\n<\/p>\n
What\u2019s the key to paying fewer taxes<\/strong>? A cost segregation study<\/strong><\/a>. Never heard of it? Most real estate investors haven\u2019t, but we\u2019re about to unlock a world of tax-free income<\/strong> earning using this specific tool. If you\u2019ve wondered how the wealthy pay such few taxes<\/strong> while owning million-dollar-producing real estate, this is how. In today\u2019s episode, you\u2019ll learn how to use cost segregation, too, so you can keep more money in your pocket.<\/p>\n Taxes aren\u2019t everyone\u2019s favorite subject, but paying fewer taxes? You can probably get behind that. We\u2019ve brought on CPA and CFP Mitchell Baldridge<\/strong> to explain how he helps real estate investors, large and small, delete their taxable income<\/strong> and build their <\/strong>real estate portfolios<\/strong><\/a> faster<\/strong>. Our own Rob Abasolo uses Mitchell\u2019s team to cut his taxes down by more than six figures!<\/p>\n In this episode, we\u2019ll explain what cost segregation is<\/strong>, why so many top real estate investors <\/strong>use it to lower their taxes<\/strong>, when you can (and can\u2019t) use it on your properties, the short-term rental <\/strong>tax \u201cloophole\u201d<\/strong><\/a> to take advantage of, AND what happens when you do it wrong.<\/p>\n David: Mitchell: David: Rob: David: Rob: David: Rob: David: Rob: David: Mitchell: Rob: Mitchell: David: Mitchell: David: Rob: David: Mitchell: David: Mitchell: David: Rob: Mitchell: David: Mitchell: Rob: Mitchell: David: Mitchell: Rob: Mitchell: David: Mitchell: Rob: Mitchell: David: Mitchell: Rob: Mitchell: Rob: Mitchell: David: Rob: David: Rob: Mitchell: David: Mitchell: Rob: Mitchell: Rob: Mitchell: Rob: Mitchell: Rob: Mitchell: Rob: Mitchell: Rob: Mitchell: Rob: Mitchell: Rob: David: Mitchell: Rob: Mitchell: Rob: Mitchell: David: Rob: Mitchell: Rob: Mitchell: Rob: Mitchell: Rob: Mitchell: David: Mitchell: David: Mitchell: David: Mitchell: David: Mitchell: David: Mitchell: David: Mitchell: David: Mitchell: David: Rob: Mitchell: David: Mitchell: David: Rob: Mitchell: Rob: Mitchell: David: Rob: David: Mitchell: David: Mitchell: David: Mitchell: David: Mitchell: David: Mitchell: David: Rob: David: \u00a0<\/p>\n<\/div>\n Help us reach new listeners on iTunes by leaving us a rating and review! It takes just 30 seconds and instructions can be found here<\/a>. Thanks! We really appreciate it!<\/p>\n Interested in learning more about today\u2019s sponsors or becoming a BiggerPockets partner yourself? Email <\/em>[email\u00a0protected]<\/span><\/em><\/a>.<\/em><\/p>\n Note By BiggerPockets:<\/b> These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.<\/p>\n
This is the BiggerPockets Podcast, show 823.<\/p>\n
So cost segregation is the wheels to the ground strategy of how real estate investors create tons of bonus depreciation year one and lower their tax bill by a ton. So that, just like I said, rather than paying taxes, real estate investors can continue compounding and continue that big snowball of buying real estate.<\/p>\n
What\u2019s going on everyone? It\u2019s David Greene, your host of the BiggerPockets Podcast, the biggest, the best, and the baddest real estate podcast in the world. Joined by my co-host today, Rob Abasolo. Rob, what\u2019s going on, bro?<\/p>\n
It\u2019s going well, man. It is a Wednesday, but it basically is Friday because I am flying to San Diego tomorrow for the next couple of days, so I\u2019m really excited.<\/p>\n
What are you going to be doing there?<\/p>\n
Well, it is my best friend\u2019s 40th birthday party, and I wasn\u2019t going to go, and my wife was like, \u201cHey, you need to go. It\u2019s his 40th birthday party.\u201d And I was like, \u201cReally?\u201d And she was like, \u201cYes.\u201d And so I booked some flights with points and I\u2019m going to go surprise him. He doesn\u2019t even know.<\/p>\n
So not only is Rob working out every day, eating clean and has moved on from wearing Haynes pocket tees all the time, he also has made a friend who would be happy to see him in San Diego. Let us know in the comments on YouTube, how proud you are of Rob, and please congratulate him on this. And I would like to congratulate all of you who are about to listen to this show because this is fire. If you\u2019re someone who doesn\u2019t like taxes, which I\u2019m assuming all of you are, you\u2019re going to get a lot out of today\u2019s show because we are going to get into ways that you can legally save in taxes that you may not have known about, with specific steps that anybody can take if this is something they want to do. Rob, what is the most valuable insight that people will take away listening from this show?<\/p>\n
Today we are going to talk about how to leverage tax strategy to compound your wealth over the course of your life. All right. But you have to listen closely and you have to understand that there\u2019s a lot to this stuff, and we don\u2019t expect you to be a perfect expert by the end of this episode, but bookmark it and really pay close attention because I think it can have a huge significant impact over the course of your real estate career.<\/p>\n
That\u2019s great. My advice would be listen to this show until you can explain it to somebody else who doesn\u2019t understand taxes or real estate. That\u2019s the best way of knowing that you have a firm grasp on how you too can save in taxes. Now, before we bring in our guest, Mitchell Baldridge, I\u2019ve got a quick tip just for you. Stop thinking about solving tomorrow\u2019s problems and start thinking in terms of decades. Real estate in general and tax deferment in specific is not utilized very well as a short-term strategy. When you\u2019re using 1031s, when you\u2019re using bonus acceleration strategies to cost segregation studies, you\u2019re not avoiding taxes, you\u2019re often deferring them. And if you defer taxes the wrong way and end up in a situation where you\u2019re not making money and that tax bill hits you when you\u2019re not ready for it, it can hurt.
