Tax Strategies Every Real Estate Investor Should Know | EP. 22

Hey everybody, Flip here, co founder of the Free. One of the co founders, I should say, of the Freedom Real Estate Group family of companies. And I am enjoying today with our CEO, Mr. Randy Brown.

Hello.

And today's podcast again. Our podcast is called Real Talk, which is real talk for the real estate investor. And I'm sure that you've seen our vlogs out there which always sort of lead into these podcasts, which are longer, more content, more diving into the topics. And this is cost segregations and 1031 exchanges.

Correct? Episode number 22, episode C. Yeah, yeah.

I'll stop counting around seven. I think so. But so before we get into all of that, I know it. We. What do you have here? But is there anything you want to lead into, like what this is like for the lay person, like what is cost segregation in 1031 exchange?

Sure, sure. They're real estate investment tax strategies. Hopefully some folks listen to the vlog. We talked a lot about the 1031 exchange during that vlog. We barely even broached the subject of a cost segregation study. But these are two powerful tools when you're making your tax plan to, you know, use the most aggressive tax rules when you're getting into a property. And then subsequently, if you find yourself in a position, which a lot of folks are right now, where prices are just crazy, you weren't really thinking about exiting or selling, but you get a price that you can't refuse. How do you best get out of that property without having to pay a huge tax. Right. Burden? So just the groundwork would be just tax strategies. Tax strategies. Every real estate investor should know.

There's. That's a good title. I like that. So it says here, talk depreciation. Now, again, I'm treating this like I don't know anything, which I really don't know anything. I do know one thing though. I found out that a cost segregation segregation study in like once you're in the, the, the, the crew that who buy apartments, this is called a cost, A cost sack.

That's right. That's right. In fact, that's where the abbreviations are going to be.

Yeah, there's, there's so many abbreviations. Once we got into multifamily, there's so many abbreviations. I'm like, what's that? I didn't know what that was. So now I know what it is. But, so the next question that I have is, what is depreciation?

So depreciation is the recognition of an expense for an asset over time. So to try and Bring that into real terms. It would be if you have something that has a useful life, so you're going to have it for more than a year, it has a useful life of more than a year. The accounting rules are, and subsequently, subsequently tax rules are that you have to recognize that expense over a period, a period of time.

Right.

So if I buy a building, I can't just write off that building, even if it's a perfectly, you know, it's 100% business use. Whatever the case is, I can't write it off in year one. The IRS has set up rules for the amount of time that you have to take to recognize that expense. You know, and some of them are super arbitrary. You know, business startups is 15 years. And, you know, a car is five years. You know, just carpet five years. Appliances five years. A computer three years. You know, just, just all over the board. Right. Fortunately, we have software that.

Right.

But so instead of taking, you know, I spend $3,000 on a computer, instead of being able just to write off $3,000, there are other rules to be able to do it.

Right.

All right.

But just talking about depreciation, instead of writing that off, I, you know, in my books, I write off $1,000 a year for three years.

Gotcha.

Yeah. So that's depreciation.

Yeah.

There's. It seems from what I've learned from just being around you for the last few years is that there's plenty of ways to skin a cat.

Right.

All right.

So. So moving on to the next one. So is there a difference in the treatment for flips versus rentals?

Sure. So if you are a. If you're going to fix and flip or, you know, you're going to buy, improve, and then sell, then that's inventory. All right, so we. I don't want there to be any confusion about how you depreciate real estate.

Right.

Because a resident real estate, a building is a rental property is depreciated over 27 and a half years.

Right, and a half.

27 and a half years. Yes, 27 at 330 months.

Oh, okay.

Right.

I got you.

All right. So when you have a property that you've bought to fix and flip, that's just inventory, you're not going to depreciate that. Even if you carry it over a tax year or if you have it in your inventory for a period of time, it's still, it's just aging inventory at that point. So it is different. So we're talking about buy and hold properties. We're Talking about recognizing the expense associated with those properties over time. Got it.

