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You have stumbled on to another episode of Get your FILL, Financial Independence and Long Life, where we explore ways to achieve those two goals. Today we’re focusing on the financial independent side of FILL.
You’ve probably heard the adage, “It’s not what you make, it’s what you keep. Well, today’s motto is: It’s not what you make, it’s what you don’t have to pay in taxes.
Today is part one of a conversation with Jeff Hiatt. Jeff is an Expense Reduction Consultant. He and his team at Performance Business Solutions LLC, help business owners and property owners to reduce expenses and increase profits. A link to his website and to anything else interesting that we talk about today, you’ll find on my website, GetYourFILLPodcast.com,
Jeff, thanks so much for joining us today. Will you bring me up to speed on your business and how it works?
Jeff: I started back in ’94 doing expense reduction consulting for business owners trying to help them reduce expenses across a wide array of areas that they spend money on. Over time, that evolved and added, I added different tools to that toolbox of expense reduction. In ‘99, came across what is called cost segregation and as time progressed with my business and the economy, I began to really focus on cost segregation. About ‘02 or so, cost segregation really took off in terms of acceptance within the real estate marketplace. So since ‘99, we’ve probably done 18 000 cost segregation studies across the country.
We do them for almost every type of property out there whether it’s retail or office buildings or manufacturing facilities or restaurants, anything out there that has a depreciable life is eligible to take advantage of this thing called cost segregation and that’s what we’ve been doing and it’s really been a great tool to help real estate folks accelerate their ability to buy property and/or improve property.
So that’s what we’ve been doing.
Chris: How, for somebody who’s not familiar with – maybe somebody who’s just getting into real estate investing or somebody who hasn’t ever taken advantage of the segregated sort of accounting, could you give like a scenario of how it could work? So I’m a new investor and I just bought something…
Jeff: Sure, so the way that it works is if you buy a building or build a building or just do improvements – in other words, you’re just a tenant – so if you buy, build or improve a building, the IRS will automatically assume you’re gonna do 39-year straight-line depreciation. So, everything under the sun – every kind of building out there has 39-year depreciation – except for apartment buildings which are 27 and a half, so if it’s an apartment building 27 and a half, everything else is 39. So whatever you spend on the building, let’s say it was a million dollars, you’re gonna get a write-off of that every year for the next 39 years, equally. Equal payments.
So the bottom line is, I think that would be about, it would end up allowing you to write it off over that amount of time. What we do is allow the client to take write-offs, instead of the straight line $25 grand a year for the next 39 years, you would end up being able to find the pieces of the building that the IRS will allow you to write off over five years, seven years and 15 years.
So instead of that really long depreciation, you would end up being able to take pieces of it more quickly and thereby allowing yourself a better tax benefit early versus 39 years from now. The reallocation that we usually find on these buildings is somewhere between 20% and 30%. So, if you spent a million bucks on it, we might be able to move somewhere between $200 and $300,000 into the faster line.
So that would end up, if it was a $300,000 reallocation and you’re in the upper tax brackets that would save you about $100 grand of income tax-ish, so that can be substantial. On a million dollar property that’s about 10% of your purchase price as a tax impact, first year.
C: So for example, you might say, “Oh this heating system is gonna be… right. You’re taking pieces of the building like that?
J: Like that, except… And I’ll be real specific, because the folks that I hang out with are usually accountants and they’re real specific so I have to be real careful with the way things are explained. So a building to be a building has to have certain elements, it has to have walls, windows, doors, roof, HVAC for comfort, electrical for lighting and plumbing for a bathroom.
And other than that it’s not considered structural or not considered a building, so what we do is go in and identify the wiring that isn’t for lighting or the wiring that’s for secondary lighting, so a building only needs to have one source of light or a room only needs to have one source of light.
But many times – think of an office space, there might be multiple sources of light. You may have recessed light, you may have box lighting, you may have indirect light, track lights, sconces, all of these other styles of lighting, other than the main lights. Well, all those other – chandeliers for instance – all of those other lighting products and the wiring back to the circuit breaker, become secondary or decorative, and you can take them in a faster life, and then you’ve got wood trim, built-in cabinetry and you’ve got the reception desk that might be a built-in type thing, you would have kitchen cabinetry in the employee break room, let’s say, and the plumbing for the employee sinks and dishwashers in the break room. All of these items add up and again they typically come to between 20% and 30% of the building purchase price.
Once you sub out land, I needed to throw that in there. You’ve got a sub-out land, but once you are to the building/ land allocation the building number would be 20% to 30% usually.
C: So then what happens when you get – so say you are able to depreciate the lighting, the decorative lighting, on a five-year schedule, what happens at the end of those five years? Have you now lost a lot of your depreciation, or if you sell the building, you can say, “Oh we’re replacing the lighting or what kind of things are your options at that point?
J: Well, keeping in mind it’s a commercial property, and it’s there to typically create rental income, usually people will be maintaining and improving those buildings over time.