At the same time, if you\u2019re trying to build and accelerate your portfolio, this can be a massive, massive beneficial accelerator for you. So come up with an overall strategy, a plan for where you want to be 10, 20, 30 years from now, and ask yourself which of these strategies would work for you to get you there faster. Rob, anything you want to add before we bring in Mitchell?<\/p>\n
Just listen to the end because we really do talk about a lot of those key watch-outs. There\u2019s a lot of good and not necessarily bad, but I think caveats that really is important to soak in. So really, anytime David says anything, listen particularly closely because, man, you really broke it down so well today.<\/p>\n
Well, thanks for that, man. I appreciate the compliment. I try to break it down every chance I get. I hope you break it down in San Diego and let\u2019s let Mitchell Baldridge break it down for us now. Mitchell Baldridge, welcome to the BiggerPockets Podcast. So to kick things off, tell me a little about yourself.<\/p>\n
Hey, thanks for having me. Yeah, my name\u2019s Mitchell Baldridge. I\u2019m a CPA and a certified financial planner in Houston, Texas. I run my own CPA firm. We primarily work with small business owners and real estate syndicators. And then in addition to that, I have a bookkeeping tax service called betterbookkeeping.com, and then I\u2019m a partner in RE Cost Seg and STR Cost Seg.<\/p>\n
Well, awesome, man. Well thanks for coming on. For anyone who might be ready to tune out because we\u2019re going to talk about taxes, let me just set the table about what we\u2019re going to be talking about because personally I feel that taxes are a lot sexier than most people believe, because in my mind, if you are paying taxes, you are not keeping that money in your pocket, thus you are making less every single year. I\u2019ve had multiple six figure tax bills and this one strategy is how I\u2019ve been able to lower my bill through the power of real estate tax knowledge. And Mitchell here is my partner over at strcostseg.com, wanted to bring them in to really set the stage for what I think is the most powerful wealth building strategy in real estate.<\/p>\n
Yeah, totally. You do not compound by paying taxes to Uncle Sam.<\/p>\n
And that magical tax strategy we\u2019re going to get into today is called cost segregation. For those that already knew where we were going, well done. Mitchell, why is it important for investors to know about cost segregation?<\/p>\n
Sure. So cost segregation is the wheels to the ground strategy of how real estate investors create tons of bonus depreciation year one and lower their tax bill by a ton. So that, just like I said, rather than paying taxes, real estate investors can continue compounding and continue that big snowball of buying real estate.<\/p>\n
Rob, tell us about why you believe cost seg can be even more powerful than cashflow itself, as heretical as that may sound.<\/p>\n
Definitely. Well, I think most investors getting into the game, we tend to focus on cashflow because we want to make money today. Now granted of course that\u2019s overgeneralizing, that\u2019s not everybody, but for those people that are really set on their cashflow, I think it\u2019s really important to look at the overall ROI of your investment, not just the cash on cash return. Because when you look at all of the different components from cashflow to appreciation to debt pay down, and then you start adding in the tax deductions that you can get, your ROI on any property can really begin to skyrocket. I\u2019ll tell you about a quick deal, and granted this is a bigger deal. This isn\u2019t something that everyone at home is going to be working through. But I\u2019m actually working through a $2.4 million property right now. The cashflow on it is going to be on the lower side for that specific property.
It\u2019s going to, I think, cashflow between 30 to $40,000 a year, which again, it\u2019s not a bad amount of cashflow, but relative to that property, I typically look for a little bit more. However, once we start using some of these tax deductions that we\u2019re going to talk about today, this specific property will actually help lower my tax bill by about 250 to $300,000. And again, we\u2019re going to get into another deal later on in today\u2019s episode that\u2019s a much smaller deal, much more tactical for a lot of the people out there, but big or small, it can work for anybody.<\/p>\n
All right, so now we know why it\u2019s valuable, but how does it work? Mitchell, can you lay the foundation for us in simple terms so our listeners can understand what cost segregation is and how it can be used?<\/p>\n
Sure. So in very simple terms, cost segregation is the mechanism, it\u2019s an engineering report where you blow your building up into almost like, picture one of those blueprint component piece diagrams. Well, you take a real estate investment, whether it be a short-term rental or a huge industrial property and you blow it into all of its component pieces. You take the land as a piece, you take the roof as another piece, you take the foundation as a different piece and windows and special air handling systems, and you attach a tax life to every component of your building. The reason you do this is because there are these different tax lives for different assets.
So the roof and the foundation and the walls and the framing of a building would have either a 27 and a half or 39 year tax life, whether it\u2019s a residential property or whether it\u2019s a commercial asset. But a lot of these components of the building will have much shorter tax lives, would have five, seven, or 15 year lives, like landscaping or vinyl flooring or certain cabinetry or certain mechanical systems could have a much shorter life. So what this engineering report, this cost segregation study does is takes the building and puts it into different tax life categories so that you can hand that to your CPA and you can save money year one.<\/p>\n
All right, Mitchell, so you\u2019ve described how cost segregation works, but let\u2019s back it up a little bit and talk about how overall depreciation works. How about if I give you my understanding of it and that as a professional, you could correct me if I miss anything? Sound good?<\/p>\n
Sounds great.<\/p>\n
So if you were a small business owner, which we are as real estate investors, our real estate portfolio is our business. And let\u2019s say you owned a restaurant and you bought a dishwasher for that business and you spent $20,000 on this industrial grade dishwasher, that would be a write-off for the business. So even though the business may be made $100,000 in the year, you had to spend 20,000 of that dollars on the dishwasher. So you\u2019d be able to write off $20,000 against the 100,000 you made. But the government usually won\u2019t let you write off the full amount in the first year because then if you had a construction company and you bought a whole bunch of trucks for that business and the amount of vehicles you bought was more than the actual profit that was made, you\u2019d never have to pay taxes and you just keep accumulating assets.
So instead what they do is they let you write off a percentage of that dishwasher every year and they figure out how many years that dishwasher will last, say it has a useful life of 10 years. And they\u2019ll say, \u201cYou can write off one 10th of that dishwasher every year,\u201d that way you can\u2019t take the full deduction in the first year because then you wouldn\u2019t probably pay many taxes at all. If you bought new equipment constantly, you could avoid or significantly reduce your taxes. That same principle, which is called depreciation, applies to real estate investing. So the building that we\u2019re buying is actually falling apart over time. The siding is wearing out, the air conditioning unit, the mechanical systems, all the things you mentioned wear out.
