WPOA June 2016
Massachusetts Law Reform & Tax Segregation Savings
Attendees heard from Annette Duke and Judith Liben, both attorneys at Mass Law Reform Institute. The duo discussed: Why the new HUD conviction guideline matters, Perspective on the long rent escrow debate, and the Housing Court Expansion. This meeting also featured Jeff Hiatt debating CPA Jenn Williams on accelerated depreciation. The information addressed has the potential to save landlords thousands on taxes each year by changing the way their books are done.
"It would be crazy not to come. Why else did you join the organization but to make money at your business?" -Rich Merlino, MassLandlords Worcester Emcee
If you were unable to attend this meeting, make sure to catch up by watching the videos below!
See bottom of page for full transcript of this video
Segregation Studies Accelerated Depreciation Transcript
Jeff: Hello, everyone! Again my name is Jeff Hiatt. I’ve been doing cost segregation studies in New England and all over the country since 1999. I’ve been working with the firm, MS Consultants. How many folks have ever heard of cost segregation studies? It’s maybe a handful probably under 10. I will analogize this concept, which what cost segregation does is accelerate depreciation by moving items out of 27-1/2 year life for your types of properties. Commercial property is 39, apartment properties is 27-1/2. Moving stuff out of 27-1/2 year straight-line depreciation into 5- and 15-year and you might say so what?
Well that means to you is that you can free up a lot of depreciation and get more of it early when cash flow might be more important to you. The analogy I’d like to go with here is that understanding cost segregation studies is just one rule or one tool that might be in your tool belt. It’s almost like how many people here have played Monopoly, the game Monopoly? You kind of get it. It’s a real estate game. You go around. You’re buying stuff. You’re putting more and more stuff, more and more houses up and then hotels and all that. One of the rules, there’s all those little cards in the game and all those little rules that are some are on the table and some are not. One of the rules is you if you ‑
Female Audience 1: Are you okay [background conversation 0:02:00]?
Female Audience 2: He slipped in his chair.
Female Audience 1: He’s all right.
Jeff: My Monopoly analogy got it there. Sorry about that. When you go around the board, one of the little tiles, one of the squares says, if you go around go, you can pick up $200 and if you choose to do that or if you know that rule is there, you pick up the $200 and if you don’t pick up the $200, you can get it later but missing that one or two times is not a big deal. You won’t go out of the game early on especially but later on when all of those properties are developed and you’ve just landed on Marvin Gardens, and Ventnor, and Atlantic and you’re coming down to Boardwalk and Park Place, man, you want that $200 because everything else has been depleted, so you really need that.
My point to you is understanding cost segregation is like knowing about picking up $200 when you go around go. You can do it or you don’t have to, but many people consider it a good part of the game and it makes them more competitive with buying properties and holding properties.
With that said, I’m just going to run through it here quickly and hopefully this will – okay, so these are the folks we speak for. We normally hang out with CPAs because they’re the ones who bring us to the table. I know that’s an exciting crew to hang out with but that’s who we hang out with. One of the prizes we’ll often give out when we’re doing speeches for CPAs is a depreciation book and they get really excited about it. Sorry I looked at you, sorry but many of them do like the depreciation books we give out. I know that’s quite exciting. If anyone wants to read it, it’s only about 1,000 pages. We’ve done 12,000 studies. We do them for apartment buildings and commercial properties as well. We make fun of ourselves as you see.
The reason that we’re in business to provide these services because the rules are very complex. Some of them date back from 1962. Most clients don’t quite get how depreciation works and what the benefit of more depreciation yearly is, so that’s what we tried to explain. The IRS said in 2004-11, that’s for the CPA here, which was a Rev. Proc., which is how the IRS communicates to the CPA world. They said that qualified professionals need to complete cost segregation studies. Cost segregation studies are the correct way to determine depreciation and you don’t have to amend your tax return to go back in time and grab previously missed depreciation.
I’m going to go fast here so that we keep you on time here to wrap up. I can talk about this afterward or later at another time if you want to or if you have questions, just stop me. I’m going to try and keep you awake and go quickly.
We’re going to start at what’s in it for me, why do you guys know about this.
