Secrets Behind Real Estate Investors Success

TRANSCRIPT

Kevin Schneider: [00:00:00] Welcome to another episode of The Hidden Money Podcast. I'm Kevin Schneider, joined with my partner Mike Pine, and today we have the privilege and honor to be joined by Chuck Mayfield of MatchGrade. Chuck, welcome to the show!

Chuck Mayfield: Howdie Kevin! Glad to be here. Mike!

Mike Pine: Good to see you, man!

Kevin Schneider: Yeah, and Chuck... yeah, Chuck is one of our valued partners here and he's the magic behind all of our tax planning. We get to be the heroes on the front, on the end part of an engagement by our clients how much tax they save, but we cannot do that in the real estate realm without our friend Chuck here.

So Chuck, tell us about this magic that you hold and how you can help clients save money in real estate by doing what you do.

Chuck Mayfield: I have a cousin in Nigeria... I'm just kidding.

It's cost segregation. What it basically is, it's like doing an appraisal on a property, but rather than determining the value of an overall building or the condition, what we're looking for is how to carve out of [00:01:00] that building items that we can classify as personal property or items that we can classify as land improvement, which is real property like a building, but has a better depreciable life.

Before we get into how we do it, you've probably been through this before to make sure we're on the same page... the aim here is to optimize depreciation deductions for your taxes. So, if you purchase a short-term rental house, you can carve out whatever the land is at because land doesn't depreciate, and you can set the rest of that stuff up with a 39 year life because basically, you're running a small hotel, and Uncle Sam will thank you and shake your hand and everything's fine, but what we're allowed to do by law is to break that down a bit further. The first place we'd look is land improvements. So, let's just say you have a really nice 5 bedroom vacation house in Orlando, and it has a big, old pool in the backyard.

Well, this swimming pool a land improvement. It's real properties like the building, but land improvements have a 15 year life, [00:02:00] whereas that building has a 39 - same for a fence. Speaking of Florida, they'll have covers over those pools-that qualifies; landscaping is usually pretty out there; any number of things you would expect to see outside a house that are attached directly to land. Then, inside the house you can find items that are there because they're accessory to your business, which in this case is running an Airbnb, or things that are considered impermanent by Uncle Sam because of the method by which they're attached to a building.

Let me caveat us here right now to say this is tax law, so, If it deviates some logic just a little bit, don't let that bother you too

much.

Just a little bit.

just a little bit. For example, this is the one every time we give a presentation, the conference room would laugh, is one of the big ticket items that's removable and reusable, is carpet or vinyl flooring.

You, In their eyes, you can pick that carpet up, put it in another house, and everybody's happy. Now, whether in fact you ever intend on doing that doesn't matter. The courts have determined [00:03:00] that you can, and so therefore that carpet is personal property and has a 5 year life instead of a 39. The same goes to pretty much any kind of flooring except tile, because tile is set down with mortar and not with glue or stretched over a tax strip - that is permanent, is what it is.

So, nowadays a lot of people use that LVT, the Luxury Vinyl Tile, and they should - it looks really good; if anything happens in one of those little rectangles, you can replace it very easily; it's not quite as hard on your feet in the winter as tile is, and there's a lot of upside to it, and personal properties.

So there you are. The other big ticket item usually is the kitchen. You're going have cabinets in there. You're going to have appliances in there, going to have plumbing in there. You're going to have electrical in there. Oh, that's personal property 'cause this is an accessory to your business of renting a house overnight or over a couple of nights, however that may be.

There are other things in the house like window blinds or ceiling fans or power and connections for TVs or laundry. There's other things that add up, but those two are big tickets. [00:04:00] So, even if we didn't have bonus depreciation, which we'll leave out for right now, you've carved down a fairly substantial portion of this building to depreciate over 15 or 5 years at an accelerated rate,

and so that's to your benefit. Now, lately, we've been very spoiled and blessed to have a 100% bonus depreciation. The legal definition of that is anything that has a tax life of 20 years or less is eligible to be written off completely in the current year, which is going to be everything we find. Now, bonus has been set to expire before and always been renewed.

The last time they renewed it, they set a 100% up for, I think it's 5 years, so in 2023 we're going down to 80%. I'm starting to have some phone calls - 'People are saying it's going away!'