And as a general rule, the IRS has said, \u201cHey, we say that a house has a useful life of 27 and a half years for a residential dwelling. We will let you write off one 27.5th of that every single year against the income that you make.\u201d So if the property makes eight grand in cashflow, but that appreciation on it is $6,000, you\u2019re only taxed on $2,000, which is significantly better than if you earn money at W2, you have no way to shelter it. My understanding of cost segregation is that rather than extending it over the full useful life of the property, which is 27 and a half years for residential real estate, you can accelerate that and take chunks of it in the very beginning.
Those cabinets aren\u2019t going to make it the full 27 and a half years. The air conditioning, the boiler, some of the other components of the flooring planks you said, they\u2019re probably not going to make it the whole time. So they\u2019ll let you take a bigger chunk, which is those pieces in the beginning, which gives you a bigger write off for that year\u2019s income. How did I do?<\/p>\n
I think that was pretty good.<\/p>\n
The idea of sure, I own a business and I buy a stapler, I can write off the stapler year one. But I buy, to your point, this commercial grade dishwasher or this house, they\u2019re going, \u201cWhoa, whoa, whoa. This is not an expense. This is a capital asset and the way that you\u2019re going to recover that cost over time is through depreciation.\u201d And there\u2019s different methods and there\u2019s a lot of different rules around that, a few of which we\u2019ll get into right now.<\/p>\n
Now I think it\u2019s important to mention, and I know we\u2019re about to get into it, we tend, as investors, to think when I buy a $500,000 property that I invested $100,000, that\u2019s 20% down. That\u2019s how our brain sees it. I invested 100,000, because that\u2019s what I took out of my bank account and gave to the seller and then the bank gave the other 80% of it. But you actually bought a $500,000 asset. You were on the hook to pay back the full 400 grand that you borrowed. It was not free. It feels free because we pay it back with the money that came from the tenant. But indeed, in fact, you bought the full $500,000, which means you are able to write off, I should say, you are able to use a basis of $500,000 minus whatever the land was with your depreciation.
And it\u2019s important that people recognize you\u2019re not taking the 100 grand that you invested and making that your basis, you\u2019re getting the full $500,000, which means when you incorporate leverage into real estate, it makes it even easier to save in taxes. Can you break down, Mitchell, how that works?<\/p>\n
The simplest example outside of real estate would be I can walk into a car dealership on the last day of the year with $1,000 and put that down on the table and walk out with $100,000 Chevy Tahoe. And so I\u2019ll also, to your point, David, walk out with a $99,000 loan that yeah, they will insist I pay that back. And then we\u2019ll talk more about bonus depreciation, but using bonus depreciation, I can write off, or section 179, I can write off that whole car the year I buy it. So wow, I just walked into a car dealer with $1,000 and walked out with a car and with $100,000 write off. That\u2019s amazing. Well, that happens in real estate the same way, where, to your point, a 20% down payment on a house, that seems like a pretty large down payment for a home, that\u2019s actually pretty high leverage. If you go look at an industrial warehouse or if you go look at a self storage deal, they\u2019re going to want you to generally put down an awful lot more than 20%.
But with this home, they\u2019re great targets for depreciation in the sense that in your example, I\u2019m going to take $100,000, I\u2019m going to buy a $500,000 house, and then of that 500, I\u2019m going to separate the land from the improvements and then I\u2019m going to take the improvements, both the site improvements, the building improvements and cost segregate, meaning break all those improvements into their tax lives, shorter lives and longer lives. And then I\u2019m going to use bonus depreciation to accelerate all the short life property and take a huge deduction year one. It\u2019s super convenient because the year that the capital goes out of my bank account happens to also be the year that I get a huge deduction.<\/p>\n
Yeah, there\u2019s a few things to unpack there. I mean, the high leverage benefits of real estate are pretty nuts, because just like you talked about, you can be very high leverage in real estate, whereas you can\u2019t necessarily go and take $100,000 and say, \u201cHey, I\u2019m going to buy $500,000 of Tesla stock.\u201d There really aren\u2019t ways to do that, not easily that I know of anyways. Whereas you could go to a bank and get that same exact leverage on real estate because it\u2019s an appreciating asset and banks are willing to do that. And you sort of define the idea of depreciation, so I think we get that over the course of time, whether it\u2019s 27 and a half years or 39 years for commercial property, you get a small line item deduction. You talked about cost segregation, how we\u2019re able to, I guess, break down those components and see what could be deducted faster. But the one thing that we haven\u2019t really jumped into specifically is bonus depreciation. So what is the difference between bonus depreciation and depreciation in general?<\/p>\n
Bonus depreciation has been around a long time in various forms. And bonus depreciation really means for the shorter life property, these five, seven and 15 year items like machinery and fixtures and land improvements, that bonus depreciation allows you to accelerate all the depreciation or a chunk of the depreciation to the very first year you placed the property in service. In 2017 in a budget reconciliation, they passed the Tax Cuts Jobs Act that unlocked this huge bonus opportunity. One, it took bonus back to 100%, meaning any five, seven or 15 year property, that was real property that you placed in service in that year could be 100% bonus depreciated. And the other thing, the Tax Cut Jobs Act unlocked is that you could apply bonus to used property. Previously cost segregation and bonus depreciation was super valuable for ground up development. It could only be put on new cars, new property, new equipment. Well Tax Cuts Jobs Act allowed you to go take an apartment that was a value add from the 1970s and buy it new to you and start to cost segregate and bonus it and bring all that depreciation forward.<\/p>\n
So if I understand you correctly, before, you could only write off the useful life of some of these things like the air conditioning, the roof when they were brand new, when it was first built. And they adjusted the tax code to say, \u201cHey, even though when you bought it, that roof was 20 years old, we\u2019re still going to let you write it off as if it was brand new over the useful life of that roof.\u201d<\/p>\n
Well, the roof\u2019s a longer life asset, but yes. So another thing about bonus depreciation as opposed to 179 and the huge unlock, is that bonus depreciation will allow you to offset your income below zero, so you can generate net operating losses in real estate. So Rob, back to your point of this Arizona house that\u2019s going to generate 40 to $60,000 of net cashflow every year. The first year, you\u2019re going to lose a quarter of a million dollars. So you\u2019re going to be left with cashflow of $40,000, but a net loss of $200,000 out of that property. So that\u2019s where this all really comes together. Sort of back to that Chevy Tahoe example of I put $1,000 down and I buy this car and I just generate $100,000 loss day one.<\/p>\n
