Every investor knows there are amazing tax benefits to directly owning real estate. And one of those tools to amplify the benefits is cost segregation. In this week’s episode, co-hosts Ben Fraser & Jim Maffuccio talk with cost segregation expert Erik Oliver to learn about how these tax benefits impact passive investors. They also explore the “lazy man’s” 1031 exchanges, what changes are happening in 2023 with bonus depreciation, and what asset classes provide the best tax sheltering. Don’t miss this episode!
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Read the full transcription https://aspenfunds.us/podcast/real-estate-tax-shelters-for-passive-investors-feat-erik-oliver/
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Watch the Episode here
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Real Estate Tax Shelters for Passive Investors feat. Erik Oliver
Hello, future billionaires. Welcome back to another episode. Today we brought on a cost segregation expert Eric Oliver, talking about cost segregation and how it impacts passive investors. And so if you are not familiar with this term, uh, you definitely wanna tune in because this is a very, very powerful tool to have in your arsenal when you’re investing in real estate.
And even if you are familiar with cost segregation, you’ve been investing for many years in real estate, you should still tune in because we talk about some of the changes coming down the pike. Um, specifically how these, uh, you know, rules in the tax code can be benefiting passive investors, specifically, not just active investors.
And we also talk about the lazy mans. Is 10 31 and, uh, some ways that you can use these passive, uh, tax losses and carry those forward for future passive gains and how to really, uh, kind of manipulate your income to where you wanna be and pay less taxes, which we all wanna do. And so I had a lot of fun talking about taxes in this episode, which is not something I say very often.
I think you all enjoy it as well, so we appreciate you listening. Again, if you, uh, like this podcast, we really appreciate the support if you’re willing to leave us a review on iTunes or any other platform. I really appreciate that, so we can continue to share the knowledge and with the guests that we bring on and really appreciate you all.
Hope you enjoy this episode.
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Welcome back to the Invest Like a Billionaire podcast. I am your co-host, Ben Frazier, joined by fellow co-host Jim Meucci today, and we are talking with Eric Oliver, who is the cost segregation authority. and, uh, you know, very excited to have Eric on, especially this time of year. So this is, uh, you know, being released right at the beginning of 2023 and there’s been some changes going on kind of in the tax realm as it relates to real estate investing.
And so we wanted to bring Eric on to kind of discuss what some of those changes are. And this is a primer for cost segregation. So Eric, thanks so much for, uh, coming
Erik Oliver
on the podcast. Yeah, thanks Ben for having me. I’m excited to be,
Ben Fraser
. Yeah. Well, for those that are confused by cost segregation, maybe they’ve heard of it, maybe they haven’t heard of it.
You know, give us kind of a primer on, on what it is and why is it important, and, you know, why, why do you wanna be an authority in cost segregation? It sounds kind of, kind of boring, honestly.
Erik Oliver
No, that’s a great question that my kids ask me that same question all the time. They’re like, dad, what is it you do for a living and why do you wanna do that
So, um, that’s a great question. Uh, Ben, so cost segregation really is just accelerated depreciation. And so one of the benefits of owning real estate is that you get to take depreciation, which is a, is a form of an expense. It’s a non-cash expense. Um, just like any other expense, you get to take that ex expense against your income and typically depreciation.
Is either you depreciate your buildings either over 39 years, if they’re commercial buildings or residential buildings get depreciated over 27 and a half years. And so just to make the math easy, if you were to buy a $275,000 single family home, you’re gonna get about a $10,000 write off every year over the next 27 and a half years.
Um, so that $10,000 write off, let’s say you make a hundred thousand dollars a year. , instead of getting taxed on a hundred thousand, now you’re only taxed on 90,000 because you have this $10,000 depreciation expense. Correct. So that’s kind of standard depreciation. We call that straight line depreciation.
Um, But what if you could accelerate those deductions? So I may not own my home or my single family rental for 27 and a half years, and so I wanna accelerate those deductions. And the way to do that is through a cost segregation study and really what that is. Is, it’s just accelerating those deductions by segregating the different items that you purchase when you purchase a, in that example, a single family home.
So when you’ve purchased a single family home as an investment property, you’re not just purchasing the land and the walls, you’re also buying some appliances. You’re buying a ceiling fan, you’re buying a garbage disposal, a washer and dryer. There’s all these different components. You’re buying a driveway.
you’re buying landscaping, and the IRS says that all these components should be depreciated at a faster rate than 27 and a half. Because if you think about it, carpet doesn’t last 27 and a half years, right? Your driveway typically doesn’t last 27 and a half years. And so by having a Costa Study done, we come in and we take that again in that example of $275,000 purchase, and we segregate the costs into different buckets.
We say, okay. Um, out of that 275,000, 20,000 of that was for flooring, um, 10,000 of that was for the driveway. 15,000 of that was for the landscaping, and we. By putting it in those different buckets, it allows us to depreciate that carpet over five years versus 27 and a half. It allows us to depreciate the driveway over 15 years versus 27 and a half.
