Ep 101: Real Estate Tax 101 – How to defer taxes as a real estate investor

I sat down with my friend, mentor, and CPA Mitchell Baldridge. Mitchell is a CPA in Texas, a small business planner, and the founder of recostseg.com. In short, he spends a lot of his time thinking about how to save people in taxes. He has 150 clients in his firm, primarily big clients like small business owners, real estate syndicators, and other wealthy individuals with complex tax situations. He knows that it doesn’t matter how much money you make, it’s about how much you get to keep.

There are two types of CPAs I’ve run into in my life: those that fight for the IRS, and those that fight for you. I’ve fired CPAs because they act like they want to maximize my tax payments, whereas Mitchell helps me find every edge in the tax code that we can find. He’s not afraid of getting audited, because everything we do is compliant. But he’s fighting tooth and nail to minimize my tax payment in the right way. Taxes are a business decision, and you can use tax-advantaged strategies as a lever in your business to push the ball forward.

The first tax strategy that real estate investors can use to their advantage is bonus depreciation, it is a tax-saving machine. When you buy a property, the IRS assigns a useful life of 39 years (for commercial property), meaning that you can deduct 1/39th of the total property value (excluding land) each year over the course of the property’s life. But our tax code doesn’t apply a 39-year lifespan to every component of the property; things like landscaping, HVAC, flooring, light fixtures, windows, etc. all have their own useful life and can be depreciated faster than 39 years.

So the first step to maximize your depreciation strategy is to perform a cost segregation study. This is when an outside firm, like RE Cost Seg, will come to your property and break down the value and lifespan of each component. Of your $1M property, the windows may be worth $10K with a useful life of 7 years, the HVAC may be worth $35K with a 10-year life, and so on. Cost segregation breaks your building down into component pieces, assigns a tax code and lifespan to everything in the building, and then gives you a new depreciation schedule based on these components. The beauty of this is that it allows you to frontload your depreciation, and therefore your tax savings.

After getting a cost segregation study done, bonus depreciation allows you to take all the property components with a useful life of under 15 years and write off their value in year 1. This is the ultimate acceleration of the depreciation curve. And as of 2017, the latest tax code allows used properties to be eligible for bonus depreciation, which opened up this savings strategy to a ton of more people.

In 2021 I bought $50M of storage and $12.5M of that (25%) was eligible for bonus depreciation. On top of that, only $20M of the purchase price was in equity. This means we put $20M of cash down on these purchases and got a $12.5M tax deduction in year 1! That tax deduction frees us up to take on more deals, and therefore more tax savings, in the years to come.

It’s important to note that this is a tax deferral, rather than pure savings. You’re pushing your tax liability into the future, kicking the can down the road. But that means this is an interest-free loan from the government for years, and you won’t have to pay those taxes for decades. In the worst-case scenario, you’ll pay back what you saved but it will be 5 or 7 years later. But it’s easier to make that payment when you just got liquidity from a sale, not when you’ve just put your cash into a property.

Another great tax advantage comes from being, or marrying, a real estate professional. The IRS classifies all income (or losses) as active or passive. Active income includes your W-2 job, running a company, etc. while passive income involves investments and other sources where you’re not fully focused on operations. Typically, you can’t offset your active income earnings with passive income losses, but that changes if you’re a real estate professional.

Since bonus depreciation is a passive loss, it can offset a real estate professional’s W-2 earnings or any other active income they have. I have several cash-flowing businesses, but my private equity company can offset their income since I’m a real estate professional.

So how do you become a real estate professional? It’s a simple tracking of time. If you are spending 750 hours and more than half of your time performing real estate activity, you qualify. This means developing, constructing, renting, leasing, operating, managing, or brokering real estate activity. And the best part is the crossover of passive losses to active income applies to the spouses of real estate professionals too.

It’s clear now that Mitch has dedicated his career to understanding the tax code and helping effectively manage tax payments. And with RE Cost Seg, he offers a cost and time-efficient approach to unlocking bonus depreciation. Most cost segregation studies cost up to $5K; engineers come in, take a ton of pictures, model your building out in CAD, and so on. RE Cost Seg operates around virtual meetings where the engineers have the owner walk through the property, show them the light fixtures, HVAC, measure square footage, etc., and over the course of two hours, they’ll have everything they need to build a model, perform a cost segregation study, and provide it to you. All for under $2K. This has opened up the market for people who have cheaper, smaller properties but still want to unlock their tax savings, a lot of the clients at RE Cost Seg have homes with a purchase price under $200K and still see a great payback on their study.

There are tons of cases of the success of this type of approach, and one includes a short-term rental with a $550K purchase price. The cost segregation was done for $1.6K, and the net first-year depreciation from the study was $223K, almost 50% of the purchase price! In the owner’s tax bracket that resulted in a $82K tax deferral, and it was turned around in just six weeks.

Another example was a self-storage property I bought for Bolt Storage. The property had a security system, roll-up moveable doors, and HVAC temperature control that were all ripe to take bonus depreciation on. For a $3M purchase price, the cost seg was done for $2.8K, and the first-year depreciation was $663K. We had 40% equity in the deal, and over half of that came out as depreciation in the first year, resulting in over $200K in deferred taxes.

The last example I’ll give is at a huge scale, it was an industrial portfolio purchased in the northeast. The purchase price was $100M, and $15K was spent on cost segregation studies on the portfolio of properties. The total year-one depreciation was $30M, resulting in a $10M tax deferral!

Follow along for the back half of this conversation on Episode 102, where we talk more about real estate and small business tax-saving strategies!

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I started the Sweaty Startup in December of 2018 because I believe the Shark Tank and Tech Crunch culture is ruining the real spirit of low-risk entrepreneurship.