Well, and let\u2019s just clarify, when you say \u201closs,\u201d quote, unquote, for everyone listening at home, we\u2019re talking about a paper loss, which is effectively the concept of you are actually profiting in your cashflow, but that doesn\u2019t mean that on your tax return, it doesn\u2019t look like you lost money because of all the advanced, or I guess the bonus depreciation or the depreciation that you took. Is that kind of an accurate representation of what a paper loss is?<\/p>\n
Yeah. So if you want to go way, way nerdy, it\u2019s a deferred tax liability. So you are basically creating a loss today ahead of schedule and you\u2019re just pushing taxes into the future. So yeah, I used to work at a big corporate tax firm doing tax provisions for public companies. This would show up on your balance sheet, a deferred tax liability out there. So I basically took five years from now\u2019s tax deduction and pulled it into this year. And we\u2019ll talk more about recapture later and we\u2019ll talk about there\u2019s no free luncheon in the tax code. What goes up must come down. But yes, like I was talking about earlier, it\u2019s a nice thing to have that the year that the equity goes out the door and that the bank debt comes online, is also the year that you get to generate this massive deduction so that you\u2019re not paying taxes the same year that you\u2019re buying property, hopefully.<\/p>\n
Right. And it is important to notice that we call this a paper loss. So you are writing off \u2026 they assign a dollar value to the loss of the materials in the home because at some point you\u2019re going to have to replace them, but that doesn\u2019t mean that you actually lost money on the deal. And when you\u2019re applying for financing, they\u2019re not going to hold the depreciation against you. So if the property made $50,000 in a year and the depreciation was 40,000, you\u2019re only taxed on 10. But when you go to apply for a loan, they will let you use the full $50,000 as income in most cases. I think a lot of people get confused as well, if I take a loss on depreciation, it\u2019s going to affect my ability to borrow money, it\u2019s going to affect my debt to income ratios. But for most lenders, that\u2019s not the case. Correct, Mitchell?<\/p>\n
Yeah, that\u2019s a great call out. Any good banker will allow you or will go to their underwriting and allow you to add back either all or a part of that depreciation to get back to-<\/p>\n
And so in theory, using this strategy of both bonus depreciation and how cost segregation studies can help you do this, is it, in theory, possible to take such a big loss on your real estate holdings, that it actually crosses over to other types of income, like your W2 income and makes it look like you lost money there, effectively lowering your tax bill in that moment, is that something that people can do as well?<\/p>\n
So yeah, we\u2019re getting into now how do I utilize these losses? And this is definitely worth calling out here, that real estate income or rental income by its nature is considered passive income and your W2 income by its nature is considered active and you cannot offset active income with passive losses unless you\u2019re a real estate professional. So we can get way into real estate professional status if you\u2019d like.<\/p>\n
Yeah, let\u2019s get into that. So is this something everyone listening can do? Can they just all start taking depreciation against not only off of their real estate deals, but also off of the money that they\u2019re earning in other endeavors?<\/p>\n
So you may have to jump through some hoops out there. So real estate professional status is a bright line status recognized by the IRS that allows you to offset ordinary income, ordinary active income with these passive losses out there. But to become a real estate pro, you have to work 750 hours and more than half your working time in your own real estate business out there. So you have to be acquiring, or developing, or redeveloping, or rehabbing, or brokering, or managing real estate for a business that you own more than 5% of. So you can\u2019t even be a W2 employee for a management firm or a W2 employee for a brokerage house. You have to be in the real estate business and you have to be working more than half your time and really working in real estate to be a real estate pro. So it\u2019s a big hurdle to jump over.<\/p>\n
Yeah. So it\u2019d be really hard to be just a full-time W2 worker and a real estate pro because full-time W2 workers work roughly 2,000 hours a year. And so if you want to be a professional, real estate professional and a W2 worker, you basically have to work over 4,000 hours a year, right?<\/p>\n
Yeah. If you\u2019re a dentist, it\u2019s going to be hard to be a full-time dentist and be a real estate pro. So being a real estate pro is fantastic because not only is the real estate that you buy and bonus depreciate able to offset your business income, but then you\u2019re also able to go be a limited partner in deals and kind of aggregate all your real estate activity and create actual passive losses that will offset your \u2026 if you\u2019re a property manager or a broker, I mean, it\u2019s just a fantastic way to be able to kind of passively go mute your income with real estate and not have to get fully into buying and owning and operating real estate on your own. But if you cannot or will not become a real estate professional, there are a couple of ways that you can still get the benefits of real estate losses, but you got to jump through a couple of hoops.<\/p>\n
One of the main ways, one of the biggest hula-hoops you can jump through is you can just marry a real estate professional. I mean, I know that\u2019s not all that easy, but in theory, once you\u2019re actually married to someone, let\u2019s say you marry a broker or a real estate agent, their status, does it sort of transfer over to you? How does that work?<\/p>\n
Yeah, we keep joking about starting up this dating app where we take real estate pros and then we take high income W2 folks and we just match them together. And so yeah, if you are married to a real estate pro, their status is automatically imbued onto you. So a lot of doctors, lawyers, folks like that always talk about, \u201cOh, just marry a pro or have your stay at home spouse become a real estate pro.\u201d<\/p>\n
Do you hear that, ladies? If you\u2019re making a ton of money and you need some tax shelter, I\u2019m your guy.<\/p>\n
That\u2019s right, because David Greene is both on the real estate agent side and brokerage. So it\u2019s kind of like you become a double real estate pro.<\/p>\n
More value. Maybe I can be the face for this dating app when it actually comes out, Mitchell. Rob, is that how you got your wife? You just basically was like, \u201cListen, I\u2019m a full-time real estate professional, very rare. You don\u2019t want to miss this opportunity, it might not come again.\u201d<\/p>\n
And she was like, \u201cYes, continue talking to me about taxes, please.\u201d And I was like, \u201cMy girl, right here.\u201d<\/p>\n