So what ends up happening is, in a few years, the wear and tear on the carpet or the lighting looks dated now or things need to be refurbished. So bottom line is, the landlord or the owner of the property would end up changing things around and doing it, fixing it up again. At that point, the depreciation clock is gonna reset on that improvement. But keep in mind, I’m only talking about re-allocating 20% to 30%. So that means you still always have… for the next 39 years, you still have 70% to 80% of the depreciation, you would have had without me.
So, by taking it early, it’s not a… Some people do get nervous or they’ve been told by their accountant: Well, you’re not gonna have any depreciation later if you do this cost segregation thing, and that’s not the case, you still have 70% to 80% of what you would have had, but the impact is so great by accelerating even the 20% or 30%, it has such a financial impact that many of our clients use this. We’re the second folks in the door. So they close on the building on Monday, Tuesday morning we’re in that building, doing the Cost Seg because they wanna have this tax deferral in their pocket right away.
The other upside of it is because we identify not only the 5-, the 7- and 15-year items, but we put values on the 39-year items.
And you say, “Why do you need that?
Well, the upside of the 39-year items and having a value put on the roof or the windows or the HVAC. The upside of having those values is that when you do a renovation, so let’s say five years in the client goes to put a new roof on the building because the tenants are complaining, it’s leaking. The landlord, the owner has tried to fix it and patch it as best possible but it’s just not working so all of a sudden, they go put a new roof on.
Well, if they don’t know what the old roof is valued at related to the price they paid for the building, the problem is they’re gonna be writing off two roofs: the one they just put on, as the replacement roof, and then the one that came with the building.
One of the things that distinguishes our cost seg reports is that we provide the detail for the original roof even though it’s not an accelerated item. If you have that information in hand as the building owner, you can take a write-off when you replace the old roof with the new. You get to write off the old roof even though the new one just went on the depreciation schedule.
C: So basically you’re almost fully-depreciating the old roof, you’re getting that off and then you’ve got… Now you’ve got a new one that starts on his own schedule.
J: You got it, that’s exactly right ’cause it starts from that point and you would write it off for the next 39 years there. Keeping in mind that would also apply to HVAC, and elevators and siding and windows and all of the other pieces that make up that 39-year element are going to be – our report is going to be reusable, whenever you go and do these renovations.
C: Because realistically that HVAC system is not gonna probably last 40 years.
J: You’re right, and that is the challenge is that typically real estate investors think logically and they think… Well, the HVAC should be a 15-year item – at best – and the roof won’t last 39 years and they’re accurate statements on both, but unfortunately, the way that the tax code is, it’s not that way. The IRS says those are 39-year items and those are gonna be written off over 39 years whether you can use them for that long, or not.
C: Yeah, okay, interesting. So based on – I’m sort of thinking of a cost-benefit analysis for an investor who is a smaller-time investor maybe they’re just buying – although you can’t even get a small apartment building for that little money anymore – but let’s say, I have a friend who just bought a place in New Hampshire. It’s a five-unit building and it costs $400,000. Would it makes sense for him to do this type of thing or is there sort of a minimum purchase price where the cost of the study makes sense?
J: Well, back when I first started doing this back in ‘99, up until about 2017, we would have said the starting point would be about a million dollars of purchase price and the reason for that statement is, we usually find that clients consider cost segregation a good thing to do if they get a five-to-one ratio, so if they spend a dollar on the study, do they get back five or more in tax deferral? And if they hit that ratio – you give me a dollar, I give you five in tax benefit, typically people will move ahead, and they consider that a good scenario. We used to hit that at around a million. Now, we hit it probably about $500 grand, because the new tax law, allows what’s called TCJA or Tax Cuts and Jobs Act. That was the 2017 2018 tax law change.
Instead of making you… ’cause I’ve talked about five- and seven- and 15-year items. And so, in talking about those, that would mean instead of 39 years, you’re writing it off over 5 or 7 or 15 years. TCJA changed that and asked:: Hey, Christine, why would you wanna wait five or 7 or 15 years, why wouldn’t you wanna take it all in the first year?
So you get to, if you want to, take it all in the first year, you can take that entire 5-, 7-, and 15-year stack of items as write-offs the very first year of purchase. That said, the normal number would, at this point, be about $500,000 is what our normal statement would be. If a client has – sometimes they’ll have multiple properties – and then we can kind of gang them together, and come up to get to that ratio that will be beneficial for them and make sense for them to do.
So, at $400k, we’re in the right ball park. That was probably not their first time at the rodeo, so they probably have other buildings, too, that we could try and make a bigger snowball for them and make it work for them that way.
C: But it seems like you’d be doing double the work if you did two different buildings.
J: Oh yeah.
C: So it wouldn’t necessarily be half as expensive.
J: You’re right, it would be a multiple, but the tax benefit is still strong. And so usually, like I say, if we’re at $500k and we’re gonna get that five-to-one ratio, if we get to $700,000 or $800,000 then maybe it’s gonna be 8- or 9- or 10-to-one. So as you start to go up from the $500 grand, the benefit goes up very nicely. You’re at a couple million you might be looking at 10- or 15-to-one, and it continues to go up from there.
So we always offer a free, no cost, no obligation, estimate of tax benefit for the client, so that, without – so that they know ahead of time what to expect in tax benefit, number one, and number two, what they’re the expense would be, what their fee would be.