So you’re just front loading your deductions. So, so
Jim Maffuccio
there’s, so there’s a, there’s a connection, there’s a nexus between the particular item that’s being segregated and it’s useful, typically useful life. Right? I mean that’s, that’s the kind of general principle behind it. So you can accelerate it because it is not gonna last 27 and.
Erik Oliver
Fears. . That’s correct. Yeah. The IRS is basically, there’s a, there’s a big book that the IRS has taken just about any item you can think of. Of course there is Tells you . Yeah. They really make it nice and simple. Um, they take any item that you can think of and they say, okay, carpet gets depreciated over five years.
Now the problem is, is that when you buy a $275,000 single family home, you don’t know the value of the carpet. You just look at it as one big lump sum of asset and you typically depreciate it over 27 and a half years. A CASA company will come in and segregate that and say, okay, you did buy some carpet when you bought that home, and that carpet is valued.
Whatever, $8,000, $10,000, and now you get to take that carpet and put it as a line item and depreciate that carpet over five years instead of 27 and a half. And are
Jim Maffuccio
those timeframes per item, are they set forth in the code somewhere or is that, is that where you have some subjectivity or what?
Erik Oliver
Uh, there is some subjectivity, however, the i r s does publish an audit guide on cost segregation.
Okay. Alright. Kind of the way this came ab came about, Jim was at some point someone took the i r s to court and said, listen, I’m not depreciating my flooring over 27 and a half years, cuz flooring doesn’t last 27 and a half years. So there was a court case where they said, you know what? You’re right, flooring only lasts five years, so we’re gonna change that to five year assets.
And so there’s all these court cases and case. There is some subjectivity to it, but there is an IRS audit guide that basically says in a building, the the flooring should be depreciated like this, the countertop should be depreciated like this. And so there’s an audit guide that we follow where they’ve pretty much outlined how all this stuff should be.
And, and those are,
Jim Maffuccio
at the very least, those are safe harbors. Like if, if you use those timeframes, you’re, you’re not gonna get questioned. But you could, if you could make a case that maybe the life of a component. Was less. You could there, that’s where the subjectivity comes in. You could push for,
Erik Oliver
you could push, um, not so much on the individual asset.
I think the subjectivity comes in, is this carpet worth $9,000 or the additional value. Got it. Yeah. Okay. And so that’s where the expertise of having somebody with a background and construction comes in. Um, to, to identify. And then not to get too, too complicated, Jim, but there also are like indirect costs that get factored in.
Like when you build a building, you have to pull a permit, you have to get architectural fees, you’ve got, um, construction loan interests. There’s all these other outside indirect costs or soft costs that we also tie in, and we put a value to those and those get divvied up amongst the different assets. Um, yeah, it’s more than just pulling the assets out.
There’s a kind of a, a, a process to it, but the IRS has published an audit guide that tells us how to do these. Um, and so as long as you follow that audit guide, you’re, you’re pretty good. And, and again, there’s a number of reasons why we wanna do this, right? I mean, Uh, deduction today is worth way more than a deduction 26 years from now, or again, I may not even own my building 26 years from now.
So gimme my deductions today. Let me go reinvest that money in a new duplex. Let me go pay down some debt. Let me go buy a boat. Whatever it is you want to do, gimme my money today versus letting the i r s hold onto it. And
Ben Fraser
from an investor standpoint, I mean this is very powerful, right? Because if you can defer taxes and you can redeploy those savings into other, you know, cash flowing or you know assets you can grow, then over time that’s gonna be very meaningful.
And it’s kind of funny as you’re talking about the suing the I R S for basically, You know, paying taxes where any other business , you know, it doesn’t work. But in real estate, you know, we, they basically created your whole industry through a lawsuit that they apparently won and Yeah. Came now way
Erik Oliver
to go.
Yeah. So , yeah, there was one, one big court case. It was, um, hospital Corporation of America Hospital Corporation is a, a big outfit out of Tennessee, I believe. They’re headquartered in Tennessee. They have a bunch of hospitals throughout the mid-Atlantic area. Um, back in, I believe it was the early to late, uh, early to mid nineties, they had some pretty savvy CPAs that said, Hey, why are we depreciating this laminate flooring over 39 years?
There was in the, there was a court case at one point that said it should be a five-year asset. So they started doing, it was kind of when modern cost segregation was born, but they basically segregated all this stuff, created this massive deduction, and the irs, they filed their taxes, saved millions of dollars in taxes.
The IRS said, hold up. What’s going on here? What are you guys doing? And they’re like, listen, we’re just doing what you guys have in your code. , we’re just interpreting. Right. You know, they, what the IRS put forth was they basically said, if I were to replace my carpet, I get to depreciate that new carpet over five years.
They never looked at it like when I buy a new building or an existing building and there’s carpet in there. that carpet should be treated the same way as if I were to replace carpet in a building, right? It’s just no one knew how to pull those numbers out. And so that’s where cost segregation kind of was born.