So then, yes, you can marry a real estate pro, which could be great or could be very difficult, depending \u2026 So there\u2019s a couple of other routes you can take as well, which are really to take that real estate passive income and make it active. Oh, one way to do that is I\u2019m a CPA, I own the CPA firm, I could go buy a building that I operate out of, and that would not be a passive rental activity, that would be an asset that my business owns, similar to the servers or the copier or any other asset we own, that we operate out of. And so that active loss of the real estate that I purchased could offset the business income of any of my active businesses.<\/p>\n
You are able to use depreciation from real estate you buy to shelter income that isn\u2019t directly related to that specific asset. So your loan commissions, your realtor commissions, I would imagine a construction worker, might be some of the money they make from doing construction projects, consulting, property management fees, all of that. You can shelter that income with the same depreciation, otherwise it just stacks up. And if you don\u2019t use a depreciation, you save it and next year you could use it if the property made more money then. So that works for the people like me that make our living writing books and teaching people how to be real estate investors and running brokerages. But what about the high income earner that isn\u2019t able to completely go full-time real estate professional, but still wants to take advantage of what we\u2019re talking about?<\/p>\n
So yeah, aside from being able to buy your own building or buy property for your business, which by the time you\u2019ve bought the building and bought the warehouse and bought the other building, you can only buy so many buildings for your business. You can also create another type of business, a short-term rental business, the STR loophole. So the IRS looks at a short-term rental, not as rental real estate or real rental property, but looks at it as a hotel that you operate, that you happen to own the real estate of, that looks an awful lot like a rent house, but it\u2019s considered to be a whole different thing. And so if you run a short-term rental, which means seven nights or less, you have the opportunity, or seven nights or less on average, you have the opportunity to take all the depreciation related to that trader business and offset other active income.<\/p>\n
And so one of the big requirements for this short-term rental loophole, which is applicable to really probably a very large majority of our audience that own short-term rentals, is the idea of material participation. And so that basically means, in a very simple way, if you\u2019re self-managing your property, you are likely materially participating so long \u2026 I mean, I think there\u2019s seven ways to do this, correct me if I\u2019m wrong, but one of the main ones that probably applies to most people is if you are working on this property a minimum of like 100 hours every single year, which is I think two hours every single week, and working on the property more than anyone else, then that would be considered material participation, right?<\/p>\n
That\u2019s right. So where the real estate pro designation is 750 hours and more than half your time, material participation is kind of an or test. So if you work 500 hours in that business, you materially participate. If you work 100 hours and more than everybody else in the business, meaning you spend more time in that business than any other single person, you\u2019re a material participant. Or if you\u2019re just the only operator of that business, you\u2019re materially participating. So if you have a ADU behind your house that you\u2019re the only person who really works in it, but it takes you 20 hours a year, that you\u2019re materially participating.<\/p>\n
So that would be like if it\u2019s on your property, but you clean it, you\u2019re the maintenance person, the landscaper, you\u2019re the one that\u2019s really owning everything about that, okay, then you actually don\u2019t have to fulfill, yeah, you don\u2019t have to fulfill the 100-hour requirement in that.<\/p>\n
That\u2019s right.<\/p>\n
Wow, that\u2019s crazy.<\/p>\n
So yeah, the material participation guidelines are a little bit looser. If you want to go full nerd, there\u2019s publication 925, which is about passive activity rules, that if you really want to go to sleep, you can read that whole thing tonight.<\/p>\n
The tax sleep talk, as we call it. Well, so if you materially participate in a short-term rental, I mean, again, I think a lot of people do without even knowing it, this is sort of where it all comes to a head from a bonus depreciation, cost segregation standpoint because it\u2019s at that moment that you\u2019re able to take your losses and apply it to your W2. Or am I missing something?<\/p>\n
That\u2019s right. So yeah, if I work for some big tech company making a million bucks a year and either me or my spouse runs a short-term rental and materially participates, we\u2019re able to aggregate those two income sources, the high earning W2, and the huge loss from the paper loss that we\u2019ve generated, put them together and pay way less tax and defer it to a later time.<\/p>\n
Dang. So is there a limit? Any amount of money that you make at your W2, you can just wipe out?<\/p>\n
So along with all of these great rules that the Tax Cuts Jobs Act gave us, they also created one limitation, the excess business loss rules that came into effect last year. So a single person can deduct about $300,000 from their W2 and a married couple can deduct about $600,000. So if you are a hedge fund trader with a $5 million W2, you can\u2019t just go start buying a ton of car washes and wipe out your entire income, you\u2019re going to be limited to that 300 or 600,000 out there.<\/p>\n
And then what about on the real estate side? Is there a cap on how many losses you can take with real estate?<\/p>\n
Excess business loss rules apply to any type of business loss against a W2. So if you\u2019re running a gelato shop or if you\u2019re running a real estate business, or if you\u2019re running an STR business, you can only lose 300 or 600, if you\u2019re married, against the meta $1 million W2 for the software engineer.<\/p>\n
I\u2019m saying in your real estate holdings, you can only take $600,000 of losses on that? Because I thought you could take infinite losses.<\/p>\n
The most you can take against a W2 is 600,000, but David Greene\u2019s brokerage business that makes $20 million a year at least, he can offset that as much as he wants by buying as many stadiums or amphitheaters or whatever he wants to go do. Does that make sense?<\/p>\n
Yeah, yeah, totally.<\/p>\n
So in essence, the government is sort of rewarding those who make their living through real estate if they invest their money back into real estate. So if you\u2019re making loan commissions, you\u2019re flipping houses and making profits there, you\u2019re trading capital gains, but you didn\u2019t necessarily execute a 1031 exchange, you have a loan company, you\u2019re doing things that employ people, generate revenue for the government. Maybe all your employees are paying taxes on their stuff, but if you take that money and you go invest it into more real estate, which creates more jobs and more economic opportunity, your reward is you don\u2019t get or you don\u2019t have to pay taxes. You just have to be aware it\u2019s not all sunshine and rainbows, it\u2019s not free money. You are highly susceptible to fluctuations in the economy when you make your money as a real estate broker or a full-time real estate professional. Interest rates going up, economic recessions, people get decimated at those times.