All right, now, so I already. I see the next question on here and what's. What's neat is because I know that a lot of people have been following us over the last few months and Danny and I, we acquired the apartments last fall and we actually had this done. So. But I'm going to ask you because I want to hear what, like the real definition because I found out what it was after the fact. But what is a cost segregation?

Okay.

A cost segregation is where we take that, that, that amount that we paid for the building.

Okay.

And we say that some of the things that we purchased as part of this acquisition were not building.

Right.

They, you know, a lot of it was, you know, we bought a lot of sticks and bricks.

Right.

But we also bought some carpet, we bought some appliances. We bought some other leasehold improvements. We bought some. Some things that would be. Had we not done these things as a part of a purchase, we would have been able to depreciate those over a different period of time. So you hire someone who's credentialed to go in and separate those things out.

Right.

They separate the cost. I'm trying not to use the words. Right, right, right. But they separate them into those buckets. Five year property, 15 year property. And then 27 and a half. Gotcha. And what happens is once we have those buckets separated out now we can use different tax treatments based on the type of property that we acquired.

Gotcha. And so real quickly. So what was the year like? How many years can we depreciate?

The.

The drug dealers and the squatters that were in our apartments. Where did we get? 5. Is that a 5 year?

Yeah.

Well, so then you get some in service rules. That was probably just expense. We probably took that. Right. Right now if we were.

But we would have made a killing.

Probably operating cost. If you were collecting rent at the time, if you weren't collecting rent at the time and you had to get people out of there, then those would be upfront Capex.

Yeah, you just went down the rabbit hole. Sorry about that. So now you brought in a demonstration so you can show an example, Correct?

Right. Yeah. So I just wanted to walk through. It's a pretty basic example I used. I'm hoping everyone can see it. We did a lot of testing prior to.

Yeah. So hopefully when we edit this, we can zoom in on the areas that you're talking about here.

So I'll move this around as I get toward the bottom here. So what I did was I put together a really basic cost segregation study based on a four plex that we bought for half a million dollars.

Okay.

Now to make this easy, we did it on January 1st and we paid all cash. Just because I don't want those variables to muddy the water for anyone, I want to keep it super simple.

All right?

Now, folks probably know this, may or may not know this, but you don't depreciate land. So the very first cost that you have to segregate is determine the land value.

All right?

And so in this case, the land value is going to be 80,000 bucks. All right? So we bought it for half a million. We have land value of 80,000. That gives us a depreciable base of 420,000. Hopefully everybody can see that 27 and a half years. We're doing it in January so that there's no like missed months or any of that kind of stuff. That means that we're going to write off in depreciation for that building. 15,200 bucks in year one.

Okay.

It's pretty decent right off. Yeah. You know, that size. So on that size property, that's the, that's the depreciation is the secret sauce that gives us the tax free cash flow.

Right, Right.

Okay. And so when we have a lot of ventures that we're in, in various stages of depreciation, accelerating this depreciation is what keeps us from paying taxes. All right, so not too bad.

Right? Good rule.

We're taking it over time, which is cool because we're receiving rent over time.

Right.

But let's say we're in a situation where we want to accelerate. Maybe we have another business venture that's doing really well and we want to, you know, bring up some losses to offset the gain from that. Or, or maybe, shoot, maybe this property is just doing super great and we need to accelerate some of the depreciation to stay tax free. We can do a cost segregation. Okay, What I see, I've been a part of several of these over the past several years. What I will typically see is 20 to 30%, sometimes as high as 40% of the costs get to be segregated out. So just using our example, we do a cost segregation study. The engineer comes back to us and says 10% of that property was 15 year.

Okay.

So it fits into the category that we could depreciate over 15 years. 25% of that was five year property. And then the rest of it is the 27 and a half year. So nothing exciting about the rest of that property. And it's also to be expected.

Right.