Like, 'yeh.. No!. It's acting like it wants to, but it's gradual and 80% is still pretty good.' Now, if you want to wage a side bet, I still think that at some point this year, both Democrat and Republican congressmen are [00:05:00] going to realize, 'Wait a minute, bonus is going away!' and they'll extend it again. I just think they will because they always seem to, and it does seem like property ownership is something that transcends politics, which is nice. I hope it keeps doing that.

Kevin Schneider: So, before we get into the conversation of Chuck, and what it is he does, and that magic he brings, Mike, would you give some Real Estate Tax 101, and some basic high level of what even cost segregation is, and what benefit it even brings?

Mike Pine: Yeah, for people who aren't familiar with cost segregation, let's start with, 'What is Depreciation?' The IRS... if you buy an asset that has a useful life of more than one year, like a house... the IRS says, 'That has a useful life of more than one year, you cannot deduct the entire cost of it as a deductible expense, but we'll let you depreciate it.'

So for example, let's say we buy a house for $450,000 and the land we agree is worth $60,000, so you have [00:06:00] $390,000 that's attributable just to the building - let's assume there's no land improvements or anything on it - you have $390,000 that you paid for that building, and IRS says, 'If it's commercial asset or commercial real property, (which we'll assume it is as a short term rental), it's just like a hotel,

you can depreciate it over 39 years, meaning if it's worth $390,000, we'll let you take a deduction of $10,000 per year for the next 39 years. Well, $10,000 per year is nice, but it's not nearly as nice as maybe a $100,000 in the first year, or more. So, what a cost segregation study does, (and I have no idea how they do it, but that's why we have Chuck, he does them).. a cost segregation study this... they go with basically engineering methodology and they go in and say, 'Okay, on this $390,000 house, we have all kinds of things the IRS says has a shorter useful life. We [00:07:00] have flooring, (not all flooring, but most flooring) that's got a 7 year life, we've got cabinetry, countertops, those all have shorter life,

we have appliances, and the IRS says, 'Hey, as long as you follow what we agree is reasonable (some methodology that they've agreed to or that tax courts have agreed to), we'll let you carve those things out, and once you get the cost of those out, you can either bonus depreciate it immediately, or you get to depreciate it over a much quicker period.'

So, instead of getting $10,000 a year in a deduction, you can get a lot more, and that's what we're going to unpack here in this episode.

Chuck, let's talk about bonus depreciation for a minute.

You mentioned that you think, and I agree completely with you - it's probably going to be renewed. When was the first time we had bonus depreciation? Was it right after 9/11?

Chuck Mayfield: New York was a mess, and people were scared, and so I believe back then it was 30%.

Mike Pine: Yeah. 30 and [00:08:00] then 50, after they renewed it.

Chuck Mayfield: Yeah... yeah. So, to pause for a second, the way bonus depreciation works, let's just say that of this property, we find $100,000 in 5 year property. If we didn't take bonus depreciation, that's going to accelerate over that 5 years at a double declining balance, which is nice.

What bonus does is takes a percentage of that for immediate write off; the remaining balance of that writes off over 5 years. Still nice. Nicer though, because of that 100,000 now you write off 30, and you would apply the double declining balance to the remaining 70.

And then it went away for a little while and came back in '08 at 50%, and then I think it was 2011, it kicked up to a 100 and 100's nice - it's basically a 100's saying anything you find is an expense.

When they did that in 2011, it was set to sunset, and then it got bumped up, and I know Obama bumped it up, and then Trump really did. So, it does seem to be something that benefits Americans and not [00:09:00] members of one affiliation or the other, which is nice.. and so for that reason, I just feel like it's going to get bumped back to a 100.

The reason they've done that before is to stimulate the economy. I mean, if you look around, there's a lot of empty rental space out there. There's some construction going, but anything they can do to stimulate the economy and keep people growing, and keep people leasing new buildings, and put jobs out, that's what this is designed to do..

Mike Pine: I guess.