Jim Maffuccio
Got it. In that, so I, so I know there’s somebody in the audience that’s, that’s, that’s thinking, okay, you’re talking about tax savings, but aren’t, aren’t you just kicking the can down the road? And I think the answer in general is you’re reducing the basis in the property. Right. But then when you, when you have an exit event that moves it over to the capital gain side of the equation, and then if you’re using like a tax deferred to 10 31 exchange, you’re continuing to kick that capital gain, potential capital gain down the road.
So it really is, it really is creating it, it’s creating money out of, out of thin air in a. If, if you play it, if you exit
Erik Oliver
properly, right? Yeah, no, there’s some strategy to the exit, but even like 10 31 s are a great tool, um, because it does defer those, those two types of tax. When you sell an asset, you pay your recapture tax.
That recapture tax is typically calculated based on the amount of depreciation you’ve taken. And so I think that’s what you’re getting at is I’m sitting here saying, Hey, front load all that depreciation, but when I sell it, don’t I just have to pay it back? And the answer is no. And yes, you do pay it back.
If you don’t do a 10 31 exchange and you just pay it back as a capital gain, you’re paying it back at at at a the highest rate of 20%, but you’re taking your deduction at like a 35 to 40%. You’re moving it into a different bucket altogether. Yeah, right. You’re moving it into a different bucket, and we’re playing a rate arbitrage where you’re taking your deduction at 35, 40%, paying it back at 20% and saving the.
That’s the
Ben Fraser
first thing. So E, even if you don’t continue to defer, right, you win. I mean, you already Right a
Erik Oliver
win right there. Yeah. Yep. You just saved 15% on your taxes by taking a deduction at 40%, paying it back at 20%. Well, in that case, 20%. Saving 20% on inner rate arbitrage. That’s the first thing. The second thing is you don’t actually have to pay it all back.
You pay a portion of it back. And so I’m gonna kind of back into this example, cause I think it’s easier, but. . Let’s say you buy a building for a million and you sell it five years later for 2 million. If you don’t do a cost segregation study, you’re telling the IRS that everything doubled in value. I bought everything for a million.
Oh, everything is now worth 2 million, and you’re paying tax on that million dollars of gain. But what are your five year assets worth? After owning your building for five years, what’s your carpet worth? It’s worth zero. Zero book value. , right? But when you don’t do cost, you’re saying, Hey, my dirty old nasty carpet that I bought for a million dollars is now worth 2 million and I’m gonna pay tax on that.
Well, carpet doesn’t go up in value. Your land and your walls go up in value, but your personal, what we call personal property, your carpet, your countertops, your cabinets, your appliances, that stuff doesn’t go up in value. That stuff goes down in value. And so your five year. Are worth zero on the books after five years, which means you pay no recapture tax on ’em after five years.
Wow. If you don’t do cost again, you’re, you’re telling the IRS that that dirty, nasty old carpet you’ve had for five years is worth double what You bought it for five years later and, oh, and here I’m gonna pay tax on that.
Ben Fraser
And does that apply to all the accelerated. , um, personal pr, uh, personal, uh, items in there.
So if it’s a seven year or a 10 year depreciation schedule and you sell it in five years, whatever is remaining in value is taxed.
Erik Oliver
Correct. Got it. Correct. Yep. So like typically on a cost segregation study, we take a 27 and a half or a 39 year asset, and we move it into either a five, seven, or 15 year bucket.
So if you own your building for five, , that stuff gets no recapture. If you own it for, uh, seven years, your seven year stuff gets falls off. If you own it for 15, your 15 year stuff falls off. So the longer you own it, the bigger your tax savings is essentially. Um, but again, even if you buy it this year and sell it next year, you’re still gonna save that 20% on the rate arbitrage.
The difference between the ar Yeah. The rate, yeah. Yeah. Taking your deduction. Even if you pay it all back, as long as you’re paying it back at a lower rate, you come out ahead.
Jim Maffuccio
But then just to be clear, but, but if you do decide to defer by through a 10 31, , you’re not paying, you’re not taking that recapture and being taxed on it, even at the lower rate.
It’s, it’s just your new basis that moves forward into the next adventure, right?
Erik Oliver
Yep. You got it. So yeah, we have a lot of investors who buy a property, do a cost egg, 10 31 exchange into a larger property, take that additional new basis, cost sake, get 10 31, 10 31, 10 31, and then unfortunately, all of us die at some point.
leave that to our estate. It gets a step up in basis and nobody ends up paying tax on it.
Ben Fraser
I like it. Now, now, sorry. Let’s, let’s pause there cuz you’re, so let’s walk to that example again. Yeah. Uh, cuz when you do at 10 31 exchange, your basis doesn’t increase. Right. So the basis that, so when you purchase the property and that, that becomes your basis.
And when you, when you do a, you sell that property, you take those gains and roll into a new property, I guess the, the, I guess your basis and that new property is established, but you still carry forward. The, um, the, the, the difference that is your taxable deferred balance over
Erik Oliver
time. Correct. Yeah. So at 10 31, I always look at it like you already took some depreciation on that first property, and so when you defer it into the second property that depreciate depreciation you already took, you can’t take that depreciation again on the second property.
