Table Of Contents
In this episode, Brandon and Thomas are joined by Billy Withers, MST, and he talks about deducting expenses as repairs and capitalizing and depreciating expenses over time.
This episode is sponsored by Landlord Studio.
This podcast has been transcribed using AI, please excuse spelling, grammatical, and other errors.
Thomas Castelli 0:00
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Brandon Hall 0:03
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Thomas Castelli 0:29
Hey, everyone, thanks for tuning into this episode of the tax smart Rei podcast. In case you missed last week's episode, we are rebranding the real estate CPA podcast. As we feel the text more investors brand that we've been building over the last year better aligns with the content of the podcast and the audience we're trying to serve. It's the same podcast just a different name. So going forward when you see tax smart real estate investors podcast on your feed. Just know that's us. If you're looking to learn more about tax smart real estate investors, you can find our free Facebook community by going to facebook.com/groups/tech smart investors or by visiting tech smart investors.com. That said we had requests release a nother session of the 2022 tax and legal summit here on the show. So today we're joined with Billy withers MST. Billy is a partner here at the firm who's been helping real estate investors reduce their taxes for over 10 years. He's going to discuss the differences between repairs and capital improvements, and the key safe harbors that can help you save 1000s in taxes. We'll jump right into that after a quick word from landlord studio. If you're doing yourself landlord managing rental properties the landlord studio is made for you. The software helps landlords simplify income and expense tracking. With their easy to use app. You can digitize receipts record income and expenses in real time and generate reports and even manage leases and tenants plus landlord Studio makes late rental payments and bank visits a problem of the past with secure online rent collection get the rent paid directly to your bank account. And you can even automate rent reminder emails and late payment fees. Landlords studio is also the best way to stay tax compliant. They offer a range of financial reports including Schedule II and supplier expense reports designed for tax time, you can learn more about landlord studio and start your 14 day free trial at landlord studio.com/cpa. And use the coupon code real estate CPA at checkout to get 25% off your plan. Again, that's landlord studio.com/cpa and use the code real estate CPA to get 25% off your plan today.
Brandon Hall 2:24
Hey everyone, he just came off of the lease agreement session with Ron I hope that you enjoyed that or found that valuable. If you want to purchase recordings for all the sessions you can go to recordings dot tax and legal summit.com. But now you are on the repairs verse capital improvements session. And I've got Billy withers here. He's a partner at the CPA firm. He's going to be telling us all about whether or not we can deduct expenses as repairs or if we have to capitalize and depreciate expenses over time. Obviously, we would like to be able to deduct things as repairs today. Because we get the deduction today, we don't have to deduct it slowly over 27 and a half years or 39 years if we're talking about commercial property. So pay attention to today's episode because you're going to learn the nuances between being able to deduct an expense today as a repair versus having to capitalize it and slowly depreciate it over time. Billy, go ahead and introduce yourself.
Unknown Speaker 3:20
Hey there. So I'm Billy withers, I have been a partner here the real estate CPA for a little over a year. And I've been in firm here for almost five years, I've been helping real estate investors my entire career. And that's what I really enjoy doing. And so I'm happy to share with you guys what I know about capitalizing versus repair of improvements to your property.
Brandon Hall 3:40
Awesome. Awesome. Well, let's jump right into it. So the repairs versus capital improvements kind of got clarified back in 2013. Due to the tangible property regulations. Give us an overview as to what those regulations are and why real estate investors should care. Yeah, definitely. So
Unknown Speaker 3:55
back in 2013, the IRS released the final tangible property regulations to bring framework to the mix of conflicting case law and administrative rulings. When it comes to the difference between deducting ordinary unnecessary expenses in your trader business and capitalizing the cost of acquiring producing and improving tangible property. Tangible Property, of course, is anything that you can kind of touch or move. It's not real estate, you know, big buildings and land. So within that framework, we have several elections and tests that we can step through in order to decide how we should treat for tax purposes, the acquisition of tangible property in your rental property business. So if I have a quick example here, so say for example, you purchased a TV for $375. Before the TPR is the tangible property regulations were introduced, most taxpayers and practitioners would have depreciated that expense over five years capitalized and depreciated over five years. But now with the guidance of the tangible property regulations, we now have a couple of tests to run through that help us determine if depreciating the asset was indeed the correct treatment.
