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A question for you, how would you like to pay little to no taxes because you’re an owner of real estate? Since 1997, the increasing number of property owners have cut their current income taxes by using something called cost segregation. With cost segregation, an owner of real estate can accelerate their depreciation and thereby reduce their federal income taxes for years. The benefits of doing a cost segregation or what’s referred to as a cost segregation study can include an immediate increase in cashflow and a reduction in your current tax liability. That means the deferral of your taxes. Fourth, the ability to reclaim missed depreciation deductions from prior years. You can do this without having to amend the tax return. Cost segregation is based on a fundamental principle and that is that a dollar now is worth more than a dollar tomorrow. This is also something known as the time value of money. This same logic can be applied to tax deductions because a tax deduction now is worth more than a tax deduction tomorrow.
The major advantage of a cost segregation is not necessarily that it will produce more depreciation deductions for you. Instead due to the time value of money, the advantage of these front-loaded deductions can be quantified and is greater than had you taken those deductions spread out over longer periods of time using slower depreciation methods. By accelerating a property’s depreciation, you as an investor or any property owner can lower your tax liability and thereby realize a significant increase in cashflow because it’s more money in your pocket, more dollars. A larger cashflow is a great thing because that’s one of the main reasons why we invest in an income-producing real estate is for the cashflow and then the equity growth over time. My guest and I are going to dive into the topic a little deeper, so you can learn more about the tax savings available to you through this.
If you missed our last episode, be sure to listen to High Performance Habits For Investors – Brendon Burchard (Part 2).
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How to Pay LOW or NO Taxes Using Cost Segregation
It’s my pleasure to welcome Alan Goldstein to the show. Alan is the Founder of Emunah Cost Segregation. He is also an IRS enrolled agent, a Florida real estate broker, a Florida mortgage broker and an expert in depreciation. He is out to help taxpayers legally pay no taxes or very little on their real estate investments. Alan, welcome to the show.
Thank you. I’m glad to be on your show.
I’m excited to have you because in my conversation with you, we were discussing cost segregation, what it can do and the benefits of it. It wasn’t something that I haven’t heard before. If I’m not mistaken, we touched upon it in an older episode. It was very engaging in listening to you talk about how it works and the tax benefits of it that I thought, “Why isn’t everybody using this?” We’re going to get into the meat of this topic here because everybody wants to know how to save taxes and pay little or no taxes if they can legally. Alan, tell us a little bit about yourself and how you ultimately got into cost segregation.
I’m an enrolled agent and I represent the taxpayers in problems that they have with the IRS and with state taxation. Over 5,000 cases have been done related to representation work. One of the clients ended up having an issue with real estate and cost segregation and that’s how I was introduced to it. Ever since, I’m solely dedicated to cost segregation and so are our partners and everything. We disposed of the other parts of the company and now we’re solely dedicated to this service to the investor community.
What was your original background? Were you in real estate sales or on the mortgage brokerage side? Where did you start with your career in real estate?
Originally, it was in real estate as a sales associate. Then I became a broker and I mostly was handling businesses as business brokering. I was also handling the mortgage side for commercial lending and things like that. That’s how I started. Then that led to taxation. I went through school, obtained my license and that was tied to cost segregation. That’s where I am now.
Whenever I have a guest on and we’re talking about a topic, especially if it’s something that’s a little bit technical, I always like to start with the basics and the most fundamental building block of the whole thing. In this case, the question is what is cost segregation?
The term is a little confusing and sometimes is misunderstood. In essence, the IRS allows you to separate the components of a structure into different asset classes. What I mean by that is an example. If you take a single-family residence or a multifamily residence, we go ahead and we break that down. We break it down into the foundation, the floor structure, interior finish, exterior, finish, electrical. All of those falls under different class lives, five years, seven years, fifteen years but this is what happens. Most professionals and even investors will lump all of the depreciation in one, meaning a single-family residential would depreciate in 27.5 years. Generally, what they do to keep it easy is they take their basis and your basis is what your property cost you and your expenses. They’ll divide it by 27.5 and then they’ll go ahead and deduct that every year, whatever that amount is. That’s leaving a lot of money in the table because some of those components, up to 50% of it, you can go ahead and separate from a straight-line depreciation and accelerate all of that depreciation and end up with a huge net operating loss, which is applied against your income. Then you either pay very little taxes or no taxes at all up to the next fifteen years.