But a lot of people will exchange into a larger property. So let’s say you bought the first property for 500, you bought the second property for a million. You now essentially have an additional 500,000 of new basis that you can cost save that has no depreciation taken out. And so as long as you’re, um, deferring into larger properties, it definitely is a good strategy to defer your taxes and never.
Never pay
Ben Fraser
tax. Okay. Well, one of the things I wanted to talk to you about, and I’ve, I’ve heard this being done. I’ve not personally done it, so I, I’m curious, it sounds too good to be true, but it, it seems like it might be possible. Um, basically it’s called like the lazy man’s 10 31, right? So you, you, you take a property, so in your example, you buy a property for a 500,000, you sell it for a million, and just for some simple math, you have a $500,000 capital gain.
Well, then you go and invest that capital gain into. Uh, property that you also do cost segregation on, and the accelerated depreciation plus bonus depreciation in that year. One that you, uh, take covers the full taxable, um, income from your last property sale, and now your basis is at that new level and you don’t have any kind of.
Tax liability that you’re carrying forward is, is that possible? And hopefully my example makes
Erik Oliver
sense, . Yeah. I’ll kind of walk through that example cause that is a great example and, and it absolutely is possible. So I think one thing we need to touch on before we go there is just bonus appreciation. Yep.
Perfect. You mentioned bonus appreciation, so let me just kind of touch on what that is. So, back in 2017, um, when Donald Trump was president, there was a tax overhaul. It’s called the Tax Cuts and Jobs Act. and with Donald Trump being a real estate investor, the tax changes were very favorable to real estate investors.
And, and something came out of that. There’s something called bonus appreciation that the, the, the government’s had, it’s been around for long before Trump was president. It’s been around for a number of years. Bonus appreciation is always used as a kind of a lever to stimulate the economy when it needs to be stimulated.
And so they say, okay, the economy’s not doing great, so we’re gonna. Hey guys, if you go out and buy stuff, we’re gonna allow you to take those depreciation amounts much sooner. And so they give you a percentage. They might say it’s, you know, for 2016 it was 50% bonus, meaning you go out and buy a million dollar bulldozer, you get to write off 500,000 of that, or 50% of that in the first year, the other 50% goes, gets played out over the useful life of that bulldozer.
And so, . Two things happened with the Tax Cuts and Jobs Act. One is it went from 50% at the time, up to a hundred percent bonus depreciation, which was huge. The second thing is that back prior to that tax law, it had to be brand new equipment. You couldn’t go buy a used bulldozer. You had to go buy a brand new bulldozer, and so they changed that instead.
It just has to be new to you, the taxpayer. So let me kind of put bonus depreciation into context on how it works with real estate. bonus depreciation only applies on assets that have a useful life of 20 years or less. And I think the I R S did that on purpose cuz they didn’t want bonus to apply to real estate.
So they said, well, real estate gets depreciated over 27 and a half and 39. So if we put this at 20 years, it won’t apply to real estate. But what if you have a cost egg study done? . Now all of a sudden we’ve got five, seven, and 15 year assets where bonus does apply. And so under the current tax law, any properties placed into service between 9 27 of 17 and the end of this year, 2022 are eligible for 100% bonus.
So remember Ben, I talked about how we segregate those different items into the five, seven, and 15 year buckets. So if you buy a $500,000 property, . We typically segregate around 30% as kind of an industry average, and so 500,000, 30% of that is 150,000. That goes into those five, seven, and 15 year buckets.
Because those buckets are less than 20 years, they’re eligible for that bonus depreciation, which means you get to take 100% of those deductions in the first year versus. Taking ’em over five years, seven years, or 15 years, right? Instead of having to take one fifth, one seventh, or one 15th, you get to take all of it in the first year.
And so that’s been a huge advantage for real estate investors. to be able to really maximize it. It’s basically taking cost segregation and put it on steroids, right? Because instead of accelerating stuff to five, seven, and 15, we’re now basically accelerating it to one year because it’s a hundred percent or all of it in the first year.
So I just wanted to touch on that because I think that’s important to your example. No, that, that’s
Ben Fraser
very helpful. And, and just to create further context, so without bonus depreciation, , what percent of you know your capital invested in a in a given property? Could you expect to have a year one deduction on just a percentage wise?
Rough, rough estimate.
Erik Oliver
Yeah, that’s a good question. It’s hard to, to answer that just because I do want, and I’ve kind of oversimplified things. Let me just make it clear that land is not depreciable, right? Right. So if you buy a million dollar property in Oklahoma and the land is worth a hundred thousand, that means you have 900,000 of depreciable basis.
That gets spread out over 27 and a half or 39 years. That same million dollars, if you go buy a million dollar property in la. LA loves their land. California in general loves their land. So their, their land value might be 800,000, which means you only have 200,000 of depreciable basis, right? But once you’ve established that depreciable basis and you’ve subtracted out the land, you can anticipate about a 30% segregation on that and on that depreciable basis.
So, . If you buy a property for 1,000,002, you determine the land is worth 2 million, or excuse me, 200,000. That gives you a million dollars of depreciable basis. You should get about $300,000 of deduction in that first year if you apply the a hundred percent bonus depreciation. Okay, so
Jim Maffuccio
let me ask a couple a question, a two part question then.