So we have 35% here that we have other treatment for. So if we just do a normal cost segregation study, 10% of the 15 year property, that's 42,000 bucks. Our first year depreciation on that bucket is going to be $2800. 25% is five year property, that's 105,000. So 105,000 divided by five basically is going to give us the 21,000 that we can take. And then the rest of it's 27 and a half year. We got $273,000 that's left over. That's our number, 9927. So just doing the cost segregation study, we have taken our depreciation from $15,272 in year one to 33,700. $929. I missed. No. $729.

Yep.

Yeah. So my handwriting is rough.

Considerable jump.

That's more than double. Yeah, definitely could be worth, especially depending on your tax bracket and how that's going to be taxed for you and the other gains that you need to offset. Now, I know it's a little rudimentary here to have this all written out for us ahead of time, but I wanted to save them, me having. Yeah.

Have it.

Write it out and it all be slanted.

Thank you.

Plus being balanced on the coffee mug, moving in and out.

Right.

And so one of the things that's really cool that we can take advantage of now and it takes it. I mean, this takes it into the stratosphere. This is awesome.

Right?

We get to, we get to depreciate the 15,000. That was good. We get to double it by doing the cost segregation study. We can take bonus depreciation right now based on the tax cut and jobs act and what we did for the apartment complex.

Nice.

We can take 100% of the 15 year property and we can take 100% of the five year property in year one.

Wow. Okay.

And so if we take advantage of this rule, we can write off the full 42,000, we can write off the full 105, and we can write off the same that we would have with the 27 and a half year property, the 9927, and we can write off in year one, $156,927.

It's a lot more now. 10 times.

This is game changing.

Yeah, Right.

Yeah, absolutely.

Now this is something that it's a. I Mean, it's a powerful tool. I actually had to write a letter to a bank recently because we wrote off almost $800,000 for a client.

Oh, my gosh.

They were like, this guy went from almost a million dollars to making barely over six figures. Can he afford his house? So he went into the tax strategy. This is. This is real money.

Yeah. Right.

And so you want to. You want to make sure that this makes sense for you and that you have a way to apply this 156,000. If you don't have a. Something else to offset. You don't want to necessarily get into this, but if you do, then you.

Yeah, yeah, absolutely.

It's powerful. All right, so that's the tax tax savings piece with the cost segregation study.

That's huge.

Yes, big time.

Yeah, yeah, yeah. Now. Now I understand why people want it done.

They want it. Yes. Yeah. And the larger the property, the bigger opportunity. Right. So in your situation, you have the 56 unit, right? That's going to be. The numbers are way bigger, right? Yeah. So, yeah.

And then 300 and the 300 unit down in Daytona Beach, I think they just did one, two.

I mean, you know, I haven't seen that cost SAG yet.

Yeah, I haven't seen it yet. I can't wait to see that, you know.

Right. It's gonna be a big number.

So. And, yeah, I mean, it's. That's just. That's amazing how you went from 15,000 down to 156,000 or whatever it was. That's. That's crazy. That's crazy. So. So that's the cost seg part. Cost seg.

Right.

To be cool.

Yeah.

So this 1031 exchange, so how does that play in.

Okay, so in this particular. What I've done is I put together an example using the same building, but there are times where you're sitting really well in a property, and you're gonna have gains to pay.

Okay.

But if your intention is to continue investing with your money, you can use a 1031 exchange to not have to pay the capital gains tax, and you can roll it into the deal.

All right.

And so this is a good way to kind of upgrade properties and to, you know, keep the engine going. Here's. I keep saying that, but I'm just going to show you the example. Right. Sweet. All right, so here's a 1031 exchange based on the exact same property. And the reason why I use the same property is because it's going to illustrate why having a strategist involved or having Strategy makes a huge difference. Okay, so we bought this building, we did a tax or a cost segregation study. We took the tax advantage, all right? So when we take that tax advantage, it actually reduces our basis.

All right?

So what we're going to do now is two years later, we're going to sell this same property. We're going to sell it for 600,000 bucks.

All right?