You’re essentially taking your real estate and chopping it up into sections. Each section is entitled by law, by IRS tax code to be depreciated on a different schedule. Some of it might be three years, some five, seven, ten, fifteen, 30, whatever the case may be. The idea is to take as much of that property of that real estate and accelerate the depreciation so you’re taking more of it sooner and as fast as you can. You can write off more of your taxes and do from those real estate investments now instead of waiting until next year or the years to come. Is that a good summary of that?
Absolutely, that’s totally accurate. There are different strategies that are used and everybody has a different reason for doing it.
Maybe it’s redundant to ask the question of why do a cost segregation because for me, what’s right in front of my face is we want to pay low or no taxes. Drill into that a little bit more in terms of why do a cost segregation? Are there other reasons or benefits in doing it that we’re overseeing here?
The number one reason is to pay little or no taxes but there are other reasons. For instance, there are state reasons. There are taxation reasons in the sense that let’s say your LLC where you have your holdings might be a little bit low on cash or not what you projected in your cashflow. In those cases, you can get the money back that you paid in taxation. Some people use it as an interest-free loan instead of going to the lender and saying, “I want $1 million to do a rehab. It’s going to incur all that expense and interest.” What some people do is they go ahead and do the cost segregation. Then they amend the previous returns. They get all of that money back from the IRS and then take that money and invest it in their rehab or purchase other properties. There are a bunch of reasons why. If you want to stabilize your income, you take the amount of depreciation from the report and then you say, “No, I don’t want to take $500,000 this year. Let’s revise the numbers and make it $100,000 each year because I like round numbers.” There are all sorts of reasons why people want to do this.
If I can amend the previous year’s tax return, how far back can I go in making amendments?
You are allowed to go back fifteen years. That brings up a very important point. There are two types of cost segregation termination, the end of the process. You have one where you say you bought the building five years ago. You go back five years, will put into the basis, split the building, do a segregation or the single-family residence. All of that lost depreciation that you didn’t take, you can claim in this year’s taxation. Any balance that’s leftover is a net operating loss and you carry it over. If you’re in a situation where you need money for whatever reason, we can go ahead and up to four years, go back and do the study. For those four years, the IRS will go ahead and return to you all the missed money from depreciation that you did not take.
This is a conversation that would be between a real estate investor and their tax advisor or their CPA because they would have to analyze what they’ve paid in years past and what could be revised and carried forward.
We work either directly with the investor or we work with their professional, their CPA, their financial advisor or whoever it is. We go ahead and determine what’s the best strategy for them to use based on what they want. We then coordinate all the professionals together to make things happen for the investor. When I say working with professionals, it’s okay if you don’t have a professional. We have clients who do their own returns and all of that. That’s okay, we can take care of you also.
We’re talking about saving taxes, paying low to no taxes. This is something that a lot of people don’t talk about. Is it possible that a cost segregation causes an audit? Is that a risk?
That is almost the number one question that I get asked. The answer is it hasn’t yet in thousands of studies and it normally does not. There was an article released in The New York Times, regarding Kushner, the husband of Ivanka Trump and how he used this cost segregation to pay no taxes. For the past years, out of $3 billion or $4 billion sold, he’s only paid $1 million using cost segregation. He has not been audited and it’s totally legal. It states in the article that there’s nothing illegal about it or anything that triggers anything. One of the forms that we complete is a form 3115 for the IRS. We use a method that is called automatic acceptance. We’re not going to do this and then somebody at the IRS is going to say, “Let me review this and if I like it, I’m going to do it. If no, I’m going to deny the claim.” It doesn’t work like that. It’s automatic acceptance. The theory is that a properly licensed individual like ourselves and like your professionals know what they’re doing. The volume of work is not sufficient to justify getting someone in auditing all of these returns and putting them under the microscope before they grant us. They call that automatic acceptance of the form 3115.
