April 14, 2023

JF3144: Cost Segregation 101 ft. Erik Oliver



Erik Oliver is the vice president of business development at Cost Segregation Authority, which performs cost segregation studies to help investors save tax dollars. In this episode, Erik explains exactly what cost segregation is, why it’s becoming more prevalent in the commercial real estate industry, and some of the misconceptions surrounding it.

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Erik Oliver | Real Estate Background

  • Vice President of Business Development at Cost Segregation Authority
  • Portfolio:
    • A few short-term rentals 
    • A few long-term rentals
    • Passive investor in Salt Lake City micro apartments
  • Based in: Salt Lake City, UT
  • Say hi to him at: 

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Slocomb Reed: Best Ever listeners, welcome to the best real estate investing advice ever show. I'm Slocomb Reed, and I'm here with Erik Oliver. Erik is joining us from Salt Lake City, where we've just had the Best Ever Conference 2023, and we'll be back there next year as well. Fabulous city, great downtown area for hosting our conference. Erik is the Vice President of Business Development at Cost Segregation Authority, which was represented very well at the conference as well. His personal portfolio includes a few short term rentals and long term rentals. He's also a passive investor in Salt Lake City area micro apartments. Erik, can you tell us a little bit more about your background and what you're currently focused on with Cost Segregation Authority?

Erik Oliver: Yeah, thanks for having me, Slocomb. I appreciate you having me on. So kind of my background is my degree is in accounting; going through college I wanted to get through college as quickly as I could. Math always came easy; I hated writing papers, so I figured I would either be a finance major or accounting major. I majored in accounting, got into business development sales. That job took me to the East Coast, where I lived in New York for a number of years. And then about seven years ago, I was looking to come back out west to Salt Lake City. I came across this job; always interested in real estate investing. I had heard of Cost Segregation; didn't really fully understand what it was... And as I started doing my research, I came across this company; I thought it would be a great opportunity. I've been doing Cost Segregation studies for seven years now. Currently the vice president of business development. My main role within the company is going out, training not only investors, but also CPAs on the importance of cost segregation, how it works, how it should be utilized etc. So that's kind of what got me here. I love doing it, I love working with investors to help save tax dollars.

Slocomb Reed: Nice. For those of our listeners who are not as familiar, can you explain what a Cost Segregation is and what it does for real estate investors?

Erik Oliver: Sure, that's a great question. So Cost Segregation really is just accelerated depreciation. So one of the great benefits of owning real estate is the ability to take depreciation expenses or a non-cash expense against your income. Typically, real estate gets depreciated over either 27 and a half years for residential, 39 years for commercial. So just to make the math easy, if you have a $39 million commercial building, essentially you would get a million dollar write-off every year for the next 39 years. Well, I may not own my building in 39 years. I want my deductions now. And so how do we accelerate those? And the way we do that is through an engineering based study where we come in, identify different components of the building, and reclassify those into shorter asset lives.

For example, when you buy a $39 million office building, you're not just buying the land and the walls, you're buying some flooring, you're buying some carpets, and countertops, and cabinets, and window coverings. You're buying a parking lot, curbs, gutters, asphalt. All those different components, according to the IRS, should be depreciated at a faster schedule than 39 years. The problem, Slocomb, is we give our closing statement to our CPA, and the CPA says "I don't know how much the parking lot is worth. I know you paid 39 million for this building." They're not able to put the value to those different components. So that's where you would hire a Cost Segregation company to segregate the costs into those different buckets, which allows us to depreciate at a faster rate. And there's a number of reasons, Slocomb, you want those deductions. There's time value of money, there's inflation, there's cashflow... There's a number of reasons why you want those deductions sooner. And that's usually done through a cost segregation study where we're reallocating those costs into shorter asset lives.

Slocomb Reed: One of the major topics of conversation within cost segregations recently has been bonus depreciation. Can you explain what bonus depreciation is, or what it has been and what's happening with it right now?

Erik Oliver: Yeah, that's a great question. So bonus depreciation - the IRS has utilized bonus depreciation for a number of years now. And they utilize it to stimulate the economy. So when the economy is not doing well, they'll increase the bonus percentage; when it's doing well, they'll decrease the bonus percentage. Bonus depreciation in 2017 with the tax cuts and Jobs Act. - so back in 2017, Donald Trump was president. As many of your listeners know, Donald Trump owns real estate. When he was revising the tax code, it was very favorable to real estate investors. And a couple of things happened; back in 2017 bonus depreciation only applied to brand new assets, meaning you had to build a brand new building in order to take advantage of bonus. And at the time, it was only 50% bonus.