Yeah. I mean, regardless of where you sit on the political spectrum, I think we can all agree that our politicians in DC like being re-elected, and when the economy's not performing well, they want to be able to say, 'Hey, we helped the economy with some kind of tangible result, tangible legislation.'

and I suspect that's why, 'cause every time, as soon as we start slowing in growth or potentially in a recession, whether you think we are in or not right now, Congress has said, 'Hey, we need to do something to improve the economy - both Democrats, both Republicans - and they reenact it. It's proven itself; it's been around for 20 + years and [00:10:00] it's proven itself as an economic engine and a driver for our economy.

Kevin Schneider: When we're talking cost segregation and bonus depreciation, (I want to reiterate and we've covered this on prior podcasts and bonus content), but when we're talking bonus depreciation, we're not generating additional deductions.

Instead, we're just playing with the timing to defer more taxes into the future; that's all we can keep doing. We can't eliminate tax with cost segregation and bonus, but what we're doing is in Mike's example of $390,000, you're owed that $10,000 over 39 years. All we're doing is we're depreciating $100,000 in year one,

then you get the remaining $290,000 depreciated over the 39 years. Essentially, if the cost segregation came back with a 100,000 being qualified improvement property and eligible for bonus, so you're still owed the exact same amount of depreciation, but time - value of money tells us if we can get a $100,000 [00:11:00] deduction today versus $10,000, that's going to save you another $30,000 in tax.

So, we're going to get $30,000 of tax savings today, instead of a few thousand dollars of tax savings spread out over 39 years. You could see the cash impact that holds - instead of getting little drops in your bucket over time, you're going to get poured in year one, and then in the future years, you're going to get smaller drops, but it's not going to be as noticeable.

So, we really want to free up cash flow today to either reinvest into the economy with growing your own portfolio, buying additional properties, and now you're snowballing a real estate portfolio with tax savings utilizing cost segregation.

Chuck Mayfield: Yeah... that one of the things I always say is, 'This is what I can bring the table; you need to talk to your CPA and see what this is going do for you. They know your tax position and I do not know your tax position.'

So, I'm very careful about that, and one of the things I love about working with you guys, is y'all have chosen real estate as something in which to [00:12:00] specialize and

that's why you've gotten into it. Nevertheless, it just does demonstrate that you won't break even; you won't be behind; you'll be ahead by doing this, especially in an inflationary market, if you're able to generate that cash flowing out and put a down payment in your next house, now you've locked that in,

so you're in a good spot.

Kevin Schneider: You want to be working with your CPA 'cause the engineer - they're kind of our hired gun. It's like the CPA generally will say, 'Hey, I could save you a ton in tax. I can't do the work for you; I need to bring in my buddy Chuck. Chuck is going to come in and he's going to do all the detail review.

He's going to bulletproof this thing, basically. Chuck will give us a report that's way too many pages thick with a lot of lingo even I don't understand, but in the event that you're audited, you're going to be thanking God that you had Chuck do that because we're going to have all of our methodology in there.

We're going to have pictures, we're going to have every piece of evidence of why we took that position. So, it's very important to work with a cost-seg specialist that knows what they're doing. I would be [00:13:00] very wary of DIY cost-segs out there - if you Google Cost Segregations, there are some services online where you put in your property value, you put in the dates and it'll spit out something.

Well, first, that's not as strong in an audit, just because you did it yourself. I just wouldn't feel comfortable defending a cost segregation with that. Secondly, it's probably going to be very conservative. You don't have a human being going to the property, which Chuck doesn't always go to the property...

but you're going to have an actual engineer looking at the details of this, doing the calculations - that holds a lot more weight in an audit than just some formula-based website.

So Chuck, can you speak to that a little bit of the different kinds of cost segregations offered? Because if someone buys a rental property and they want to get into cost segregation, their first option may be Googling it and they might have 50 options presented to them.

What are the difference cost-segs that are offered, and which one do you offer, and why?[00:14:00]

Chuck Mayfield: Okay. Good question. Yeah, starting, I guess, with what you're talking about - I haven't actually gone to look through one them, but I do know there's the one where you basically fill out a form, 'What kind of flooring, how big's your house, what'd you pay for it?' and it spits an answer out. I haven't heard one way or the other about whether these things are an audit target or not;

maybe they get away with them. I don't like it; every building's different. Now I'll step into the next thing - on the other end of the spectrum, you can have somebody get a full set of blueprints, do a full site visit, and literally estimate everything. All the electric that qualifies, all the electrical that doesn't qualify.

