not worth it?

SPEAKER_01 12:49

Yeah, if they tell me they're gonna sell the property in the next two years, I would say you probably don't want to do it just because you're gonna have to pay back all of the depreciation that you take in. I had a client recently have me work up estimates on properties that are all listed for sale. So she is selling all of her real estate and she was gonna step up and start buying into syndication deals where they're buying hundred unit apartment complexes. And I just warned her, I said, if you sell these property or you do the cost egg in the year that you sell them, you're gonna have to pay all that money back next year. So it's gonna save you a bunch of money this year, but next year you're gonna get hit with it. And if you're going into a syndication, all of a sudden that's gonna be passive income. So the passive income that you're generating through that syndication, are you gonna be able to offset? Are you gonna be able to use the depreciation or you're gonna have to pay it all back? Selling property in future years. So I would say, again, talk to your CPA about it, have them crunch the numbers for you so you know exactly what it looks like ahead of time. And then absolutely don't do it if you're planning on selling the property within the first year. And that's just because it's not it's not really a depreciable asset, and you're selling inventory, so you can't depreciate inventory like you're flipping a property. Yeah, so hold hold on to it. That's that'd be my advice.

SPEAKER_00 14:12

Makes sense. Another question is does CPAs do most of them know much about cost segregations, or is this something that every CPA knows, or a few know about it?

SPEAKER_01 14:22

When you're looking at tax preparers in general, you're gonna have your retail tax preparers that probably have their P10 and they're preparing for a larger company. Then you're gonna have your enrolled agents who are not CPAs, but they're enrolled agents. They might know about it. And then most CPAs will be familiar with cost segregation. Now, any one of them could apply it to your depreciation schedule, but not all of them know about it. However, with the new one big beautiful bill that just passed making 100% bonus depreciation permanent, I feel like that is going to increase the size of the industry dramatically over the next couple of years because the CPAs and other tax preparers that didn't know about it, it's going to get introduced to them very quickly.

SPEAKER_00 15:17

Makes sense. Cool. Listen, I've got also I've also got clients that have bought properties over the years that have not done call segregations. Can they go back and do that for prior years? Or does it make sense?

SPEAKER_01 15:30

It does. So it depends on how long they've owned the property. If they acquired a property back in, I don't know, 2005 and they want me to look at it, I'd probably say it might not make sense to do that cost segregation study. And we'd also want to make sure that we have a documentation of the assets that you acquired when you when you acquired it, when you purchased the building. We're going to want to see what you actually bought. So I'll work up the estimate. Maybe it really depends. I would say going back probably five years isn't a bad idea. So I do look back studies all the time for clients. I have a lot of portfolio clients that'll come in and maybe they own, I don't know, 50 homes, 100 homes, and they've been taking straight line depreciation over the last couple of years, and they'll say, hey, look at the portfolio and let me know what you think. And we'll pull forward hundreds of thousands of dollars for them. And it's just a huge savings for them. And the nice thing about doing a look back study is you don't have to amend a prior year's tax returns. You just have to file Form 3115, an automatic change of accounting method. Your CPA or tax preparer can assist you with that. I provide a completed sample, Form 3115. So if your CPA is not familiar with it, they can follow the highlighted boxes. You just really want to make sure that you're answering all of those questions for the individual taxpayer to make sure that you're checking all your boxes. Yes, you can absolutely do look back studies.

SPEAKER_00 17:01

Does this ever trigger the IRS to audit you? Or is there anything that we have to combat that? I guess you might say.

SPEAKER_01 17:08

No, but you know, it can. Usually there's other items on the tax returns that they're looking at, anyways. And then what they'll do is if the file's in an examination, so they're examining your return, they'll let you know, they'll send you a letter saying, hey, we're examining the return. And then if they start looking at the cost segregation study, you know, feel free to give me a call. I'm always happy to help provide audit support, answer questions on the studies that we've provided. Now, the IRS doesn't always agree with the findings, and it's because the individual auditor may not understand the rules surrounding cost segregation either. So a lot of them, just like a CPA or tax preparer, maybe that's not their specialty. So the ones that I've been involved in, where we've responded back to them, we'll show them the audit technique guides and then we'll show them the court cases that show that, hey, yeah, fencing is a short life asset. It's a 15-year asset. Same thing with landscaping. And then they'll ask, how did you come up with the RCN, the replacement cost new? And you provide your data sources and you justify any of the depreciation. And if if they see eye to eye with you, you move forward. Hopefully it's not an issue.