Maybe I’m making a little bit of an assumption here, but why don’t most accountants mention cost segregation or talk about it or maybe even know about it? I can’t imagine that most CPAs or tax advisors had never heard of cost segregation. It appears to me that most accountants don’t mention it, talk about it or even advise clients to look into it.
That’s very common. The majority of CPAs are not aware of it or don’t understand it. What ends up happening is like any specialty, let’s say you become a medical doctor. You know about cardiology, nephrology, all the different areas of the body, but you’ll become a specialist in a particular area. It’s the same thing as CPA. You have general CPAs but mostly CPAs like to stay in an area that they can master. Let’s say single-family residential CPA will be very familiar with this process. A CPA who does 1040 easy forms at H&R Block or wherever they do it, they’re not going to because those types are not into investing. Those CPAs are not exposed to these advanced tax strategies that people who have higher income or are solely investors, real estate investors or customers.
It seems to be somewhat of an area of specialty or at least special knowledge. How does a cost segregation work? I’m sure people are wondering, “I get it. I understand what it’s for, what it is and why I need to do it, but how does it work? What does it look like?”
There are several steps. The first step is to make sure that we have your basis calculated correctly. Almost every basis that we’ve received is calculated wrong. For instance, let’s say right now you fired your CPA. You have 100 properties and you don’t like the last CPA. You throw everything on the new CPA, but the previous CPA didn’t do everything correctly. The new CPA might transfer basis incorrectly and therefore right from the beginning, the numbers are wrong. The first step is to calculate your basis correctly. That means making sure that we have the purchase price in there, the sales tax in there, the closing costs in there and all that. Another point of confusion is the land cannot be depreciated. That is completely true, but what people fail to realize is that there’s a cost to getting the land ready for that property. That you can go ahead and depreciate, add to basis.
Let’s say that it was full of rocks and now you have to make it into solid dirt or the foundation for a building and all that. You’re not depreciating the land, but you’re depreciating the expenses related to getting the land ready for the structure that you’re putting on it. Once we have your basis, then we have to determine what type of property is it. Is it residential? Is it commercial? Is it industrial? Why do we determine that? There are other issues involved, EPA studies, phase one, phase two. Once we have that narrowed down, we know what type of assets correspond to what type of structure. For instance, a single-family residence is not going to have hopefully any manufacturing equipment in that property, so we know that that section won’t apply. That’s what we do. Then we see if the person has all the documents. Is it a new construction? Is it just that they purchased it? What documents are available? We go ahead and then rebuild the property as if we were going to construct it now. We get into the software and we say, “This is a single-family residence, a 3:2 located in Tennessee,” or wherever nationwide.
It’s going to cost, as an example, $200,000 to rebuild. That $200,000 is composed of $15,000 for electrical, whatever the case may be. We go ahead and rebuild that and then we adjust it based on the basis amount. Meaning now it might be $15,000 to do the electrical but when you purchased it, it was $5,000 as an example. Once we have that, then we calculate the percentages, add anything else. You might have furniture and fixtures. We add all of that in there and then based on the segregation of the split of the structure, we generate the report. The report is pretty complicated because we have to cite the law, we have to cite cases, why did this refrigerator depreciate faster? Then we say, “Based on such and such case, that qualifies for accelerated depreciation.”
When you first started answering my question, you were talking about the land and those initial costs preconstruction. It sounded like those applied to builders, not specifically to real estate investors or even those who are passive real estate investors buying turnkey rental properties. As you continued to answer that question, it sounded like it doesn’t matter what kind of an investor you are or what you’re buying, you can segregate virtually everything?