Typically, what we do is - we do break the building down into components, electrical, plumbing, mechanical, and so forth, and then estimate what qualifies and leave the rest in 39 year,

and so, actually working one of those things all the way out, we determined that our methodology was pretty good, that we were right, about, where we normally are. So, we it's been a while since I've done one, but we have had done a proof of concept, which leads me to what we do is - it's not a full engineering; it's a mostly [00:15:00] engineering, for lack of a better phrase. I will go through and identify whatever items qualify as personal property or land improvement, and then I will use nationally recognized estimating guides like RSMeans or Marshall and Swift to find the value of it.

All those guides are very specific about what item it is, what part of the country it is, what year it was placed in service; so there's steps that you have to go through to find the correct price for, say, a duplex outlet, and so, what I'll do is quantify those things, go through those guides, produce that price, and then we'll take the building,

we'll produce a model of what it would cost to construct that from the ground up from scratch, divide that into the various components, electrical, concrete, wooden, plastics, etc... and then deduct out what we find, and so you have a document that has these calculations that shows that, 'Yeah, the overall building electrical in this building is $80,000 and we found 25 or 30 that qualify.'

That's about right, because you have all this power in a kitchen. You can go to the panel box and look [00:16:00] in a house that has 20 breakers - between kitchen and laundry, you're going to have half of them just about, and then you factor in one for televisions or you have outdoor lighting or whatever, it fits. It's not something out of the ordinary

I have not had to argue one of these in front of the IRS. I didn't do a very extensive study on a ranch out east of College Station once, where we were bringing, like, yard equipment into the equation; I did a lot of estimating; I normally do. It got audited and then I never heard another word.

So, presumably, it did alright,

and as far as why the report is designed to be a standalone, where it has citations from cases over the years, (which have explained why carpet qualifies, explains why kitchen cabinetry qualifies, and so on and so forth), so, that report is designed to be a standalone document.

Kevin Schneider: No, that's great, Chuck, because you know when we file tax returns, and I mean we do how many hundreds of cost-segs with you, but every time we file a tax return, we show our work. We take your cost-seg as a PDF, whether it be a hundred pages, 200 pages, [00:17:00] whatever.. I don't care how big the file is... we attach it to the tax return, and we submit it to the IRS with the position being taken as bonus, and we just say, okay, we're taking bonus on this property. Here's the cost-seg up front - don't bother us. Just give my client the refund. If you want to look into the cost-seg yourself, here it is.

We're going to show our work up front, and you know, your reports are so detailed, and you got the case studies in there, and everything that.. We have never heard any peep from the IRS either, and so, maybe that'll prevent future audits, as if they want to see the cost-seg report, here it is up front.

Mike Pine: So, Chuck, you do these incredible reports and calculations, figuring out the value of buildings and land improvements, but we can't depreciate land. That's the one thing the IRS won't let us take a deduction for, is the cost of our land. How do taxpayers who are doing a cost segregation study, how do they go about figuring out how much of their purchase price to allocate to land?[00:18:00]

Chuck Mayfield: One common way to do it is go to your county appraisal district. So many of those are online right now; they're really easy to see. Sometimes they're lower even than I think they should be, and sometimes they're higher. It seems to be an industry standard for most properties that take 10%.

On the residential side, a lot of people are just getting into all this, and so they don't really have their own opinion, but on the commercial side, a lot of those guys do, and a lot of them like 10%, and I haven't gotten any pushback on it,

so, my default value's 10. Now, if it's California, my default value's more like 30... 35 even.

Mike Pine: What are the actual rules or guidance from the IRS or Treasury Department, say, when you're doing a cost-seg, what should you use to figure out land? Are you familiar with any case precedent on that?

Chuck Mayfield: Somebody buys a lot with a house on it knowing they're going to get rid of that house and expand their commercial business.

Well! That house is part of land.