If you had a 2016 acquisition for $400,000 and I’m going to go through a number of these, four units single structure, multifamily. You spent $400,000 on it – laser pointer I think is right here. Okay, so you spent $400,000 on it in 27-1/2 straight line depreciation. Your straight line depreciation is right here, okay so you’re going to get $14,000 per year for 27-1/2 years. What we’re going to do is identify all of the assets in the building that are eligible for 5-year and 15-year. We’re going to find that 16 percent, so basically even though you bought the building as a going building, you can move almost all of the items in the kitchen into 5-year life, so we’re going to move all the kitchen items into 5-year life including the countertops and the millwork, which is the cabinet tree, the sinks, the plumbing, all of that stuff can go into 5-year life. Plus if there were appliances present, we can move those into the same life as well.
So $64,000 of your $400,000 is now allocated in the 5-year life. We are only going to take 8 percent, so it’s a small site. Oftentimes it was a bigger site, we would have somewhere between 15 percent and 20 percent, but we’ve gone light here because it’s a small building, so a small site, $32,000 for that.
That said by reallocating instead of first-year depreciation at $7,800, you get $22,000. Changing depreciation the cost seg accelerates for you is that you have got $12,000 additional of depreciation and you end up with roughly a tax deferral of $6,000 first year. Going on down the line, it continues to add up and we summarize it right here, so additional depreciation year one $12,000, first year tax deferral $6,000. By the fifth year, you’ll be sitting with $27,000 on that $400,000 investment. You’re now sitting with $27,000 of deferred tax.
Jenn: May I ask a question? How do you get to the $6,000 of tax savings by changing depreciation of $12,000?
Jeff: Because you take the $12,000 times the upper tax bracket of 39 percent plus the ObamaCare tax of 3.8 at 43, plus the state tax rate, so it’s a 48 percent tax rate.
Jenn: This is indeed assuming people are in a high tax bracket?
Jeff: Yes, and if somebody in the case they’re not in a high tax bracket, we can reduce those assumptions.
Jeff: We’ve been going with ‑ we do this all the time. We do them prospectively, so that if somebody has some properties they want us to review, we’ll do that for them ahead of time. They haven’t spent a nickel and we can plug in their own tax rate. We often as I say work with accounting firms. They’ll bring us to the dance, so they’ll tell us, “Oh, this guy is only at a 28 percent tax bracket,” or whatever it is, so we’ll adjust it but for this conversation, that’s what those are.
Male Audience 1: What do you mean by land improvements?
Jeff: land improvements are the category that anything outside of physical structure to the property line can be moved into a 15-year depreciable life. Land improvements would include paving, plantings, irrigation systems, anything that’s outside like storm sewer, sanitary sewer, lighting, riprap walls, fencing, signage, again plantings, parking bollards, pads where dumpsters sit or transformers sit. Anything outside the building to the property line is a land improvement as opposed to land; land is not depreciable. Yes?
Male Audience 2: One thing, you put the higher tax rate. I am an accountant.
Male Audience 2: When you have a higher tax rate, that could mean that the person couldn’t make [unintelligible 0:08:52] $150,000, therefore the loss of [unintelligible 0:08:58] depreciation gets to stay.
Jenn: That’s right.
Male Audience 2: So that rate is kind of [unintelligible 0:09:03].
Jenn: There are clearly a lot of factors that come into play here.
Male Audience 2: The [unintelligible 0:09:08].
Jenn: That’s right.
Male Audience 2: You’re not going in that bracket.
Male Audience 3: I can’t hear you.
Male Audience 2: Okay.
Rich: Can I borrow this real quick?
Rich: We only have two microphones and we’re really going to have to either we’re going to hold the questions until the end, okay?
Rich: If there is something you want to address, just repeat it.
Jeff: Sure, okay.
Jenn: Just [unintelligible 0:09:26].
Rich: Jenn is actually going to go over to what this gentleman is saying because it sounded really smart, so ‑
Male Audience 2: All right.
Jenn: I believe that you’re commenting on is this is assuming that you’re in the 39.6 percent tax bracket that you’re making a lot of money, meaning your AGI is in excess of $400,000 and it’s also assuming that your AGI is over at least $250,000 so you’re also kicking into that net investment income tax as well. There are some assumptions in here that may not apply to everybody and we’ve got to be cognizant about.
The other point that he brings up not all of you I believe, I know some people in here, I don’t believe everybody in here are real estate professionals, in which case you may not be able to avail yourself of the passive losses in any given year.