So even though it looks like, oh, this is great, I\u2019ll never pay taxes again, well, maybe you don\u2019t pay taxes because you lost money for four years in a row. 2010 wiped out a lot of people that were in the real estate space. So I think it\u2019s important to highlight, it\u2019s not like this cheat code where, oh, all I have to do is go make money in real estate. It\u2019s very hard to do that. It\u2019s very competitive. There\u2019s no ceiling, but there\u2019s no floor. I hear people talk about it like, \u201cOh, that\u2019s all I\u2019ll do. I\u2019ll just quit my job and go be a real estate agent.\u201d And five years later they\u2019re begging their boss to take them back into their W2 job because it was really hard. I see you smiling, Mitchell. Have you seen some of this before?<\/p>\n
We were all going to quit our jobs in 2021 and trade crypto. Market cycles have a way of doing that. And I mean, also I talked about this as the idea of I\u2019m going to cost segregate and bonus depreciate my property is going to create a deferred tax liability. Well, that\u2019s called a liability for a reason. Remember we did this 20% down, 80% loan rent house. Well, I\u2019m adding more leverage to my real estate deal by frontloading all the depreciation. It\u2019s just another form of leverage. You owe the IRS money in the future. It\u2019s not showing up on your balance sheet or your personal financial statement if you\u2019re not doing great gap accounting. But if you were doing great gap accounting, it would show up right there as a liability of a future tax you owe.<\/p>\n
Okay. So Mitchell, you walked us through the basic concepts of cost segregation. Next, we\u2019ll get into an example that lets us see how this actually works in action and maybe we can hit some pitfalls of cost segregation too here at the end. But I actually just want to go through a case study of a property that I just closed on and kind of walk people through really, I think, a very realistic property for anyone at home. Is that cool?<\/p>\n
That\u2019s great.<\/p>\n
Okay, awesome. Well, this property, the purchase price, and we\u2019re rounding up a little bit to keep the math simple, but the purchase price was around $300,000 and the land value of this property was about $111,000. And the reason that\u2019s important is because like you said earlier, the land value, you can\u2019t really depreciate land. You can only depreciate the improvement on the land, which is typically the house. And so we\u2019re depreciating things like the actual house itself, the concrete, the patios and everything like that.<\/p>\n
That\u2019s right. Yeah. I think this had a lot of decking and improvements outside that were all 15 year bonusable property.<\/p>\n
And so we looked at this one, and to your point, you paid about 300,000 for it, the land is 111, you can\u2019t depreciate that, so you\u2019re left with 189,000 out there. And we were able to find about $60,000 of just first year depreciation between the bonus and what would\u2019ve been the 27 and a half year property anyway. We took things like trim finish, carpet, luxury vinyl plank, shelving, disposals, microwaves, and then like I told you, a lot of this outside landscaping and land improvement stuff.<\/p>\n
So let\u2019s really break this down for people at home so that they understand. So you said I was able to depreciate about $60,000. So the way you would calculate any tax deferment on that end is are you just multiplying that $60,000 by your tax bracket?<\/p>\n
Yeah, so your tax rate becomes a limiting factor. There\u2019s really five limiting factors. There is the land value as opposed to the improvement value of what you pay for. There is the amount of the short life property we find inside of the deal. There\u2019s the leverage that you put on the property, like we talked about before. Then there is, to your point, Rob, are you in the 37% tax bracket or are you in the 10% tax bracket? Because if you\u2019re in the 10, you may not want to do this, especially if you\u2019re going to have a high tax year in the future. And then the last is that where are we at in the point of the bonus depreciation, are we in the 80, 60, 40, 20 or zero out there?<\/p>\n
Yeah. So on this particular property though, once we calculated it for my situation, it lowered my tax bill by $21,000, which is significant because the depreciation on this was 56,000, which is pretty close to the down payment of this property.<\/p>\n
So yeah, you pay 20% down and you were able to in effect, net of the land, net of everything, net of the 80% 2023 depreciation bonus what you put down on the property. What that does in effect is turn your down payment into a 401 K contribution or an IRA contribution, where you just get to deduct your down payment and then defer that tax to a later date in time.<\/p>\n
Yeah. So that right there just shows not really that crazy of a property for anyone to go out and get. And crazy tax deferment strategy there makes it to where the ROI on that particular property now skyrockets. So Mitchell, are there any other cool things that listeners should know about cost segs?<\/p>\n
Yeah, so again, like you just mentioned, this is the most kind of advanced tax strategy for regular people, where you can borrow against an appreciating asset and write off taxes like this. Some opportunities for people are if you have put a property in service from late 2017 to today and not executed this strategy yet, it\u2019s not too late, all\u2019s not lost. You can either catch up depreciation by filing a change in accounting method with your next tax return, or you may potentially be able to amend a prior tax return. You can optimize that with your accountant on what you should do. But you\u2019re able to go back to the moment that they put Tax Credit Jobs Act into place and catch up the depreciation by getting a cost segregation study today.<\/p>\n
And then if you take a big loss, what happens, let\u2019s say you take more of a loss than the actual profit that you make, do you just lose that the year that you take it?<\/p>\n
Yeah. Well, the way that tax brackets work, you never want to post a zero, especially if you\u2019re a perennial high income person. But let\u2019s say you do. Let\u2019s say you just generate a net operating loss because you put a big property into service one year, you can carry that net loss forward and it\u2019s not a problem.<\/p>\n
What that means is that if you don\u2019t use all of your depreciation, if you have $100,000 of depreciation, but there\u2019s only $80,000 of money that could be taxed, you don\u2019t lose the $20,000, it carries over into the next year and you could theoretically use it then and then every year in perpetuity. Is that accurate?<\/p>\n
Yeah. It just carries forward until you use it.<\/p>\n
So it\u2019s not that if you don\u2019t use it, you lose it. You keep it.<\/p>\n
That\u2019s right.<\/p>\n