Brandon Hall 4:57
Very cool. All right. Well, in the TPRS we have several safe harbors. So let's talk about those safe harbors. Let's start with the de minimis Safe Harbor. Tell us about how that works.
Unknown Speaker 5:10
Yeah, so my opinion, the Dominionist Safe Harbor is the most useful of the tests or safe harbors introduced with the tangible property regulations, because it sets a bright line dollar value to help you decide whether to capitalized or expense the purchase. That bright line was originally set at $500. Back in for 2014, and 2015 tax years, it then later increased to $2,500 for 2016 and beyond and it hasn't moved set. So $2,500 is the de minimis Safe Harbor, as of today. So that means for every invoice item under $2,500, we can immediately expense that item to reduce the burden of determining whether or not we should capitalize smaller dollar amount items. Because technically speaking, we would need to, you know, if there's an improvement of $2,000, technically speaking, we might have to capitalize that, but because it's under that $2,500 de minimis Safe Harbor, we can just go ahead and deducted because the dollar value is so small that it's not worth anyone's time to look into further. If you have the applicable financial statement. That means that you're required to provide audited financial statements to either a government entity or the SEC or potentially your bank, we can then increase that de minimis Safe Harbor amount to $5,000 in some cases, so that's something to be aware of.
Brandon Hall 6:24
Got it. Now, many practitioners say that this is a book conformity rule, not necessarily a quote unquote, loophole. Can you talk a little bit about what that means?
Unknown Speaker 6:35
Yeah, exactly. And so when I say it's, it's for reducing the burden, that's what I mean, you know, you shouldn't really approach this as I'm just gonna deduct everything under $2,500. and run your business accordingly. What it's really for is, it's just to say that if I need to make a an improvement or repair to my property, I know that if it's under $2,500, I'm just gonna expense it and move on, and doesn't really court require further conversation with my accountant about the impact of that expense.
Brandon Hall 7:03
Yeah. And so I just want to emphasize that your books need to match the tax return for this to work. So it's not like a tax benefit, per se. It's more about what Billy was saying, like on an ongoing basis with your accounting, you need to make sure that you're deducting those invoices or the components or the materials that are less than $2,500 on your books. So it's not something that like, you know, we get to the tax return, and we scrub your improvement schedule and look for these $2,500 or less items. You need to be doing this already. In your accounting software. That's the whole point of the de minimis Safe Harbor. It's not really a loophole to go and utilize. But I do have one more question about so we get this question a lot. Let's say that I buy a property, I don't know in November, and I do like a $50,000 rehab, and then I lease it out. Maybe December 15. So for 45 days, I'm doing this rehab, when can I use the de minimis Safe Harbor? Can I use the de minimis Safe Harbor to write off the cost of my rehab?
Unknown Speaker 8:07
So I would say that it depends on a lot of factors. If we're talking about a single family rental, generally speaking, the answer is probably no. The reason being is it's important to note that the de minimis Safe Harbor does not apply for any expenses that are required to be capitalized under Section 263. A. So that's when you're improving a property, the or constructing a new building especially. So it's really important to get with your accountant and discuss reason why I say reason why I highlight single family rentals is maybe maybe you're getting a multifamily rental that's in service, and you're just renovating one of the units, that could be a different answer. So I think it just requires a conversation and kind of like we emphasized earlier, if you're going to be spending more than $2,500. By and large, it's going to require a conversation with your accountant.
Brandon Hall 8:51
I think the key point that you just made is that the property has to be in service to be able to utilize the de minimis Safe Harbor, you said it on the multifamily piece. So a lot of times if you're doing this major rehab, your property's not actually in service. So you can't go and just use the de minimis Safe Harbor to deduct all the costs associated with that rehab or even some of the costs associated with rehab, so doesn't have to be in service before you can use the de minimis Safe Harbor. Just wanted to call that out because you mentioned it there. So let's move on to the next safe harbor the safe harbor for small taxpayers tell us about that one.