Jeff: Good point, so we customize the presentation per each client, so I’m not trying to ask you to do this or not to do this based on this. I’m trying to just educate you as to how this might play out for you. It would obviously require you to talk to your accountant and us to communicate with them as well.
This was a 2012 acquisition for $1.2 million multifamily residential, so the good news is here, you bought it in 2012, you didn’t know about that go-around-go rule and now you want to take advantage of it and you can step back and get all of the times you’ve gone around go and you didn’t pick up the $200,000 now you get to grab them retroactively without amending your tax return.
The way that works is here you’ve got the $1.2 million, so far you’ve taken $154,000 of depreciation under straight line. We come in and reallocate 14 percent into 5-year life, 10 percent into 15-year life. By doing that reallocation, you end up being eligible to have taken into $293,000, so that you say to the IRS, “We’ve taken $154,000 but we could have taken $293,000,” so your changing depreciation first year is $138,000. Again making some assumptions on tax rates and all that, which would be adjusted per conversations, the client here would reduce their income tax liability by $75,000. That is a tax deferral, which means if you take it today, you can’t take it tomorrow, so we often will present value out these calculations assuming you did the most conservative thing you could do with the money.”
The most conservative thing you could do with that $75,000 would be to pay down a loan. I didn’t see a lot of bankers in here; maybe there are some but nobody identified themselves as a banker but if you took your $75,000 and did the most conservative thing you can do and pay down a loan at 5.5 percent, then you’ll be ahead of the game, having completed the cost segregation study in 27-1/2 years. You will be ahead of the game by reduced interest payments of $41,000. That’s the most conservative thing you could do with it.
Most of my clients don’t do that. What they do is they go buy another building or they take the $75,000 and they improve their current property portfolio that they already have. They go and put in new bathrooms or new kitchens or whatever they do. They don’t have to borrow that money and now they can charge a higher rent. All of a sudden, they take that $75,000, re-plow it into their current buildings or buy other buildings, but then they end up making more money out of that.
You look puzzled?
Jenn: They can actually do this prospectively in terms of taking the additional depreciation that they’ve missed?
Jeff: Correct. The way it would work is if they are real estate professional, they can step back in time and get a refund of previously paid taxes if when you sign your tax return, you’re saying it as a real estate professional. If you’re not signing it as a real estate professional, then you take it going forward and the accelerated depreciation would sit in your back pocket if you can’t use it all today. In other words, if you can’t use all of that $75,000 and you want to use it in the next few years, that’s what would end up happening, but yes you can step back in time effectively or the reality is you’ll typically look at a window of 10 years.
If you bought, built, or improved the building in the last decade, you’re over the first hurdle of cost segregation, meaning that’s the time that the time value of money will be on your side, having completed the cost seg versus not. If you’ve already owned it for 20 years, it’s probably going to make sense to do the cost seg. If you’ve owned it for 10 years or less, it probably will make sense if you’ve spent more than call it $500,000.
The reason you don’t have to amend your tax return to do this is you file what they call a change in accounting method. We do those forms. They are called Form 3115, and that’s a change in accounting method and typically it’s an 8-page form with a number of attachments. We do those and hand them to your accountant upon completion, so there’s no extra charge for that, but the beauty of that is you don’t have to amend your tax return.
I was instructed to hold the questions until the end if that’s okay.
So 2014 renovations, so this is just renovations to the tune of $300,000 on a multifamily. These are kitchen renovations, $300,000, you’ve taken $16,000 because you did it in 2014 with reallocation here. You are eligible to take $95,000 and you end up with $79,000 change in depreciation, which reduces income tax liability $41,000, so that’s a small renovation.
Here’s a 2010 acquisition – so I can keep going through this. My point ultimately is if you own apartment property, cost segregation can make a lot of sense because it frees up money for you to allow you to do other things with it other than just send it to DC. It enables you to control where that money goes now and down the road again as I mentioned, this is a tax deferral method. The accountants often used to phrase it as a timing difference, and one of the comments that sometimes will come back from the accountants is, if you look here, high is not me. I’m not giving you any more depreciation. You’re just getting the same amount of depreciation in either way.