You bought land, even though did have a house. Contrary to that, we had one in Santa Monica one time [00:19:00] where somebody bought one 'cause they were going to put a business in it and they tried and it just didn't work, but next year they raised the building and built their new one. We depreciated that; we feel like we have a very strong argument cause they gave it a go; they put inventory in it and they tried it;

they just didn't like it. So they, since they depreciated that over one period, not only didn't have to call that building land, they wrote the building, the value of the building, off. So that was very favorable for them, and I don't think they just did that as a tax trick. If they did, they hid it really well.

I mean, I think they really wanted to keep the house and really make it work; it just didn't. So, that's something to consider if somebody's buying a property with a building on it and knowing they're getting rid of that building - unfortunately, you just bought expensive land.

Kevin Schneider: Yeah. What we see a lot with the short term though.. I'm going to ask you this question 'cause this comes up a lot, is... let's say I target a property and I love the location, but it's kind of a shack; it's not up to date. there's not a lot of.. I mean, the carpet - you got shag-carpet, you got the popcorn ceilings, you got everything, right?

It's not ready for market. [00:20:00] So, how do you walk a client through that on your side saying, 'I bought a property for $300,000, I'm going to demo 50% of this house. Basically, everything on the inside, I'm going to gut it and then I'm going to put in $200,000 of improvements - new countertops, new everything. When does the cost segregation process start?

Because there could be two trains of thought - do we do the cost-seg at the very beginning, if we know what the value of what you're going to demo is, and then we can dispose of that during demo, and then we account for the improvements independently? (When you pay for a contractor, you get a formalized invoice or an itemized invoice,

so you know what these things cost, and you account for it properly?) Or, do you just wait to do the cost-seg till the very end, when the demo's done, the improvements are done - then do we bring in Chuck to do the cost-seg at that point?

Chuck Mayfield: Okay. Yeah, that's very common actually. If you buy a building [00:21:00] and you know you're going to demo everything, I don't know if they formalized this, but my understanding is their position is the things you're taking out of that building have no value. so, ignore it all together. My thinking is you buy a building, you buy a building that has cabinets.

You paid for whether you like them or not. So, the way I'll generally treat that is do a cost-seg on that building the way it looked - take a snapshot of it the day you buy it, do a cost-seg on it, and then we'll have a look at the remodel costs, which... (put an asterisk near that; we need to circle back to remodel in a minute).

Now, if you bought a house, rented it for a couple of years, and then you did a demo, then you have the opportunity with a 100% bonus. You've already written off everything we find for personal property anyway, but if you remove a wall, or you do something like that, or remove stuff in a bathroom 'cause going to remodel it,

we can take what's called the partial disposition, which you alluded to, where you carve out that value from the acquisition and write it off, so the trick there is this thing had to be depreciated for a while, and in [00:22:00] use. If you walk into it, start taking it out, we cannot do a partial disposition.

People out there might (some providers may disagree with that), but to me, that's aggressive beyond necessary. I just.. I wouldn't feel comfortable with it. There'd be a very big contract saying, 'If this gets audited, you're on your own!' Basically, because I just don't agree.

Let

Mike Pine: me unpeel the... or unpack a little bit 'partial disposition' or 'partial asset disposition' for a second. So again, you buy an asset, and you're depreciating over a period of time - like a roof is a, typically, a 39 year property or 27.5 on residential. You replace a roof, it's like, happens early on - part of that roof

you haven't depreciated; you're replacing it. If you're disposing of it, there's a way to get a deduction, a tax deduction, for the what you're disposing, and that's partial asset disposition, right? How does that work, Chuck? How do you figure out - let's say I buy a 39 year property - year two, I replace the roof - we have hail damage or whatever. How does that work?[00:23:00]

Chuck Mayfield: All right, well, in your position there, I would go back to that project, figure out what the value of the existing roof was, and then provide you a report saying, 'This much is taken out.' So, you would then figure out what the remaining depreciable life of that roof was looking at your schedule, and it would be an expense for that year.

Now, roofs is a curb Volvo. If it's residential rental property, what you said is the way it'll work. If it's commercial property, which is a short-term rental if you treat it as a 39 year small hotel, you get a section 179 deduction for a roof. So, they treat roofs favorably.

Mike Pine: So, you're saying there's hidden money in telling your cost-seg specialist that you did a remodel.