SPEAKER_00 18:26

How would I tell my clients? Is it easy to get what would they need to provide you to do a call segregation for one they just bought or a previous property?

SPEAKER_01 18:35

So if it's a same-year study, the only thing I need is the property address, the purchase price, and the in-service date, the date the property was ready and available for its intended use. And the typically, I was gonna say the last thing would be the use of the property. So if it's uh specifically on a residential property, if it's a single family home, but they're using it as an Airbnb, then I'll need to know it's an Airbnb. So I work up the estimate appropriately. And then if it's on a look back study or a property that's been in service for several years, I'll need a copy of their fixed asset schedule or depreciation schedule to see when the property was placed into service. I need to know what the basis was and then how much depreciation they've already taken on the property. I want to switch gears and this next section, I just want to talk about cost segregation misconceptions.

SPEAKER_00 19:28

So tell me about the land allocation. What does that mean? Is there any mistakes that people can make with that?

SPEAKER_01 19:33

Absolutely. So this is one of the biggest mistakes I find on fixed asset schedule, properties that have already been placed into service. They'll leave it up to their tax preparer to determine the land allocation. And a lot of times they'll pull it directly from the county tax records. And that is not always the most accurate method to go with. It's the starting place. That's what I absolutely will take a look at is the land allocation that the county records have. Also take a look at the appraisal. We can look at market comparables. And the reason why determining the land allocation is so important is because land is a non-depreciable asset. So let's say you bought a property for $5 million and it is in, I don't know, call it San Diego. And then your CPA pulls the county tax records and they show that 90% of that purchase goes to the land. You would have a $500,000 depreciable asset. Not very much. That's a big problem on a $5 million purchase. And I've seen it happen. I've looked at studies where I'm where I've looked at their fixed asset schedules, and the CPA has literally taken almost all of the basis and put it to land. So it's the same thing on current year studies. Really look at the land allocation and make sure that you're comfortable with it. Ultimately, it is up to the property owner to determine a reasonable land allocation for the property they're buying. So really look at the land allocations, make sure that it's reasonable. That's what the IRS is looking for. Don't use a rule of thumb method because property in coastal San Diego is not going to be the same as the land allocation in Birmingham, Alabama. Same thing with properties that it could be in the same city, but one is in downtown and the other one's just a little bit outside of the city. So that's a big mistake clients make is not looking or paying enough attention to the land allocation.

SPEAKER_00 21:33

Makes sense. What would be, I've heard there's different types of studies. Is there a specific study that someone needs to ask for, or do you determine that? How does that work?

SPEAKER_01 21:42

Yeah, so there's a couple of different types of studies. I think there's about six of them listed in the audit technique guide. Oftentimes we'll combine different methods when it comes to cost segregation. But I would always recommend using a detailed engineering study using the actual cost. Or using the cost estimate approach. So if you're building a new building, we could use the actual cost. We should have all the build data on it. But if it's an existing property, it's you know five or 10 years old, then we have to use construction cost estimating. But we'll be able to accurately or as accurately as possible come up with what it would cost to replace the individual components of the building. So think your roof covering, your windows, your HVAC systems. We can do construction cost estimating on that. So do you do a detailed engineering study?

SPEAKER_00 22:33

Cool. So do you do that for the client or do they just say, I need a specific type of study?