The question is, is it a good idea for you to have to have money now that versus later. Another analogy that I like to use is most people understand how pensions work and 401(k) plans, and many people do them and implement because it enables their money to grow tax deferred today. 401(k) and pensions work that way: defer the tax today, let it work in the market for you, and then in 20 or 30 years when you pull out the money, you’ve got a bigger nest egg set aside and you pay tax then. You’re deferring the tax.
This concept is simply the same concept of tax deferral that you push the tax off some years and do something more constructive with it now versus later and that’s what this is about. Looking at the time here, I don’t want to overstep or overstay.
Rich: Sir, if you want to sit in the front, you can share the microphone.
Male Audience 2: [unintelligible 0:17:35].
Rich: Because we want to try to give Jeff a hard time. No, I’m just kidding. That’s why we want to have some CPAs here because this all looks awesome, and I hope it is because it is because I won’t do it. I have a quick question. I’m not considered a real estate professional now but I will be in a year or two. Would I be able to capture some of the stuff retroactively if at the time I do my say 2017 tax return, I am a real estate professional at that time. Does that make sense?
Jeff: You would have to talk to your accountant if they feel comfortable with that.
Jenn: I think that ultimately you have to do a cost-benefit analysis. I don’t know what the fees are associated with it to determine your particular situation because there are people here who may have one, three-decker and I think there are people here who have multiple rental properties, so you really have to run the numbers to see if there’s a cost-benefit to doing the cost segregation study. It’s a very powerful tool but just like the analogy with the deferral for 401(k), sometimes a Roth is a better solution for people depending upon their situation where you don’t defer paying the tax. Because you’re in a particular situation with your spouse, how much money you make currently, how much you believe you’re going to make in the future are all important factors to consider in doing this. Thanks.
Jeff: Absolutely. You’ve got to run that and what we do is if somebody is interested in that, we can supply an estimate of tax deferral because again we’re brought in typically by accounting firms. We typically will estimate conservatively because if we over blow the estimate, in other words we say the client is going to save $100,000 and they only saved $70,000, they’re going to be ticked at me and they’re going to be ticked at the accountant and then the accountant will never bring me back to the dance.
What we try to do is say, “Hey! You’re only going to save $50,000 or $60,000,” and then when I come in with $70, 000 they’re thrilled. We try to be conservative with our estimates. We’ll tell you upfront what we think it will be conservatively, we’ll tell you what our fee will be upfront. It’s going to depend on number of units, how big the site is, the fees. We do this for any like a Dunkin’ Donuts store. They’re about 2,500 square feet. Our fees to do those are roughly generating for the client for every dollar they spend, they’re going to get back at least $5, sometimes $15 or $20. That’s kind of what most people look at is they look at these estimates of tax deferral and they say if I get better than a 5:1 ratio, they’ll move ahead. Typically this type of project would run somewhere between $4,000 and $5,000 up to $10,000 or $20,000 depending on the size of the project.
Jenn: Do you more commercial property or residential in your cost segregation studies?
Jeff: Of the 12,000 we’ve done, it depends on how the economy is going, whatever is hot in the economy. In other words, some years it’s retail, retail properties are the investment of choice. Other times it’s apartment, multifamily, sometimes it’s assisted living facilities, so we do them all. We’ve done probably 3,000 to 4,000 apartment buildings for some small folks and some very, very large folks.
Male Audience 2: My question is why wouldn’t you go back and amend?
Jeff: You don’t have to amend.
Male Audience 2: No, no, no. I mean why wouldn’t you? I mean if the cash is in your hand now than putting it off later on? Why wouldn’t you take the money today?
Jeff: You don’t have that option if you’re not a real estate professional.
Male Audience 2: Okay.
Jeff: If you’re a real estate professional and you choose to, you can amend and go back and grab that money if you want to, if you’re a real estate professional. The non-real estate professionals for instance Rich over there, he doesn’t have that choice. He can’t choose to take it in retro and grab a refund check. His only option right now is to carry it forward.
Male Audience 2: All right, and the other question is if I find a lot of people have problems when I see that let’s say someone comes and it’s new is when you acquire a building, people don’t know how to allocate the land, which is not depreciable.
Male Audience 2: What method would you suggest? And I know what I use but I was just curious.
Jeff: The question – did you guys all hear the question? Okay. There are a couple of things that can be done there. One you can use the municipal tax bill as a percentage. Typically you’ll look at what’s the ratio of building value to their tax rate.