Chuck Mayfield: Everybody wins; the sooner you tell me about it, the better, or if you're planning on one. And I try to be generous about that; there's usually not a whole lot of work on my end and analyzing the remodel side, because they typically keep pretty good detail on what the costs are, [00:24:00] and if somebody says, 'I just spent $10,000 on vinyl flooring,' there's not going to be lot of arguing over that.

You have an invoice from Fred's vinyl store that shows $10,000 for flooring it; 902.. whatever... is what it is. There's not going to be a lot of fighting over that.

Kevin Schneider: Yeah.

Mike Pine: So Chuck, let's say a listener has had a property - rental property, for some years now, and they never heard of cost-seg and they hear it on this podcast. You don't have to do the cost segregation and get the advantages in the first year always, do you? Can you.. Let's say I've had a rental property 5 years;

I've just found out what a cost-seg is.. What are my options with you?

Chuck Mayfield: Yeah, that's a really good question. It's... we used to call them lookback studies on commercial. What you'll do is you will figure out what that building looked like when it was purchased or built, and you will cost segregate it just like you would as if you'd done it that day. For tax purposes, you get to treat it that way.

So, if it happened during a time when 100% [00:25:00] bonus was in effect, great, you get bonus and everything we find. Even if it didn't though, if it was back when there was 50%, or if it was far enough back when there wasn't bonus, what you're allowed to do is catch up all the depreciation you would have taken, if you had done that cost segregation study from day one. Call it catch-up depreciation; I think it's line item 481 (a) on your tax return. There's two ways of going about it - if it's fairly recent, you could amend your return, if that's what you feel like doing... or you can file an IRS form 31 15, 'change an accounting method'-

it's an automatic approval. It's another thing that's not a red-flag issue for audit.

Now, for individuals or rental homes, that's something you talk to them about - see which one's less painful. For a big, commercial property and a multi-partner LLC, they never want amend; you do not want to amend returns. That's way more headache than it's worth, and so why not use a 31 15? If you've been at this for a while, and you have some rental properties, we can absolutely still do cost segregations.

Depending on the situation, that may require a physical site visit, to walk through the [00:26:00] building with the owner so they can point out, 'Yeah, this was this way when we bought it; now it's this way - so, you can go back and figure out what that snapshot was when you purchased.

Kevin Schneider: Yeah.

Chuck Mayfield: Yep, absolutely. That's available.

Kevin Schneider: Yeah, there's a lot of logistics when doing that, and as you alluded to, Chuck, you don't have to go back. Let's say you've had a rental property for 5 years, and we're going to do a cost-seg back 5 years ago, you don't have to amend 5 years of tax returns.

First of all, you can't - the statute of limitations has already run dry, so you got to come up with a different methodology and reasoning on the tax return, and way to report that depreciation for the past 5 years. And if you go to hidden money.com/bonus content we're going to go into a little bit more of the details of if you've owned a rental property for a year or two plus years, And we're now going to do a cost-seg, how do we most effectively do that? And how do we report that in our taxes? And I'll walk through the form Chuck just alluded to the 31 15 accounting method change, the 481 (a) adjustment. We'll talk a [00:27:00] little bit about lendability too and how that would affect it. We'll go into all that in the bonus content,

so please check that out if that interests you.

Well, Chuck, it's been an absolute pleasure just talking through the details of cost segregation studies with you, and we are just so thankful for our working business relationship we have, and you provide so much benefit to our client base, and we're just a great team. And so, if anyone listening needs more information from Chuck, or you want to explore the possibility of cost segregation. Email is the best way to reach him. It's just chuck@matchgradellc.com. Send him an email and talk rope in your CPA. It's very important that your CPA work alongside Chuck. Chuck is a master of his craft in his space of engineering and doing the actual cost segregation study, but that needs to be incorporated into your tax return,

and just because you have rental properties does not mean a [00:28:00] cost segregation or bonus depreciation is deductible. That needs to come from your CPA. So, working alongside an expert like Chuck is going to be invaluable with/for a CPA. So, please reach out to Chuck, and if you don't have a CPA who is specializing in real estate, or you just have some questions, please reach out to us through hidden money.com.

You can contact us. Through the website. So Chuck, thank you so much for joining us and looking forward to many more years of bonus depreciation.

Mike Pine: Yes.

Thank you very much, Chuck.

‍