Yeah. So, so there’s, so there’s the, the bonus depreciation, which was kind of an ad, kind of taking something that’s already good the. You know, the cost segregation different, shorter lifespans and putting just turbocharging that exactly. Are either or both of those restricted to certain kinds of taxpayers, or are these available to the person on this podcast that’s just thinking about buying their first property, say they’re a medical doctor.
Uh, are there any, is this
Erik Oliver
for everybody? That’s a great question. So cost. Is not necessarily for anybody and everybody. One thing you have to remember is typically real estate deductions are considered passive. So in that example you gave where, let’s say I’m a doctor and I, I full-time anesthesiologist, that’s what I do full-time.
I’ve got a few rental properties on the side. If I do cost segregation on those rental properties, the deductions that I create through bonus appreciation and cost segregation, those deductions can only be used to offset. that’s considered passive or my real estate income in that example. So I might make $500,000 a year as a doctor.
but those deductions that are created, even though they’re large, they’re supercharged. With all this bonus, I might create a $300,000 deduction. I can’t use that 300,000 to offset my tax liability from my 500,000 of W2 active income. So you’ve got tax. So even
Jim Maffuccio
if you’re an anesthesiologist and you’re very, you’re very job is putting people to sleep.
That’s not considered, that’s not
Erik Oliver
considered passive. No, that is not
Jim Maffuccio
. Okay. Alright. I just wanna make sure that’s clear to the, to our folks
Erik Oliver
watching that. . Yeah. Yeah, absolutely. There’s two types of income. You have your active income and that’s what you do every day for a living. Now, some people are real estate investors for a living, right?
So one thing that we see quite often, I’ll just go back to that doctor example, is if I’m making $500,000 of a a year, my wife probably gets to stay home because I make good money as a doctor. Well, she stays home and she manages my real. We say that she’s the real estate professional cuz she is as, as put out by the definition of the irs.
She spends 750 hours a year doing real estate. She does it more than 50% of anything else she does. If she meets those qualifications, she’s our real estate professional. And now those deductions can be used to offset my W two income because we file a joint tax return. and those deductions become active, they can hit my active income.
And so a lot of high W two earners who have stay-at-home spouses will try and qualify their spouse as a real estate professional. So that they can take advantage of that and offset that high W2 income. But that’s a great question. It’s not for everybody.
Ben Fraser
Gotcha. But let, let’s go back to, to the passive, um, because that’s kind of more the focus of our investor base and let, let’s a base and, you know, so even though it does.
only give you deductions against your passive income. It does kind of go to the point I raised earlier of if you have capital gains from investments that is, you know, passive income and that can be used and, and these losses, if you can’t use them, do carry over, right? So you can’t be storing up these losses, even if you can’t use them in a given year, they’re generated for future passive income.
So talk a little bit about, about.
Erik Oliver
Yeah, no, and I’ll think, I’ll tie that back to your first example, kind of the poor man’s 10 31 exchange, because there are limitations if you have, um, there are limitations. If you’re a passive investor, again, you can only use these deductions to offset your passive income.
But if and when you sell a property and have a large capital gain, that capital gain gets treated as passive income. And so those deductions now become activated. I don’t know if that’s the right technical . I like it. Activate those, don’t, don’t look that up on the IRS website, but , those become active and now you can use those deductions to offset that gain, which means you’re not paying any capital gains tax in the, is is
Jim Maffuccio
that capital gains outside of the, the, the real estate investment thing too?
Like what about, what about the sale of a stock portfolio? Would that, the capital gains
Erik Oliver
generation from that typically Not typically only from the real estate, so. . There are different types of capital gains, but typically only from real estate. If you sell real estate and you’ve got this passive loss sitting on your books that can’t be used.
Once you sell that asset creates a capital gain, activates the losses up to the amount of the gain. Got it. And here’s something that’s really cool. Let’s say I have a $200,000 capital gain and let’s say I have $300,000 of, of. Passive loss is kind of sitting on my books, right? They’re carrying forward, right?
Sell a property, have a $200,000 capital gain that activates 200,000 of this loss. I have 300,000, but I don’t get to use all of it. I only get to use 200,000, but when I use that 200,000, it actually is gonna hit on my tax return against my W two. , which is great because my W2 income gets taxed at 35%, so that loss hits my W2 income before it hits the capital gain, which means I pay tax on the capital gain, but I just offset my 35% bracket by 200,000.
Jim Maffuccio
So it’s the capital gain that triggered your ability to use it. But you don’t have to use it against your
Erik Oliver
capital gain. , yep, exactly. The capital gain unlocks it, but then the way that it hits the tax return, it actually hits against my higher tax bracket w2. Did you know that Ben?
Ben Fraser
I, I did not know that.
That’s pretty cool. You need to, you need to create a product that’s a button that says Activate and you just hit that button. Once you’re ready to, those
Jim Maffuccio
losses go. No, you just go. You just go tell people, Hey, sell me your property, . That’s a good one’s. Good acquisi
Erik Oliver
strategy. Yeah, no, it works very well.