Unknown Speaker 9:25
So the safe harbor for small taxpayers is the one where you're permitted to deduct costs of repair, maintenance and improvements on leased or owned buildings when you meet certain thresholds as defined by the safe harbor. So those thresholds are average gross receipts of less than $10 million. So that means you know, less than you if you have a rental property, less than $10 million in rental income gross, and the property has an unadjusted basis of less than a million dollars. So it's a property that you acquired for less than a million dollars. You can attach to your statement to the return to deduct the repairs that are lesser of 2% of the owner. adjusted basis or $10,000. So those are kind of the three thresholds there.
Brandon Hall 10:04
Awesome. So who typically uses the safe harbor for small taxpayers? In your experience?
Unknown Speaker 10:11
That's a good question. I would say that usually we are pretty well covered with the de minimis Safe Harbor. There are certain situations though, when we have a smaller property, again, less than a million dollars in unadjusted basis, where if the total amount of improvements to the property are significant improvements are more than $2,500. But less than those threshold amounts, generally speaking, $10,000 Unless it's a really small property, so we might use it in that situation, say, if you were to make a $9,000 improvement to the property, there's no circumstance where we can use the minimum safe harbor in this specific instance, we would use the small safe harbor for small taxpayers to take advantage of that and just deducted anyway,
Brandon Hall 10:51
let's do an example. Let's say that we have a property with an unadjusted basis of $500,000. And we get like a $7,000 H fac put in. And the only other repairs and maintenance that we have throughout the year is like an extra two grand just on like little things. So we've got $9,000 of total spend 7k of is the H back to 2000 bucks is just the extra stuff in my on adjusted basis is $500,000. Walk us through what we can deduct and what we can't deduct.
Unknown Speaker 11:21
So in total, we have $9,000 of repairs, we know that the unadjusted basis of the property is $500,000 2% of that amount is $10,000. So the $500,000 is kind of where the you know, the break and the angle comes because it's both parts of that $10,000 lesser of 2% or $10,000 threshold. So we're going to be deducting all of that, because you're not substantially improving that property, it's within that safe harbor. So we can then make that election again, as long as we make that election, we're good to go ahead and deduct all those repairs.
Brandon Hall 11:55
So I can even if I can't qualify for anything else, I can fully deduct this $7,000 H back unit. Because my adjusted basis other property is 500,000. And this safe harbor for small taxpayers says you can deduct any amount that's less than the lesser of 2% or 10,000 bucks, but 2% of 500k is 10,000. So 10,000 Compared to 10,000 is 10,000. So the $7,000 amount that I know I had extra repairs, but all of my repairs are less than this $10,000 threshold on the 500k on adjusted basis, and I get to completely expense my $7,000 H back as long as you attach that statement of the return making that election Yes, as long as you attach the statement. Okay, what is the benefit of deducting that $7,000 paycheck today compared to depreciating it over time?
Unknown Speaker 12:46
Yeah, so if we're kind of run out of all our tests and decide that that $7,000 improvement to the property does indeed need to be capitalized, we're looking at depreciated over 27 and a half or 39 years, so even a relatively soft, small expense, because it's a relatively small property. And it's we're kind of running up against that the test of $10,000 because it's it's under that amount, we're saying it's not important to depreciate over 39 years, you know, if it's small commercial property, that's going to take forever to recoup your investment. However, deducting it today eases your tax burden today and gives you the benefit today.
Brandon Hall 13:22
Got it. So the $7,000, I could deduct immediately, thanks to the safe harbor for small taxpayers, I get the tax deduction today, which could potentially create a tax loss which I then get to utilize against potentially other income if I am paying attention to the passive activity loss rules. But if I couldn't deduct it today, I've got a depreciate that $7,000 over 27 and a half years or 39 years of its commercial. And I believe like 7000 divided by 27 and a half. I don't have my calculator up in front of me, but it's somewhere around 300 bucks a year. Right. The difference is getting my full 7k tax deduction today and the tax benefits that come with that today, versus taking $300 a year for 27 and a half years, which will take me a long time to extract those tax benefits. And, you know, in today's inflationary environment, probably by year 10. Those are negative tax benefits anyway. So you want to take those tax benefits immediately. All right, well, so we talked about the de minimis Safe Harbor and the safe harbor for small taxpayers. Tell me about the routine maintenance Safe Harbor This one's underutilized, I think, I think not a lot of people really know it exists or pay attention to it on an ongoing basis to talk to us about this one and how we can use it to our advantage.