First thing we need to do is figure out what our basis is in that property. All right? So these are going to be rudimentary numbers or basics, but here we go. We bought it for 500,000. We've depreciated about 165,000 because we took this 156, then we probably took another nine.

Right.

I just ballparked it there. So that gives us a basis of 335,000 in the property, all right? It's a main variable in calculating what our tax consequence is going to be. We're going to sell it for 600,000. Our cost to sell, we're going to say, are 30,000. Just to keep the math easy. That means we're going to have proceeds of 570 grand. 570 grand. We back out our basis. That means we have a tax gain of about $235,000.

All right?

So we made some money in the couple of years, took advantage of the tax basis. Right. We're paying back some of that tax basis with this, but we still made 100 grand in two years. Not too bad on the investment, right? Cap gains tax. Let's just call it 20% on 235,000. 47 grand. Ouch. 47 grand. Now, what if I told you, flip, that I could take this $47,000 and roll it into your next property for you.

That sounds like a great idea.

You get to keep use of that money. Don't get to touch it. You have to get keep use of it.

Right?

All right, so what we do is we take. We hire an intermediary. This person is going to hold the money from the. From the sale, okay? You're going to have 45 days to locate a new property. You're going to have six months to close on it.

All right?

Let's say that I buy an 8 unit apartment building for 750,000. I identify it within 45 days of closing. If I close, closing the sale, the previous sale. If I close on this new property within six months and I never touch the money, I give the money to the intermediate intermediator. Intermediary, the guy holding the bag, right?

Right, Yeah.

I don't have to pay this 47,000 bucks. Bucks.

Now, do you have to give them the whole amount or just this amount? The 47,000.

No, no, you have to. You have to roll your proceeds into the full proceeds. Yeah, they got to take them.

So you can't take like 50 grand out of this and then put the rest in. You have to. All of it goes in.

Well, actually, I have Mr. 1031 Exchange, Ryan Whitaker at DVL. Well, not to call him out, but if you need a portion of it and not the other, he can help you.

Oh, I get you. Okay, so it is.

But the part that you want to have, what to defer your tax gain, it has to be all of the.

Proceeds of all the years of doing 1031. And all the questions, that's one I've never asked until just now because I didn't know. I thought it all had to go in there. So that's interesting.

Yep.

All right, so now let's take this, this, this money that we got, this $570,000 in proceeds, because remember, we did it all cash. We're going to buy an eight unit building for 750,000. Here's one thing that's your tax accountant's going to want you to remember, okay? We're going to take that initial proceeds of 570,000. We're going to put that toward the property. Your intermediary is going to bring that to the closing table. You're going to have to bring $180,000 of new money.

Right?

So you're actually, you're going to pay the $750,000, but your basis is going to travel.

All right?

So your tax basis for your next calculation to be able to do the. The gain calculation is going to be the old basis from the property in this 570, plus the new money. So when you're calculating your taxable gain going forward, your basis is going to be 550 and not 750. Not the 750. It travels. So when you pay this, when you sell this property, this is the number you're starting with as your depreciable base.

That's awesome.

That's. That's pretty neat. 1031 is the way. Is legacy building. It is the way to keep more of your wealth. I. There's a strategy I call the lifelong 1031 exchange. And that is where we never keep the money. We're doing this for our heirs.

Right.

Not errors.

All right.

But for the people, our family, who will be behind us when we leave, right? When we pass. All right, so what happens is you buy a property, you, 1031 into a larger property, take advantage of appreciation and someone else paying your mortgage, 1031 into another property. Keep doing this until you get where you want to be. My portfolio is exactly where I want it to be. I'm going to buy and hold this forever.

Okay.

I don't give it to anyone on my deathbed. I leave it to them in my will when I pass, my family gets a step up in basis.

Okay.

If I hand you a Babe Ruth rookie card on my deathbed and I said, here you go, flip. You've been a good friend to me. I want you to have this.

Okay?

I bought it back in 1931 for $5.

Okay.

Your basis in that Babe Ruth rookie card is $5.