Let me back up a step and explain what that 50% means. That means if you were to go buy, let's say, a piece of equipment; you bought a new million-dollar bulldozer, and that was a brand new bulldozer - you got to take a 50% of the depreciation in the first year, the other 50% gets spread out over the useful life of that bulldozer. Well, with the tax cuts and Jobs Act, a few things changed. One is they got rid of the provision that it had to be brand new. They added a few words to the tax code that said "It just has to be new to you, the investor or the taxpayer." That's a huge difference. And they changed it from a 50% bonus to 100% bonus. So what that means, Slocomb, is now I can go out and buy a million dollar duplex, have a cost segregation study done where they usually will segregate around 30%. So let's call it 300,000 on a million dollars. That 300,000 that gets allocated in those short asset lives - I get to take 100% of that or 100% bonus depreciation in the first year. Typically, I'd have to split that up and depreciate my five-year assets over five years, my seven-year assets over seven-years, my 15-year assets over 15 years. But under the current tax law, I get 100% of that in the first year. Now, that goes for anything that was placed into service between 09.27 of '17, so the end of 2017, to 12.31 of 2022.

We're kind of in a phase-out period right now where any assets placed in the service in 2023, the bonus percentage has dropped to 80%, which means you would get 80% of those deductions in the first year, the other 20% spread out over the useful life. So very favorable for real estate investors right now; if you own real estate and you're not taking advantage of bonus depreciation, and you're paying the IRS tax dollars, definitely look into it, because it's so favorable right now that a lot of investors should be paying very little to if any federal tax.

Slocomb Reed: In 2023 we're at 80% bonus depreciation, and then I believe for "new to you, but not new construction assets", or newly developed or built assets, it drops 20% each year, correct? So the bonus depreciation in 2024 will be 60, then 40, then 20, then zero?

Erik Oliver: Yeah, 2027 had completely phases out to zero. However, Slocomb, I will say there was some serious talks last fall within Congress to extend the 100% bonus into 2023, simply because of the way the economy was shaping up. So this year, in 2023, it kind of depends; they can always go back and extend the 100% bonus, but you're absolutely right. Currently, it's scheduled to phase out completely in 2027, when it phases out to zero.

Slocomb Reed: Erik, my experience with cost segregation has been since 2017, during this bonus depreciation time. Let's imagine a future where bonus depreciation does actually go away. When there is no bonus depreciation. What sort of impact should I be able to see on my federal taxes?

Erik Oliver: That's a great question. So bonus depreciation really put cost segregation on steroids. So we were doing Cost Segregation long before there was bonus depreciation. So you're still going to want to accelerate the depreciation on your assets by getting a cost segregation study done. Even if 2027 it phases out to zero, no new administration comes in and makes any changes, you're still gonna want to accelerate it. We're talking about taking 1/39 of a deduction, versus moving 30% of that up into a shorter asset life. So it's still very favorable to do cost segregation.

Like I had mentioned before, I may not even own the property in 39 years; my investment strategy is not to hold the property for 39 years, so I want to maximize and front load as much of that depreciation; whether I get a bonus or not, I still want to front-load it. All bonus does is it gives you a bigger portion of it in year one, versus years 2, 3, 4 and 5. So even when bonus phases out, Slocomb, I think it's still going to be very important to take advantage of cost segregation, and still front-load those deductions so that you can give a higher return to your investors, create cash flow, pay down debt... There's a number of reasons why you want those tax savings now, versus in the future.

Slocomb Reed: I want to make sure I understand you here, Erik. As bonus depreciation goes out, assuming that it does, effectively what it does is it takes all of that bonus depreciation you could take in year one and spreads it over years one through five?

Erik Oliver: One through five for the five-year assets, one through 15 over the 15-year assets. But yeah, it spreads it out; you're still front-loading it, but instead of getting such a huge number in year one, you're spreading it out years one through 15, based on what we find within the building, what we're able to segregate.

Slocomb Reed: Gotcha. So investors with a five-year hold plan or longer are still seeing the lion's share of the benefit from cost segregation. And one last piece here before we transition the conversation a bit, Erik... I know there is this thing called depreciation recapture. And I've personally gotten Cost Segregation reports from three different agencies who explained it to me differently. And when my CPA explains it, my ADHD kicks in, and I start playing with whatever's in my hands. Is there a succinct way to explain how the depreciation recapture comes into play with a cost seg?

Erik Oliver: Yeah, that's a question we get asked most often by not only our investors, but CPAs as well. So the whole idea behind cost segregation - you do have to pay some of this back in the form of depreciation recapture. So when you sell an asset, you pay back two types of tax - you pay back your capital gains tax, and you pay back depreciation recapture. Now, your depreciation recapture is calculated based on how much depreciation you've taken. So I'm sitting here saying, "Hey, front-load all your depreciation, take all these deductions up front." And investors will come back to me and say, "Well, wait, Erik - doesn't this just mean a bigger tax bill upon sell?" And the answer is no, and I'll explain to you why here in a second. But the idea is you're taking your deduction against your ordinary income.