Unknown Speaker 14:34
So in my opinion, the routine maintenance Safe Harbor is a really useful tool to help you decide whether or not the capital that you're gonna invest in your property is going to be deductible or capitalized because it plainly explains what routine maintenance is, and how it's treated for tax purposes. You're not required to capitalize as an improvement, and therefore you can deduct amounts that meet, you know, a bunch of criteria and I'll run through those criteria right now. So The amounts paid for recurring activities. So it happens frequently, as a result of the use of your property in your trade or business but has to be, you know, busy, it can't be like an investment has to be used in your trading business, to keep the property and it's ordinarily efficient operating condition. And you reasonably expect to do this maintenance or have this expense more than once during a 10 year period, or for property other than buildings more than once during the class life of the property. So usually, that's five or seven years, depending on the property. So what it does is, it lays out very plainly if you walk through those steps, in most cases, you know, nothing's ever, you know, clear his day. But in most cases, it plainly lays out how you're supposed to treat those routine maintenance, where you're saying, you know, might not be the best example. But I have an example here of a car where, you know, if you put a couple 1000 miles on this car a month, and you got to change the timing belt, which is a significant expense, you're, when you're putting a lot of miles on it every month, you're going to have to do that more than once in 10 years, and more than once in five years, you know, because it's a class life of love less than 10. So you it's, even though it's a significant investment in your car, you're going to be doing it, you know, more than once in that timeframe, and therefore, it's routine maintenance, and you can deduct it. And what's great about this one, too, is you don't have to make any kind of special statement in tax return. This is just basically the treatment of if you say that you're doing this routinely, as long as the IRS agrees with you, you get to deduct that expense.
Brandon Hall 16:25
I think I learned something new actually. So it's 10 years, or the class life of the property in question. So carpet has a class life of five years. So if I replace my carpet once every three years, is that routine maintenance?
Unknown Speaker 16:42
I think it could be defined as routine maintenance, where you get to say, you know, anytime you have a tenant turn if your tenants are turning over frequently, it's becomes routine in that instance.
Brandon Hall 16:52
Got it? Yeah, because you would replace it in year one. And then you would also replace it again in year three. So that's two times within a five year period. So that makes sense. Basically, if you're going to replace your, I guess the way that I'm thinking about this is if you're going to replace your carpet more than once, before the five year period ends. I guess, if you can't keep your carpet for a full five years, you have to replace it in between, that's routine maintenance. Is that the right way to think about it?
Unknown Speaker 17:19
I believe it is. And if you think about why we have this rule in place, it's basically for you to be able to if you have to defend yourself against the IRS is for the IRS to be able to say you know this expectation was reasonable or not. And if you acted reasonably, you're not assessed certain penalties and things like that, you may still be on the hook for the taxes and interest. But as long as you're within the as long as you have this routine and safe harbor to fall back on, you won't be subject to additional penalties, things like that as as long as you can convince the IRS that this was a routine item. Okay.
Brandon Hall 17:52
Wow, interesting. Cool. I'm going to echo what I said a few minutes ago, I think that this is a very underutilized, Safe Harbor, I just don't think that people are CPAs are really paying attention to it. So make sure that when you are doing any sort of replacement of a component, that you have a conversation with your tax advisor, about the three safe harbors within the tangible property regulations. And if you don't qualify for one of the three safe harbors, then pay attention to the next piece of this session, because that's we're about to dive into. Next, you're not necessary, if you don't qualify for one of the three safe harbors, it doesn't necessarily mean that you have to capitalize the cost of whatever component you're replacing, it just means that you can't qualify for a safe harbor, you didn't have to apply three additional tests, which we're about to talk about. So I think the best way to talk about these three additional tests is through an example. So let's say that I have that $7,000 H fac replacement. Since it's $7,000, it does not qualify for the de minimis Safe Harbor, right, because that's the $2,500 threshold. And let's just assume here that my other maintenance and repairs were $4,000 during the year. So now I have 11,000 total dollars of repairs, maintenance and improvements. And because I'm over the $10,000 threshold, I can also not qualify for the safe harbor for small taxpayers. Right. So I have, um, can't qualify for de minimis because it's too big of an expense. I can't qualify for safe harbor for small taxpayers because I have too much too many expenses in terms of repairs and improvements. And then let's also assume well, I mean, obviously, it's an H back unit, you're not gonna replace it twice during a 10 year period. So it can't qualify for routine maintenance either. So this $7,000 track replacement in this example, doesn't qualify for any one of the three safe harbors. What do I do next?