If you don\u2019t need it, you keep it. I\u2019m trying to make that rhyme. Try to find the alternative to if you don\u2019t use it, you lose it. So let\u2019s get into some of the caveats here because I personally believe that oftentimes when people are taught information like this, it is done from the perspective of it\u2019s free. Like, you\u2019ll never pay taxes again if you do a 1031 exchange. It\u2019s not really that way. There are caveats, there are pitfalls, there is a price you pay to take advantage of these and that doesn\u2019t mean don\u2019t do it, it means be aware of what that would be. So let\u2019s talk a little bit about the fact that you\u2019re not evading taxes, you\u2019re not skipping taxes. It may be that you\u2019re deferring taxes or lowering a tax bill. Or how about the fact that when you take your depreciation up front, like we\u2019re talking about, you don\u2019t get to take it later down the road. Can you explain a little bit about what\u2019s actually happening here from a practical standpoint?<\/p>\n
Yeah, so to your point, depreciation is real, recapture is real. Your building is going to fall apart over time, and this is just an acceleration of all the depreciation allowance that the government is giving you for 40 years to year one, or a big chunk of it. So you can\u2019t do that without giving up something on the other end. And so yeah, it does sound rosy, but you shouldn\u2019t do this if you can\u2019t utilize the losses because you\u2019re not a pro or it\u2019s not an STR or it\u2019s not a business property. You shouldn\u2019t do this if you\u2019re in a low tax year already and you don\u2019t have a lot of taxes to defer. You shouldn\u2019t do this if you\u2019re going to sell the property in the next couple of years.<\/p>\n
Can you explain why?<\/p>\n
Well, so there\u2019s something called recapture out there. So the same way that we get to deduct all this short life personal property year one, when we go sell it, we\u2019re going to suffer what\u2019s called recapture. So that 30 year old fridge that we bonus depreciated, well, when it\u2019s 34 years old and we go to sell it, they\u2019re going to reevaluate it using the same methodology. And any depreciation that we took that wouldn\u2019t have happened in its own course, we\u2019re going to pay back as recapture. So we\u2019re just going to pay it at our ordinary tax rate. So to your point, this is just Newton\u2019s law of tax, what goes up must come down, but what this strategy gives you is a lot of outs. You already mentioned 1031, shoot, if you\u2019re working in an opportunity zones and you get that step up in basis year 10, this effectively becomes a tax credit because you\u2019re not going to suffer recapture year 10, you\u2019re just going to get this tax jubilee. So you should definitely do this if you\u2019re in an opportunity zone.<\/p>\n
But like Rob\u2019s example, he put $60,000 down, he saved 60,000 in taxes buying it. If he sold it next year, he would have to pay back that 60,000 in savings. Is that right?<\/p>\n
That\u2019s right. And there\u2019s some little planning nip tuck you can do around the edges on that, but directionally that\u2019s a correct statement.<\/p>\n
Got to pay the piper. Also, we mentioned, for a long time you used to be able to deduct 100% of what came up in the cost segregation study. This year it\u2019s 80%. Next year it\u2019ll be 60. So as time goes by, it becomes increasingly less efficient to use this strategy unless it\u2019s renewed in the tax code. So it\u2019s another thing to be aware of. It\u2019s not necessarily a strategy you could use forever. Do you have something to add there?<\/p>\n
Yeah, there\u2019s a whole thing about, a few rules that have come out of Tax Cuts Jobs Act not exactly related to this, that are being talked about in Congress. And some of the proposals are to continue to extend 100% bonus as partners in STR cost seg. Both Rob and I pray that they will extend it forever. But as it goes down, it loses its efficacy because ultimately this is, to your point, a deferral of taxes. So you\u2019re getting the time value of the use of your money and you\u2019re getting to borrow this money from the government interest free. And really what you save year one or what you save in the first few years divided by what you pay for this study, is your initial payback. And so you want to be cognizant of what you\u2019re getting to do this.<\/p>\n
And we\u2019re not talking about 1031s, but they are also a tax deferring strategy similar to the depreciation. And that is a thing that gets thrown around a lot as well. Well, just 1031, you don\u2019t have to pay taxes. It\u2019s not that you don\u2019t have to pay them, it\u2019s that you are deferring them. You are kicking the proverbial can down the road.<\/p>\n
And that trade off of everyone\u2019s favorite buyer is the guy on the 1031 up leg who just has no leverage or who has no ability to walk away because they\u2019re tied to this strategy because they-<\/p>\n
You don\u2019t hear very many awesome stories that come out of, I just did a 1031 and I\u2019m stoked about the deal I got, and it was awesome. It\u2019s like, you are now committed to this thing whether you want to be there or not, or it\u2019s the 11th hour and you find something because it\u2019s better than owing the taxes, or at least we tell ourselves. And I wanted to highlight, it\u2019s important to notice if you\u2019re going to use strategies like these, more than likely you will never be able to stop buying more real estate. This is not a de-leverage strategy. I often say it goes one way. The analogy that Rob likes is I say, you\u2019ve got the wolf by the ears, so he can\u2019t bite you, you\u2019re not going to pay taxes, but you can\u2019t ever let go.
You\u2019re sort of stuck in the stalemate with your own portfolio because if you ever sell the property and don\u2019t want to reinvest, you\u2019re going to have a gain on that whole amount that you\u2019ve had maybe from two, three, four 1031s over time. Would you like to comment on that?<\/p>\n
I have a comment. You have a wolf by the ears and you got to keep feeding it little biscuits every so often, so it\u2019s not trying to get out of your grip and attack you<\/p>\n
As you build this mountain of leverage, it\u2019s the idea of you\u2019re trying to move a refrigerator and you have a dolly, and when that goes against you and it just falls on top of you, it becomes a big problem. So leverage can go both ways, definitely. I mean, the problem that people face when they use cost seg, and they have this experience of paying no taxes, is that it feels really, really good and you just want to do it over and over and over again.<\/p>\n
Which is what we\u2019re wanting to highlight. If you love real estate and this is what you\u2019re going to do for the rest of your life, it\u2019s amazing. If this is a phase you\u2019re going through, you wanted to work really hard for 10 years and stop doing it, there will come a point where you\u2019re going to have to pay. A lot of people don\u2019t realize that as you buy a million dollar property and then you sell it, you have a $300,000 gain, you reinvest the money, you buy a property for 1.5 million, a couple of years later you buy a $2 million property, you do this and it becomes $8 million of a portfolio or a property, however it works. If you want to try to get money out of that deal, outside of a cash-out refinance, you are going to pay those taxes. They\u2019re going to hit you hard.