We’ve, um, the owner of our company here, we actually own this building here. And so, and that’s exactly what happened. We did a CASA study, um, it activated those passive losses and it actually hit against his W2 income before. And it’s just the way, the tax return, it’s just the way those numbers flow through the tax return.
Wow, that’s amazing. That’s fine. I’d rather, I’d rather pay my tax on my 20% tax bracket, my capital gains bracket versus my higher 37%. , um, ordinary income bracket. So what’s the carry
Jim Maffuccio
forward period on these accumulating passive losses that are gen that can be
Erik Oliver
generated? . That’s a great question. So with the Tax Cuts and Jobs Act, they actually extended it from 20 years to indefinite.
Oh. So let’s, I’ll use an example here. Let’s say I’m a passive investor, so I’m a doctor again, I’ve got a couple rental properties. They generate 20,000 of income Every year I do a CASA study On one of those properties, I create a hundred thousand dollars deduction. I’m gonna not pay taxes on my passive income for the next five years because I, you remember, I make 20,000, right?
So I’m gonna wipe out 20,000 this year. That leaves 80,000 on the books for next year. Wipe out another 20,000. I’m down to 60. I do that for five years. I pay no tax on my rental income for five years. Those lost, those deductions never expire. They just sit on, wow, that’s awesome. I eventually use them, or as you mentioned, Ben, I sell a property and that gobbles ’em all up, you know, at once.
But, um, lots of, lots of, uh, ways to apply those deductions.
Ben Fraser
Yeah. And I, I think what one of the challenges, you know, as passive investors is it can be very difficult to do a 10 31 exchange, um, when you’re in a syndication. In fact, you know, it’s, it’s very difficult to do because you have, I mean, we wanna get into all that, but, you know, so thi this kind of, you know, la lazy man’s approach is very attractive because it, it allows you, cuz the 10 31 in all of its, you know, How impactful it can be.
It is very difficult to, to do and creates certain constraints and challenges, especially if you’re in a syndication. So as a passive investor, if you can, you know, build up these, you know, passive losses and use it against your future passive, uh, capital gains, you can effectively. , you know, remove not even a tax deferral, but actually, you know, to your point, pay, pay those taxes against, uh, the higher bracket income, which is, which is pretty cool.
That’s,
Erik Oliver
that’s, yeah. That’s incredible. Absolutely. Yeah. No, and, and I, I should say cost segregation is one of the few tax tools that I’m aware of that’s so flexible. So a lot of expenses, like if I were to. Put a deck on my rental property, I have to, to take that expense in the current year. I don’t get to hold onto it and decide when and if I get to use it.
Cost segregation, you don’t have to do it in the year you buy a property. So let’s say you’ve bought, let’s say you bought a property in 2014. Never did cost segregation and on. Now all of a sudden you’ve sold a property, you have a capital gain event, and now you, you know, you’re in a tax situation. I can go back and do cost segregation on that property I bought in 2014.
Pull those deductions forward. offset my current capital gain and pay no taxes. And so cost segregation, you may not need it this year. You just keep it in your pocket until you do need it. And then you play that card and say, okay, I’m gonna do cost segregation this year on this building because I need this amount of deduction.
So you can really. If you’ve got a good C p A who focuses in real estate, you can really do a lot of great tax planning with cost segregation and, you know, apply it to different exit strategies or, um, there’s a lot of useful ways to take advantage of it.
Ben Fraser
So why, why would you wait to do it if you can carry those deductions forward anyway?
Jim Maffuccio
Yeah, if you can carry ’em anyway. What’s
Erik Oliver
the, so you would wait, the only reason you would wait is one? Well, two reasons. One. , you have to pay for a study. So you don’t want to pay me 3000, $4,000 for a study if you can’t use those deductions for two or three years. Got it. Just wait two or three years. Do the study when you need ’em and take advantage of it then.
That’s the first reason. The second reason would be it doesn’t always make the best. It’s not always the best strategy to wipe out your income to zero. So let me back that up. If I make $20,000 this year through my, let’s say I don’t work, I have a couple rental properties, I make $20,000. That’s gonna put me in a real low tax bracket, so I might be okay paying.
10%, 5%. I don’t, I don’t have my tax bracket sheet here in front of me. I don’t know what the tax bracket is on 20,000, but it’s not a lot. Right? It’s a very low tax bracket. So I don’t, I’m okay paying 10% this year at 20,000. Now, next year when I sell my property, I have another property that I sell, and all of a sudden I have a $500,000 gain.
That’s when that’s gonna put me in a much higher tax bracket, and that’s when I want to use my cost egg study. Makes sense. So it doesn’t always make sense just to wipe it out to zero even. Um, One of the nice things with bonus that we will we’ll strategize with CPAs all the time is when you do bonus depreciation, it might create a $500,000 deduction, but if you only have a hundred thousand of income, Maybe it doesn’t make sense to wipe that a hundred thousand down to zero.