Absolutely. Let’s say you provide a turnkey property, but there’s something that you had to do to some part of the land in order to get that structure ready to be a turnkey property.
Let me clarify that for you. In the example you cited, someone had to clear or grade the land and build or renovate, depending on the situation, the property. In that example, it’s often not the real estate investor who’s purchasing it because they come into the picture after the property has been completely renovated. It’s ready to go, at least it’s a turnkey rental. They’re not getting involved in that initial phase of dealing with the land or renovating. The cost involved in doing that stuff that doesn’t apply to the investor on the end of that chain, buying it as a turnkey rental.
In some cases, you can because the land is not the total amount that’s listed. Sometimes the appraiser’s office, tax assessors or whatever, every area has a different name. They might attribute $10,000 to the land and sometimes that’s not correct. Sometimes the land is too high and you want to argue that to bring it low so you can take more of the structure. Generally, to answer your question, you’re correct. That cost is already built into the property, to explore it and it’s not even worth it. In those cases, what we focus on are land improvements, which the new buyer from these turnkey properties can go ahead and use the segregation for land improvements. You spend such and such on flowers, a koi pond or whatever you did on the property.
Tied with all that, it sounds like ultimately the goal is to have the land value as low as possible and the improvements as much as possible because what you’re going to depreciate is always above the dirt.
As far as the land value is concerned, the IRS accepts different methods of land depreciation but that’s a totally different topic and very complicated.
Having said all that, how long does it take to do a cost segregation? I know this is work that someone like you would be doing, not the investor themselves.
If the basis is under a million dollars of the property, then that would take around a week to do. If there are tax returns and amendments, it might take longer. What we do is we set aside a time frame of about 45 days for the cost segregation, but it does not reach 45 days. 45 days are for more complicated commercial and industrial facilities, which are 100,000, 500,000 square feet and that takes a lot longer. To directly answer your question, for a typical single-family residence, you’re looking about a week without any amendments needed to be done to the returns or anything. If they are, then it depends on whoever does your amendments and the time they take.
Are there different ways to do a cost segregation or is it the same pretty much from one property to another?
There are different ways of doing it and it depends on what’s presented. A new construction would require a different type of cost segregation report than a purchase. We have about six of them and it depends what you do. For instance, if you own multi-family apartments, we can use a sampling method. All the two-bedroom apartments or whatever it is, the model is going to be very similar, so we can take one and spread it across the rest. For the single-family residence, it’s very simple because the only thing that determines any differences is the square footage involved, which adds to all the components of the structure.
Here’s the million-dollar question. How can a cost segregation generator yield tax savings when it’s not increasing the total depreciation or the depreciable amount?
This has to do with the net present value and things like that. The core of it is that you’re going to use that money that you did not pay in taxation and use it for further investments. I’ll give you an example. You might do a cost segregation on a single-family residence and then your tax saving is $25,000. You might put those $25,000 either towards the renovation of the property, which is going to increase the value or you might take it and purchase additional properties. Whatever you take that money and use it for, generally as an investor, you know what you’re doing so it’s going to give you a higher return than any possible taxation you may have in the future.
It’s not that you’re getting a credit or a tax refund after you do a cost segregation, whether in the present year or in a past tax year. What is the net result from a tax perspective? Is it a credit? Is it a net loss that you would apply to future tax years? How does that look like?
It’s not a credit. It has to do with depreciation loss and usually it ends up in a net operating loss. For example, if we do a 2018 study and it says that your aggregate amount of depreciation should have been $380,000, you can apply that to 2018 and forward until you consume those $380,000. Unless you use the other method, which is to go back and do the amendments and then receive that money.
It shows up as a loss and that operating loss that you apply to future years or past years if you’re doing an amendment. For our audience who don’t understand what we’re talking about, it’s accounting lingo. Your tax advisor or your CPA will understand this and know how to apply it. I’m not sure what to ask you because this is pretty clear at this point at least for me, it is. I’m hoping it is for our audience. What else didn’t I ask you that I should have asked you?