Okay.

If you go out and sell it, just make it real. I'm sure you can get a hundred bucks for it, right?

Right. Okay.

You go out and sell it for 100 bucks, you're gonna pay cap gains on that spread.

Right?

The $95. You're gonna have a taxable consequence there.

All right?

If I say flip, I'm gonna leave this to you in my will and I pass. The fair market value on the day of my death passes to you as your basis.

Oh, my goodness.

Okay. That's it. Right. So when you sell it for a hundred dollars, you pay no tax because you have a step up in basis. So I buy these properties and I 1031 into the next property and then I 1031 into the next property, and then I 1031 to the place that I want to. Where I want to be. And let's say I have a million dollar portfolio with a hundred thousand dollar basis. I leave this to my family on the date of my death. Their basis, It's a step up to their fair market value.

Right? Yeah.

That's awesome.

And this is real. Like this is, this is an actual strategy. I've seen it play out with very big numbers. Cap on, it's $11 million per person. And I've seen it play out with some smaller dollars. I had a client that went to H and R block and had like a seventeen thousand dollar tax bill. She came to me, said, this can't be right. I didn't really get any money. Like how this cannot be right. Comes back to me and she ends up no tax bill though. It's. She sold her mom's house when she passed away.

Right.

Just a couple months later. Yeah. So. So I Know that we kind of hit that pretty fast. We threw around a lot of numbers. I definitely didn't want to do this without a video. Right, right. If you haven't talked to your tax strategist about a cost segregation study on bigger properties that you bought, or if you're getting ready to sell, at least exploring the opportunity for a 1031, please do so. Please. And use that $47,000 to buy a property.

Yeah, exactly. Yeah. See, see your tax accountant. See the tax attorneys. There's attorneys that specialize just in 1031 exchange. You know, so it's, It's. I mean, it's such a. I mean, I first heard about it, you know, five or six years ago, and, and I've never really studied it. I know what it is, and I know. I know people use it, and we've helped people use it because we're always willing to sell them more properties. Sure. You know, there was people in California. They were. When we first started, they were selling their one house and they were buying three out here, you know, and so because they were moving the money and.

The 1031 exchange, purchasing properties, power out here is much stronger than other parts of the country.

Absolutely. So that was when I first heard about 1031 is. Is that.

I'm like, wow, that's pretty cool.

They just sold one, got three. And anyway, so. But this is very, very interesting. Thank you very much. I really like the, The. The board too, because that's. It's good to have the visual. So. So hopefully we can zoom in and show that even better. So it balls in your court. As far as anything else you want to say about cost segregation and 1031 exchange.

Well, really about all of it. The ball out. I'll say it again just to reinforce it, is that the tax implications of your investment portfolio are going to be the biggest drain.

Right.

You're going to have repairs, maintenance, you're going to have tenant turnover. You got to have a good tax strategy, especially if you want to get into a bigger portfolio. So please, just, just dig into them, ask the questions, bring them to your person, or look into them yourself. If you're doing your own work. Once you get past a few properties, you should probably hire a professional to do that work.

Absolutely. Absolutely. We always hire professionals because we don't know.

Or those that play one on a podcast.

Well, excellent. Anything else?

Nope, that's it.

All right, well, thank you very much for joining us today and Mr. Randy Brown and teaching us about the cost seg at 1031 exchanges. But again, make sure you check out our vlogs out there. Our other podcasts again, Real Talk for the Real Estate Investor or Real Talk, which is Real Talk for the Real estate investor. I screwed it up there. But we always like to end these podcasts with our simple tagline of Live Smart or Sorry, Invest Smart.

Live Happy.

There we go. I knew it. I knew I was gonna screw it up. I didn't have it written down. Anyway, see you later. Bye.

Thank you.

Nothing on this show should be considered specific personal or professional advice. Please consult an appropriate tax, legal, real estate, financial or business professional for individualized advice. Opinions and information on this show are not guaranteed. All investment strategies have the potential for profit or loss.