Maybe you only wanna wipe it down to 40,000, put you in that lower tax bracket, and then you save the rest of those deductions for next year when you’ve got money in those higher tax brackets. So you want to use it to manage your tax brackets so
Jim Maffuccio
you can, you can specify that I don’t want to use the everything I’ve got in the bucket I, or that I’m, that I’m allowed to use this here.
I only want to use. Amount that
Erik Oliver
brings me down past that threshold, or there are tools to do that. You can’t specify and say, I need exactly $36,000 of depreciation. But in that example where we use bonus, the IRA s allows you to opt out of bonus depreciation by class life. Okay. Okay. So what a lot of investors will do is they’ll say, , gimme my bonus appreciation on my 15 year bucket cause I’m not gonna own it for 15 years.
My plan is to own it for seven years and get out. So gimme my bonus up my 15 year bucket, my five and seven. I’m gonna let ’em spread out over five and seven, which means I’m not getting such a huge deduction in the first year. I’m getting it over five, seven and I’m getting, you know, a big bump in the first year.
Cause I took bonus at my 15. My five and seven play out. So there are ways to strategize or, uh, manage those deductions to kind of hit whatever target you’re trying to hit in terms of deductions. So it can be a real planning tool. Absolutely. Yeah. Absolutely.
Ben Fraser
So, Eric, talk a little bit about the changes, uh, in, in this year at 2023, um, as it relates to the bonus
Erik Oliver
depreciation.
Yeah, that’s a good question. So when the Tax Cuts and Jobs Act came out, bonus depreciation had a sunset date of December 31st, 2022. So right now, any properties, again from September 27th of 17 through December 31st, 2022 that go into service in that timeframe, you’ll get a hundred percent bonus, anything that goes into service starting next year.
Is eligible for 80% bones. So instead of getting a hundred percent of your deductions in the first year, let’s look at your five-year category. Instead of getting a hundred percent of your five-year assets in the first year, you’re gonna get 80% of that. The other 20% gets spread out over the next four years.
So still putting cost segregation on steroids, because remember it’s, we used to do studies before. Bonus was even around. taking a 27 and a half year asset, moving it to five years is way better. But now we’re moving it to five years and then taking 80% of that and moving it to a year, . And so, um, the way the tax law reads right now, every year, starting in 2023, it lowers by 20%.
So 2023, it’s 80%, 20, 24, it’s 60% Oh wow. All the way until 2027 when it’s down to zero. Now, I will state that there was serious talks in this last round of Congress with this lame duck session. with the economy kind of shaping up the way it was. There was some serious talks about extending bonus a hundred percent bonus into next year.
It didn’t get through on the final bill, but just because that’s the current schedule doesn’t mean they can’t get together at any point. Say, Hey, the economy’s really struggling. Let’s just reinstate a hundred percent bonus and try and get people to go out and spend money. Um, so that could happen next year depending on kind of how things shape up.
But currently 80% starting in 2023, then 60% until 2027 when it’s down to zero.
Ben Fraser
Yeah. And, and so your expectation, you were saying earlier in your example of the 1.2 million bill, we, 200,000 of it is land. You got 1 million appreciable, uh, uh, part of the property. You can get roughly 30% in a year, one tax deduction.
What would you expect that to go to? Now that bonus is going to 80% versus a hundred percent.
Erik Oliver
. Yeah. So you’re, you’re gonna get, let’s say, let me do the math here in my head. So, on a million dollar property, we’re gonna segregate about 300,000 of it into those short asset lives. You’re gonna get 80% of that.
So you’re gonna get 240. Um, plus you’re gonna get some straight line depreciation on your 27. So you’re probably around 2 50, 2 60 versus getting 300. . So, so still very,
Ben Fraser
very, very impactful and, you know, not as good as it was, but still way better than it has been. And yes. Um, and I, I would make the point too, that’s, that’s if you’re purchasing this property, you know, with, if you’re purchasing with, with debt, the percentage to your equity in the property is much higher than just the, those numbers, they’re gonna be high.
I mean, I’ve seen deals where it’s 75% of your, you know, capital contribution is, um, has a tax write off in year.
Erik Oliver
. Yeah, no, that’s a great point. So remember, our depreciation, what we’re calculating it on is purchase price. So I may take only $200,000 and go put it down on a million dollar asset as a 20% down payment.
When I do the Costa study, I’m doing it on the million dollars, right? So I get 30% of that. All of a sudden I got a $300,000 deduction on a $200,000 investment. And so you’re absolutely right. The more you can leverage, the more impactful this could be in terms of getting a a deduction on. on your, uh, contribution.
Got it.
Ben Fraser
Very cool. That last question I have. Yeah. You know, I’ve always kind of wondered this, but what, how would you kind of rank asset types. From a, uh, you know, what, what’s, what’s the best asset to get the most cost segregation, you know, in year one versus the kind of the worst?
Erik Oliver
Yeah, that’s a great question.
So there’s kind of three unique outliers. So typically, I, I mentioned a couple times, it’s around 30% segregation. So you’re your multi-family, your office building, your retail, those all kind of fall within 27 to 35%. Um, Warehouse industrial is a little bit lower because there’s less personal property. Um, but there are a lot of land improvements.