And if you want to do the cash-out refinance, which will help you avoid it, you still have to be making enough income to be able to get that loan. So if you\u2019ve bought this property, you\u2019re living off the income, you\u2019ve lived the BiggerPockets dream, you\u2019re living off your cash flow, and now you want to refi that thing, you can\u2019t get a loan on it because your debt to income ratio is all out of whack. There\u2019s a lot of things that can go wrong if the pH balance isn\u2019t just right.<\/p>\n
Yeah. And further, as you keep cash-out refinancing, you can get to the point where, to your point, you sell your entire portfolio, you pay back all the debt, and then you have this big deferred tax liability that comes due and it can just swallow up all your profits or swallow up all your profits and then some, which is just a nightmare. So yeah, be careful, folks. We are in the deep end of tax planning and tax strategy. Do not take tax advice off of a podcast. Contact your CPA, contact a professional, do the real work of planning this out because you have to think in terms of decades around this. It\u2019s not a one and done thing.<\/p>\n
But you should be listening to the BiggerPockets Podcast because we will shoot straight with you and we will tell you it is not a magic pill or a magic bean that\u2019s just going to grow a perfect bean stock. It will accelerate your growth, but with that growth comes a higher tax burden that at some point is going to work. So Rob and I have said before, buy until you die is the way you avoid the taxes. You just keep upgrading, deferring taxes. Yeah, this is the rhyming episode right now. Parapa the Rappa.<\/p>\n
We workshopped it for 10 minutes before this, but it is good. Really quick, before we exit out of here, speaking of exit strategies, when is it worth it to do a cost segregation study on a property? Is there a certain price point or sweet spot for this?<\/p>\n
With STR cost seg and RE cost seg, when you go to our website and you fill out the form and you reach out to us, we\u2019ll give you a proposal that literally says, \u201cHere\u2019s what you\u2019re going to save. Here\u2019s what it\u2019s going to cost you. Here\u2019s the payback ratio.\u201d So we, in our whole world, we do houses that are $200,000 and we do buildings that are $100 million. We perform cost seg engineering studies. We have a couple of different ways we approach it. For smaller buildings, we use data and we model and then we review. We have an engineer review process around that. For kind of medium-sized properties, we do something called a virtual site visit, where we basically get on a FaceTime phone call and walk the property so someone doesn\u2019t have to fly to your property, so it makes the whole thing certainly more affordable. And then for the $100 million industrial portfolio, we\u2019ll fly out to you and walk around and take photos and perform the study kind of the old school way.
So what we\u2019ve tried to do is be very nimble and build this product that can go a little bit down market and open up cost segs to people who couldn\u2019t normally get them, just because it was $4,500 for a cost seg for a 2,600 square foot rent house. It just didn\u2019t make sense, but now it does.<\/p>\n
Cool, cool. And then can you just, same thing, can you just give us a price range for that too, just so we have it concisely? What\u2019s the price range for most investors that a cost seg would work for?<\/p>\n
Yeah, so you can cost seg a property that\u2019s anywhere from 100, $150,000, all the way up to infinity. And these cost segs can cost anywhere from $1,000 to $20,000, $40,000, depending on the complexity. So we\u2019ve really done a good job of just trying to hit the whole market with three different products, or kind of a good, better, best solution.<\/p>\n
Well, thank you very much, Mitchell. This has been fantastic. I hope our listeners got a lot out of understanding a little more about cost segregation, bonus depreciation. These big words with lots of syllables that are related to taxes don\u2019t have to be as intimidating as they may sound. And at the same time, they are not a get out of jail free card. There is still a price to pay. But if you use them strategically, it should help accelerate your wealth building. I would also say if you use them foolishly, it can accelerate your destruction. Typically, how things like leverage tax strategies, they help you in one direction or the other.<\/p>\n
Leverage 101.<\/p>\n
Exactly, that\u2019s a great point. Leverage 101. So thanks, Mitchell. For people that want to find out more about you, where can they go?<\/p>\n
Oh, man. Well, thank you all so much for having me. This was a great opportunity. I didn\u2019t tell y\u2019all, but I\u2019ve listened to BiggerPockets since 2013 when I was sitting at my corporate job, so 10 years. I was an early listener of the pod, and it\u2019s cool to be on.<\/p>\n
You\u2019ve been here since the awkward years.<\/p>\n
Since the awkward years.<\/p>\n
Since BiggerPockets puberty, biggerpuberty.com.<\/p>\n
Back when you could just follow the 1% rule, and we should have just bought everything we ever saw, is what the lesson was.<\/p>\n
Of course, and we had reasons to complain and say it was too hard and wasn\u2019t fair, and then we had 100% bonus depreciation opportunities and we had reasons to complain, and now it\u2019s going down to 80, 40, 60, we\u2019re going to be complaining about that.<\/p>\n
We\u2019ll just complain forever.<\/p>\n
That\u2019s exactly [inaudible 00:56:07]. The only reason we exist is to help answer all of the objections that people continue to come up with to get in their own way with building their own wealth.<\/p>\n
I love it. So you can find me, the main place I operate on the internet is on Twitter, now X @baldrigecpa. I have a newsletter called the General Ledger. I have a podcast called, Stupid Tax, with my friend Scott Hambrick. You can find me at STR Cost Seg, or RE Cost Seg, Better Bookkeeping, I\u2019m everywhere, I guess. But thank you.<\/p>\n
Thank you for that. Rob, where can people find you, you handsome devil?<\/p>\n
You can find me over on Instagram @rawbuilt, at YouTube on Raw Built as well, and on the review section of the Apple Podcast app where we ask that you leave us a five star review.<\/p>\n
Yeah, if this saved you some money or prevented you from making a mistake, please do go give us that five star review so more people can find the awesome podcast. You can find me at davidgreene24.com or @davidgreen24 at whatever your favorite social media happens to be. Mitchell, thanks again. It was great having you here. Appreciate you sharing your knowledge and glad we were able to get a long time fan on the show. Let us know in the YouTube comments, what you thought, if we missed anything that we should have asked, or is your mind blown right now. We read those and incorporate them into future shows. This is David Greene for Rob, the Rap God, Abasolo, signing off.<\/p>\n