SPEAKER_01 22:38

No, that's all we do is detailed engineering studies. The other approach that I've seen a lot is the modeling approach or a sampling approach. So that's when the cost segregation provider is taking a statistical, sorry, a statistical sample set of like-kind properties and saying based on the sample set, we're going to allocate percentages to the different assets in the building. And that is not a very accurate way to do a cost segregation study. So the modeling or sampling approach just isn't very valid because not all properties are equal. The IRS uses statistical sampling sets specifically. And I think on the audit technique guide, it was talking about a Kentucky fried chicken. So let's say you're a franchiser and you build, you own 100 of these. So you went and you built 100 KFCs or fast food outlets, and they're built exactly the same all across the country. You could reasonably say that I'm allocating percentages based on a smaller sample set that I've already done a detailed engineering study on. But when you're looking at doing modeling, sampling on residential properties, unless you've actually done detailed engineering studies on multiple properties within that neighborhood, and I'm not talking about one neighborhood that has multiple builders. I'm saying maybe a neighborhood with one builder and their model matches, then I think doing a sampling sample would work, but you'd still have to do a detailed engineering study on several of those properties to have a valid sample set.

SPEAKER_00 24:26

Cool. Is there any mistakes that people make with documenting improvements to properties?

SPEAKER_01 24:31

All the time I've got clients that they'll spend millions of dollars in improvements on properties and they don't know or they know what they did. I can see that they put in new floors and might have redone the kitchen and put in a game room or whatever. But when it comes to breaking down the individual cost components, they just don't know what they actually spent their money on. They just, they just don't document their improvements that well. Or what they do is they'll start replacing items in a property, like they'll swap out an HVAC system or maybe a hot water heater, but they'll expense it. They'll just take it as a expense in the year that then made the improvement or made that capital expenditure. And you can do that on some item and some items if they qualify as the minimis, but most items you're required to capitalize them. So you would want to do a smaller capex or a capital expenditure study on those improvements. So I would just say if you're going to do any type of improvements to your property or you own rental property in general, then just keep a spreadsheet. And anytime you spend money on the property, just throw it in the spreadsheet and at the end of the year, send it to your CPA, have them review it. And if they can break it out, they'll break it out. But if they only drop everything into 27 and a half or 39 year property, then you probably want to call someone like me and I'll do a cost segregation study or a capex study on your capital expenditures for the year. And I'm sure you see it all the time when it comes to selling property. Clients will go in and do a big rehab and then rent it out. And when you're trying to figure out what they've actually spent the $100,000 on, they just got an invoice back from their contractor of four or five different bills that were $25,000 each for a general list of improvements.

SPEAKER_00 26:25

Makes sense. Listen, what is there? Any mistakes of not taking disposition?

SPEAKER_01 26:30

Yeah, so dispositions is something that not a lot of taxpayers take advantage of. So if you've done a cost segregation study on a property, and then let's say in year five, you have to replace the roof. And on that cost segregation study, maybe I've broken out $15,000 for the roof covering, you can take a disposition of that asset in the year that you remove it. So the old roof that's on the property, you don't have to keep depreciating it for the next 22 years. You could take the disposition of that asset in the year that you replace it and then start taking depreciation on the new roof. And the reason why that's so powerful is because you want to depreciate the asset or you have to depreciate the asset over 27 and a half years. But once you remove it, you can take the disposition. You can just take it that year.

SPEAKER_00 27:24

So after a cost segregation is done, you can potentially change that, is what you're saying, because you've improved the property. Is that what I'm hearing?

SPEAKER_01 27:32

Correct. You you can use the cost segregation study well into the future. And you can use it maybe 15 years down the road, but you replace all the windows in the building. You're still depreciating those windows that you removed. So just dispose of them on your fixed asset schedule and then start depreciating the new ones. So again, it all comes back to why are we doing this? The reason why we're doing it is because we're trying to reduce our taxable income, whether it's active income or passive income. Did you have any other follow-up questions that I didn't ask or we didn't go over? I don't think so. You answered just about everything. It was nice to have you on so I could talk about what I do for a change. Hey guys, I'm a cost segregation specialist. If you're interested in getting a free estimate of benefit on a cost segregation study, log on to costsegrx.com.