You think about a big warehouse usually has big, um, lots of concrete, lots of curbs, gutters, asphalt, drainage. So, but I would say your industrial is a little bit lower. Uh, your warehouse is a little bit lower. And then as you work your way up, you’ve got. Multi-family retail. Medical seems to be a little bit on the higher end because you got a lot of specialty plumbing, specialty electrical.
And then there’s those three outliers. There are car washes, which are amazing, . So you can buy a million dollar car wash and you may get a million dollar write off in the first year. Geez. And the reason for that is well, , I’m oversimplifying again. Let me back out. Land. You buy a million dollar car wash, okay?
You back out 200,000 for land that gives you 800,000 of depreciable basis. You very well could get an $800,000 write off because I, if you think about it, when you buy a car wash, what do you buy? You’re not buying a building, right? You’re buying land improvements, which are a 15 year asset eligible for bonus, and you’re buy.
um, equipment, which is also equipment, short term asset eligible for bonus. So those self-serve bays where there’s no sitting area, there’s no building. Again, you buy a million dollar car wash, you could get an $800,000 write off in the first year. So car washes, gas stations are unique because gas stations, if you sell more gas, which you typically do, then convenience, like then, um, you know, snacks and.
then car, uh, gas stations can, you can classify the whole gas station as a 15 year asset. And again, because 15 gets bonus, you just took bonus on your whole purchase. Wow. So gas stations. And then the third one is, um, Trailer parks, mobile home parks. Again, when you buy a mobile home park, if there’s no clubhouse or laundry facilities, you’re just buying land improvements and trailer services, cement pads, electrical sewer systems, all those are 15 year assets, which means you get a a hundred percent bonus under the current law on those three.
So those are kind of the three outliers that are just way out there. Okay? Most stuff’s gonna fall between 25 and 40%. Multi-family is a great asset class cause there’s a lot of, you know, you buy a hundred unit apartment building, you got a hundred washers and dryers, you got a hundred garbage disposals, couple hundred ceiling fans, and so they’re great asset classes as well.
Ben Fraser
Man. Well, Eric, I’ve never had so much fun talking about taxes. You know, I know
Erik Oliver
, I know. That’s impressive. Or, or, or, or the lack thereof I think is what’s the most exciting . That is the exciting part. I love talking to, uh, you’re right. I love what I do just because it’s kind of the good side of taxes. I’ve sat in a lot of tax seminars where it’s, you know, no one likes to talk taxes, but if you can tell, if you can talk to me about how not to pay taxes, I’ll, I’ll listen all day long, so I appreciate.
Ben Fraser
Awesome. Well, Eric, if, if, uh, folks do have active investments or even, um, if they’re in sub passive deals and, you know, wanna encourage sponsors to get cost irrigation, if they’re not, what’s the best way to reach
Erik Oliver
out to you? Yeah, so you can reach us on our website, our website’s just www dot cost seg authority.
That’s s e g authority.com. , my contact information’s on there. Please use us as a resource. We don’t bill by the hour. We’re kind of a unique accounting firm where we just do these cost segregation studies, and so we partner with your cpa. CPAs are kind of like your general practitioners. They know a little bit about thousands and thousands of pages of code.
We dive deep just into one section of the tax code. So we’re kind of like the brain surgeons, so they’ll usually partner with us when they have a client that owns real estate and say, Hey, can you run some numbers? We always do a free analysis. We never want to engage with somebody if they’re not gonna save significant tax dollars.
So, you know, if you buy a property, you can give us the closing statement and we can come back and say, Hey, based on the information here, We anticipate increasing your depreciation by X amount. The study’s gonna cost you X amount and then you can decide if it makes sense from there. So always get a free analysis done on any revenue generating property.
I would always suggest you get an analysis done just so you can use it for tax planning and, and kind of going forward. But yeah, please use this as a resource. I. I always joke, I think the weirdest question we’ve ever been asked is how did depreciate deer at a breeding facility in Wisconsin? Um, I didn’t know the answer, but I was able to talk to one of the guys upstairs and get the answer for him, and so, Um, any, what was, what was the answer?
I don’t remember. It’s, it’s similar to livestock, but it was one of these breeding facilities where they, they had all this land and they take these, these, uh, bucks and they breed ’em to have these huge antlers and then people pay ridiculous amounts of money to Oh yeah. Sit on the porch and kill these things.
Um, there was a specific way to appreciate those, those, like I said, it was kind of treated similar to livestock, but, um, We can find the answers. If it’s anything to do with depreciation, we’ll get you the answers. So please. Yeah. That’s awesome. Well,
Ben Fraser
thanks so much for, uh, for coming on. I definitely learned a lot and Hopely, our listeners cleaned a lot of information as well.
And, uh, appreciate you, uh, sharing your
Erik Oliver
wisdom. Thank you. Yeah, no thanks. Thanks, Ben. Thanks Jim. It’s been great. Um, yeah, thanks for having me. All right. Thanks so much. Take care.