So let's say I'm in the 37% tax bracket at the federal level. I'm going to take these deductions against my 37% income bracket, I'm going to pay it back at a recapture rate that caps out at 25% or a capital gains rate that caps out at 20% and save the spread. So even if I ended up paying it all back, we have a rate arbitrage between the deduction I'm taking against my ordinary income and the recapture rate.

In actuality, you're not paying it all back Slocomb, you're only paying a portion of it back, and I'll explain to you why. If I were to buy a building for a million dollars, and sell it five years later for 2 million, if I don't do a cost segregation study, I'm telling the IRS that everything I bought five years ago has doubled in value, and it's now worth 2 million. I bought it for a million, sold it for 2 million. Everything doubled in value. Well, that's not the case. My dirty, nasty carpet that I've had for five years isn't worth double what I paid for it. But if I don't have a cost seg study done, there's no way for me to pull out the carpet. Carpet according to the IRS is a five-year asset. So what is your five-year asset worth, Slocomb, after you've owned it for five years? It's worth zero. It has no value. Your carpet's fully-depreciated, so you should be allocating the sales price that million dollars of increase from I bought it for a million, sold it for two million; that million dollars of increase had nothing to do with your dirty nasty carpet, it had to do with the land and the walls. So shifting your game or allocating your sales price to the right bucket upon sale creates another permanent tax saving.

So in summary, yes, you do have to pay some of it back, you pay it back at a lower rate, on a lesser amount. And that's important. That lesser amount is dependent upon how long you've owned it; a lower rate, at a lesser amount, and save the spread.

We even see properties, Slocomb, where they may only hold it for a year, maximize the deductions in year one, turn around and pay back some of those deductions in year two when they sell it, but we're creating a permanent tax savings because of that rate arbitrage.

Slocomb Reed: Erik, that was very clear and succinct. Thank you.

Break: [00:13:47.23]

Slocomb Reed: Transitioning the conversation a bit here, Erik, I want to talk about the trends that you're seeing in the Cost Segregation space. Really, I think I'm seeing trends in the Cost Segregation space, and you're an insider and I want to ask you some questions. When did you start working with Cost Segregation Authority, and when did you become aware of this niche within accounting and taxation?

Erik Oliver: I started back in 2016. So in 2016, this was prior to the tax cuts and Jobs Act.

Slocomb Reed: It was pre steroids.

Erik Oliver: Pre steroids, right. Yes. This was all natural. So prior to that, Cost Segregation at the time was really only for your large commercial investors. So you had to have a million dollar plus asset in order to be ordered to take advantage of cost segregation, for a couple reasons. One, the benefit wasn't as high as it is now with bonus, and two, the fees were higher than they are now.

Slocomb Reed: Fees were higher than they are now.

Erik Oliver: Yeah. So less people in the game; your average study might have cost you 10 grand, but you had to have a million dollar asset to justify that type of study, or that type of cost. With bonus depreciation, it opened up cost segregation to a whole nother level of investors, everything from single-family homes on up. Now oftentimes it will make sense, based on bonus depreciation and the changes to the tax cuts and Jobs Act.

Slocomb Reed: You're leading into one of my follow-up questions already, Erik. I know that the demand for cost segregation reports has increased. It sounds like you're saying though that the cost of getting a Cost Segregation report has gone down in the last several years?

Erik Oliver: I would say industrywide yes. And I think that's just because there's more information out there about cost segregation, there's more companies coming into the space, and with technology and stuff... One of the great things that came out of COVID -- not a lot of great things came out of COVID, but one of the great things that came out of COVID was the ability to do our site visits virtually. So we used to do every site visit on every asset, we would send one of our engineers from Salt Lake to Florida, to view the apartment complex in Florida. Now we're able to do a lot of those site visits virtually, which has lowered the cost dramatically for both us and our clients. We don't do all site visits virtually, but some of them that we can justify, it's made it great.

So I think with the virtual site visits, with more players in the industry, with some of the better technology we're using, costs I have seen come down in terms of cost segregation studies, but the amount of studies has dramatically gone up, from more education, more investor summits, more conferences like you guys put on here in Salt Lake a week ago, where we're teaching investors about cost segregation. It's becoming more and more prevalent in the industry.

Slocomb Reed: Let's take it back to supply and demand, like good econ 101 students. The demand for cost segregation skyrocketed, they went on steroids; the supply of Cost Segregation companies, and the availability of Cost Segregation also rose. And on the net, you project that they cost less, due to the number of new companies able to do them. My curiosity, here is what's going to happen as bonus depreciation is phased out over the next few years, assuming that it does phase out, Erik. Do you see the costs of a cost segregation study going down because the demand decreases, while there are still a higher number of players in the space?