One of the areas is bonus depreciation. Some components, not all of them qualify for bonus depreciation. Instead of turning the five-year property into actual deduction for the five years, you can deduct the whole amount in the current year. Instead of dividing it by five, you end up getting the full amount in the same year on top of anything else that contains the cost segregation.
That’s good for someone who has a large tax impact this year or that’s coming up in the following year. You would want to accelerate as much as you can and take advantage of bonus depreciation so you can lower your tax impact in the current year or the upcoming year. Is that the general idea?
Absolutely. Also another point is the percentages involved. If for a single-family residence it can be basically between 30% and 50%, it could be accelerated in depreciation so it makes a big difference.
Has anything changed this year with the tax changes, the tax reform? Has it changed anything in terms of cost segregation? I know there’s accelerated appreciation.
Yes. A lot of the things were taken off. Leasehold improvement means that you don’t own the property. You leased the property, you made an improvement, that qualifies for cost segregation. That was specifically added in there. Another change, which benefits is the 20% pass-through that was passed, which ones that’s incorporated into the numbers, it makes a huge difference in your taxation.
How does that work?
The 20% is for certain corporate structures. You can automatically take 20% off of the income for that structure before it passes to your personal level. Therefore, because it depends on your profile, there are space-outs and things like that. The theory is that you would have to pay only 80% of your income. The other 20%, in essence, is a deduction and you don’t have to pay. Then we add the cost segregation amount to the 80% that you have to pay. It becomes a great way to save money on tax and increase your cashflow so you can continue in your investment if you’re building portfolios or whatever the case may be.
One last question, is there a minimum portfolio size or minimum portfolio value that is essentially a requirement for this to make sense? Can anybody do a cost segregation even someone who is new to real estate investing and they’re getting started? They’ve got maybe one or two properties under their belt. They plan to buy more but it’s a small portfolio. Is that a good candidate? Is this applicable to everybody?
Yes, it is. In essence, does it make sense for you to do it? When you contact any person that does these types of studies, the first thing you want to ask is for a cost-benefit analysis. There are some calculators on websites and things. They’re going to ask you some basic questions, “What type of structure, the size, the basis?” Then it’s going to give you instantly at no cost or result and say, “Based on your profile, this is how much it’s going to cost you. This is how much you’re going to save. Is it worth it?” Generally, it is. I have dealt with houses that have a very low basis, $20,000, $30,000. In those cases, if it’s one or two properties it’s not worth it. If it’s in a portfolio, because all of that is cumulative, so it’s definitely worth it. It depends on the basis. There’s a free calculator that would tell you is it worth it for you?
I assume those low-cost basis examples you’ve given were very inexpensive properties, probably in the $40,000, $50,000 range?
Absolutely. One common area for that is Texas and Tennessee, which are the ones that we’ve been exposed to the most.
I don’t think that applies for the most part to our clients in our audience here. They’re generally acquiring in terms of single-family homes, properties that are in the $70,000 to $80,000 on the low end to about $130,000 to $180,000 on the high end. When you start building a portfolio of that type of property, cost segregation starts to make a lot more sense.
Especially, if you were to hold me to the fire and say, “Give me a number.” Anything over $100,000 starts making sense.
Alan, please tell us how we can learn more and find out more about cost segregation and your services. I know you have calculators on your website. Tell us where we can find you.
You can reach us by phone at 786-545-8044 or our website, which is Cashflow179.com.
Emunah Cost Segregation
Email: cashflow179@yahoo.com
Email: goldsteinalan870@gmail.com
Whatsapp: 786-232-7872
Telegram: cashflow179
I assume that the 179 is a reference to the IRS tax code section 179, right?
Yes, we increase your cashflow using Section 179.
Any final comments?
I want to thank you very much. I hope that this has enlightened your audience and they take advantage of this great process so that they can continue on their quest.
Alan, thank you so much for your time. Thanks for coming on.
Thank you. Take care.
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