So we work on a fixed fee basis. So if you gave me some details about your client in New Hampshire and you said, I think it was it a five-unit and they paid about $400 grand for it, we can run an estimate of tax benefit for them and especially, that’s even more accurate if you could give us the street address because then we can Google Earth the building and see what it’s like before we actually send someone out. So because we have to send somebody out to comply with the IRS requirements for doing cost seg, we would give you an estimate of tax benefit. You would see it and go: Hey, that looks good or Nah, it doesn’t work for me and you get to make the decision – or the client does.
C: And is there, since you do have to send somebody out. Is there a sort of a circle, a range of where you’ll go for this?
J: We have people all over the country, so we go all over the country. So we’ve done work I think last year we did work in 42 different states. So we have a team always going someplace. Like tomorrow, I’ll be up in Bangor, Maine and we’ll be doing site visits in Scarborough and some other place farther north than Bangor.
C: You gotta switch that around so you’re doing those kind of trips in the summer.
J: I know. You go when the clients call though, right? You can’t always pick.
C: What are you buying up here now for, it’s too cold!
J: It was funny. One client of ours bought a property in Hawai’i and one of the guys had to go out in the winter and do the work in Hawai’i and he was totally psyched.
C: I bet. We’ll give you a little discount on this one. It works from your perspective, too, if you get to go someplace fun. And do you find… I had bought a property a while back and my CPA said, “Is there anything that you know you’re gonna replace any time soon? And I said: Well, basically the day I bought it, the heating system broke and then I knew I was gonna redo the kitchen and the deck and stuff like that. So he separated those out as different items and that was the first time I had heard of that. I had never had anybody mentioned that to me. I’ve mentioned our conversation to other folks since then and a lot of investors have never heard of the kind of accounting that you’re doing. Do you find that people are like: What are you talking about? That’s cool.
J: Oh, it’s very cool.
Where it’s all particularly heavily utilized is when accountants have clients, and the CPAs identify their CPA practice as real estate heavy. In other words, we do a lot of classes for state societies of CPAs all over the country, so they all have us come in and we’ll do a seminar, either two hours or four hours or sometimes we’ve done them for eight hours and the CPAs get continuing ed for this.
And if the CPA identifies they’ve got a heavy clientele that is real estate strong, a lot of real estate investors, then they’ll go to these events and/or they’ll read articles that we publish in the CPA publications or in the real estate journal, like we’re in New England Real Estate Journal frequently talking about cost segregation and what the new tax law is doing and this and that.
So if the CPA recognizes that they have a client with a lot of real estate, typically they’re attuned to what we do. On the other hand, if they’re thinking of you, Christine, and they know Christine is – I know you’re a real estate person – but let’s say you are an attorney. So Christine, the attorney, originally owned a two-family and then Christine moved out of that and continues to rent that and then bought another two-family or three-family and then a five-family and they’ve started down this path of being real estate investors. Well, often what I see is that the accountant, it never triggers in the accountant’s mind that Christine is really getting heavy in real estate and they should really start to look at opportunities for Christine.
They don’t look at it and it just kinda goes by the wayside and they just do everything in 39 or 27 and a half year and they never break anything out. So then, it takes a situation where one of those real estate people is at some conference or they read an article and they call the accountant and the accountant goes: I don’t know about that. You’re not gonna have any depreciation left, if you take it all early or a way other conversation might be, and then it is, what it is.
But we do a lot of work and usually if I am able to talk to the CPA because I’ve been doing this for 21 years myself, if I’m able to talk to the CPA I can usually help them understand the impact of this for the client.
C: Now your classes and stuff, are they only for CPAs? Like if a person, God forbid, does their own taxes or something, could they come to one of your seminars so that they could do this kind of thing?
J: I’m thinking about that. I’ve never had… It was funny, we had, the first seminar we did was in ‘02 and it was at the Natick Crown Plaza and there was one person there – we had 85 CPAs show up, plus or minus – and there was one person there who was the real estate investor guy, he was the main person and he was a big player but he had read about it. He came and he brought his CFO and his CPA and it worked out great, but basically we were drilling down into such depth, he eventually in the meeting, stood up and said, he goes: This all sounds great. He goes: You’re completely losing me here, I’m gonna leave now but I want my CPA and CFO to stay here and listen in and this sounds great.
We’re gonna be dealing with a lot, a lot of detail that most real estate people glaze over and go to sleep if we start talking that much detail, but if they wanted to send their own CPA or if they wanted to come and listen in or have a conversation with me and I could probably help them understand it a little bit more without having to sit down to bring it down to a certain level where it’s good enough for the layperson to grasp and take advantage of.
C: Yeah, and I think it’s clear, the way you explained it. I think that anybody who has already started real estate investing, and has even remotely looked at any of the tax ramifications could understand what it is that you are offering. And so now it’s just getting the word out to everybody, right?
Thanks Jeff for whetting our appetite for tax reduction, we’ll look forward to part two of the conversation which will air on February 2nd. Next week we’ll be discussing among, other things, ways to save money in your personal life. In the meantime, have a great week!