Erik Oliver: Absolutely. That's something that we're very conscious of here at our firm. Bonus depreciation, like I said, it's made cost segregation important for all levels of investors. Cost Segregation used to only be for, like I said, those high-level, high dollar worth properties. And that's a misconception in the industry, even to this day; a lot of CPAs will tell you, unless you have a million dollar asset cost segregation doesn't pencil out. And that's just not the case because of bonus depreciation. But once bonus depreciation does phase out, it will no longer make sense to do cost segregation on your smaller properties, which means there's going to be a consolidation in our industry. Prices will come down and I do think there'll be a consolidation in terms of how many companies are out there. We're already seeing a consolidation in our industry as we speak.

Slocomb Reed: Erik, I do feel compelled to ask... You own some short term rentals and long term rentals there in Salt Lake City, and you're invested passively in some micro apartments... Are all of those properties cost segregated?

Erik Oliver: Yes, they are. As I'm sure a lot of your listeners are aware, I'm a W-2 employee here at Cost Seg Authority, so part of my reasoning for getting into the short term space was specifically to utilize the ability to use my deductions against my active income. So I was faced with a tax liability in 2022, that I knew I was either going to pay the IRS, or I was going to go buy a short-term rental. So I chose to go buy a short-term rental, do a cost seg study, I was able to create $140,000 deduction. My down payment was $80,000. I'm gonna get $70,000 of that back in the form of tax savings. So absolutely, I practice what I preach.

Cost Segregation, I've gotta be honest with you, Slocomb, is the easiest sales job I've ever had, because it's just a math equation. It makes sense or it doesn't, right? I don't have to convince you. You're gonna pay the IRS $40,000 or pay me $4,000. You decide. So sometimes the math equation makes sense, sometimes it doesn't. But it's simply just a math equation of rates, and arbitrage and time value of money, is really all it is.

Slocomb Reed: Erik, last question here. I'm gonna hijack the podcast for my own interests. You mentioned short term rental... I acquired a property in late 2021 that I took my time renovating over 2022. And I wasn't sure which exit -- we're talking about a very small single family, very close to where I live here in Cincinnati. I took my time with it. I knew that I bought right, and I had other bigger projects. I'm an apartment investor. This is a small single family home. I ended up renovating permits and everything, spent way more than I purchased the property for in the renovations. I ended up turning it into a single family rental, that was, I guess you would say, put into service just a couple of months ago in 2023. So I bought it in '21, I renovated it in '22, I started renting it as a short term rental in '23. For the sake of my taxes, [unintelligible 00:21:20.22] for what year will I get the cost seg?

Erik Oliver: 2023. In service is kind of a gray area, and you want to always run this past your CPA, because I've seen CPAs treated differently in all different circumstances. But in general, in service, according to the IRS, means available for its intended use or purpose. So if it was still being renovated in 2022, still under construction, and it wasn't available, my definition is as long as I can rent it... It doesn't necessarily have to be rent it, but if there was an opportunity for you to rent it in 2022... Let's say you finished construction in November, but it wasn't until January that you've found a tenant. Technically, I think you have grounds to say that property was available for its intended use or purpose back in 2022... Meaning you could do the cost seg study still today. You could do it right now and take advantage of those deductions on your 2022 tax return.

But if it was half torn up at the end of December, and you really didn't finalize everything, it was not livable until January of this year, then you're in service date or when it was available for its intended use or purpose would be January of this year... Which means you would do the cost seg study for 2023.

Slocomb Reed: This is my own deal, so I could dive down the rabbit hole, of course, but I think that's the answer that adds the most value to our Best Ever listeners. Quick question as we're wrapping up here, Erik... Where can our Best Ever listeners get in touch with you?

Erik Oliver: The best place - I'm on LinkedIn. My name is just Erik Oliver. Always reach me through LinkedIn. Also our website. Our website is www.costsegauthority.com. And my contact information is on there and my email, my cell phone number... Feel free to use this as a resource, guys. They've got a great thing going on over here at the Best Ever. You guys are great investors, a great network of folks. Please use this as a resource; we don't bill by the hour. We see all different types of scenarios work with all different types of CPAs across the industry... So if you guys ever have any questions on depreciation... Now, don't call me and ask me about child tax credits, or earned business income ,because I don't know anything about that stuff. But if you have a depreciation question in regards to real estate, definitely use us as a resource, guys. We'd love to answer any questions you may have. But that's the best way to get a hold of me.

Slocomb Reed: Erik's links are in the show notes. Erik, thank you. Best Ever listeners, thank you as well for tuning in. If you've gained value from this episode, please do subscribe to our show. Leave us a five star review and share this episode with a friend you know we can add value to through our conversation today. Thank you, and have a best ever day.

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