Male Audience 2: Right.
Jeff: Prior to the sale, then the new person comes in with the new number, and then use that same percentage. That’s one possibility. Another is to look at possibly an appraisal and see what the appraisal puts out as a tax value. What some people do is use a residual value and what they’ll do is they’ll figure out what the building is worth from a building cost new. In other words they’ll look at the building and say, “Yeah, I paid $2 million for this building, but it really is worth – if I had to rebuild it, it would be $3 million.” Well then, you can use a higher building cost, maybe even what the municipality says related to the land value, but it all depends on what the accountant is comfortable with because they’re ultimately the ones filing the returns. We defer to the accountant unless we’re asked and then we can provide another data point on the spectrum.
Male Audience 3: What’s the tax code is there? I found out the accountants are too conservative. What is the tax code set?
Jeff: There’s not a bright-line test.
Male Audience2: It’s not there.
Jeff: There is not a specific statement in the code anyway that say this is how you’re going to do it. If it was, everyone would do it that way and everyone would do it that way. What we do is we’ll typically look at the municipal tax bill without other guidance from somebody else. If you said I don’t want to use that and you gave us a good rationale, we would work with the accountant and you too come up with a different value but again it’s going to depend on what’s reasonable. You can’t say it’s a 2 percent land value.
Typically what we find nationally is somewhere between 10 percent and 20 percent is the land building allocation, call it 15 for roundness. If you’re in downtown Boston, it might be 30 percent or 40 percent. If you’re on the [unintelligible 0:24:30] Islands, maybe it’s higher; New York City, high; somewhere in the suburbs, it can be a lower percentage.
Male Audience 3: Tax court cases where it’s adjudicated [unintelligible 0:24:41].
Jeff: No. Again there is nothing that is 100 percent of the time going to be a fixed point that you can aim at.
Male Audience 3: Okay [unintelligible 0:24:51].
Male Audience 4: Let’s say you sell a property and nothing was taken into account for money, for improvements that you made over the years to a property and like in my situation, I had a fire okay and I did a payoff for the insurance company, which was those improvements that are involved. The fire was last year. I’m going to be selling it now. Can I go back like I know you have to have a real estate license but can I go back and take those?
Jeff: There’s a lot of moving parts to that question. One of them is on your insurance proceeds that you got from the fire, that reduces your basis in the new expenditure, so if you’ve got $1 million from the insurance company and you spent $1 million on it, you don’t have depreciable basis in that expenditure, those replacement assets. If you got $1 million and you spent $2 million, now your depreciable basis is $2 million because you went over and above what the insurance basis was. Would it make sense? I don’t know. My cards were over there. They have my contact information. If you want to send me some information, I’d be happy to run it through our machinery and give you an estimate of tax referral.
Male Audience 4: Sure.
Jeff: If you would like.
Rich: Jeff, did you have anything that you wanted to make sure you covered in front of the group before they meet you one-on-one after the meeting?
Jeff: I think I’ve tried to convey it as quickly as I could and give you the big picture. The big picture is if you’re going to hold a building, the reasons that you wouldn’t do a cost seg, let me throw those out there: if you buy a building today and you plan on just let’s say painting it up, fixing the kitchens, and selling it next year, don’t do a cost seg. It’s not worth that you’re not going to own it long enough and you’re going to have to give back so much of the tax deferral you gain off the cost seg, it’s not going to be worthwhile doing, so don’t do it.
The typical hold time is 3 to 5 years. If you’re going to hold the property for 3 to 5 years, then it makes sense to do. If you’ve done 1031, so if you’ve brought basis forward from another transaction, the 1031 is going to reduce your new basis in that building, in the new acquired property, therefore if your new depreciable basis is only $200,000 or $300,000 it’s probably not worth doing. If you still have depreciable basis of $500,000, $1 million, $3 million, it’s great to do.
Rich: I know a lot of people in here still have questions. We just promised to end the meeting on time, so please ‑
Jeff: [crosstalk 0:27:50].
Rich: You’re okay if people come up and ask you, right?
Jeff: Yeah, yeah. Absolutely. Just come up.
Rich: All right. Let’s hear it for Jeff Hiatt, guys [applause]. And Jennifer Williams and the very smart guy in the blue shirt. Please fill out your ‑