Unknown Speaker 19:46
So next you need to decide if the H fac is a better man and temptation or restoration of the unit of property. And I don't know really how helpful that is. So I'm going to run through what exactly That means, but really, at the end of the day, it doesn't really help us a whole lot until we kind of dive into the numbers. So under the final regulations and expenditure must be capitalized. If it results in a betterment to the unit of property, it adapts the unit of property to a new use, which that one's kind of straightforward, or results in the restoration of unit property. And those are referred to as the bar tests. So an expenditure results in a betterment of the property if they're merely rates conditional or defect that existed before the acquisition of the property. So basically, if you're, if you're bringing bringing it kind of similar to restoration, bringing it up to new bringing it up to speed, that's definitely a betterment of the property, and that will always be capitalized.
Brandon Hall 20:39
And that is known or unknown, right? That ameliorating a defect that's known or unknown. So there are examples in the regulations where people discovered the defects after they bought the property, it was still the cost to ameliorate those defects was still considered a betterment under these regulations. And I think that's also why I thought, well, maybe maybe it would be a restoration, but between the betterments and the restorations, that's why these big rehab expenses before I placed my property in the service, that's why those are all capitalized. But anyway, sorry, I just want to jump in there. ameliorates a known or unknown defect in the property. But continue.
Unknown Speaker 21:23
Yeah, so and then we also have the adaptation test. So this one, as I said, is a little more straightforward. It adapts the unit of property to use inconsistent with your intended ordinary use, or at the time you originally placed in service, basically bringing something that was doing one job and to doing something that's a different job. That's an adaptation. And generally speaking, that's going to have to be capitalized as well. And then finally, we have the restoration. So you're either restoring the basis that has been taken into account as in computing gains or losses, returns the unit of property to a working order from a state of non functional disrepair. So I think that might be the difference between Betterment or restoration. If it's not in service, and you're bringing in service, that's a restoration, or just rebuilding the unit to like new condition after the end of its alternative depreciation system, class life, or replaced is a major component of substantial structural part of the unit of property. So when you're replacing an age back, you could be again for dive into the numbers replacing a substantial structural part of the unit of property because he ended up property is the H vac system. Mm hmm.
Brandon Hall 22:27
So let's take this in two ways, then let's say that I have a single family home with one H fac unit, and I'm replacing that one H fac unit. Is that a betterment adaptation or restoration.
Unknown Speaker 22:40
So to me that you're likely restoring the H fac unit of property, they singular H back and an H PAC system is a substantial part of the unit of property, generally speaking. So I think we're going to get into the numbers here in a little bit. But we can definitely say for sure, you're more than likely than not in that scenario capitalizing that improvement to
Brandon Hall 22:58
the property, when would when would the H fac replacement be a betterment?
Unknown Speaker 23:05
It would be a betterment when you are replacing it with a newer unit. So yeah, there's improvements to technology all the time. And this bar test is kind of a trap for if you go long enough before replacing your your property, chances are technology has improved over the years. So you know, maybe not the age back scenario. But still, if you bring in new technology, introducing new technology to the unit of property, that can be considered a betterman.
Brandon Hall 23:32
Interesting. So I guess the way that kind of thing about this is that most of my rehab replacement work is going to be potentially considered a restoration. You know, like bringing it back to, like new conditions or, you know, using similar models and things like that. But if I buy a unit that materially increases the size, capacity, efficiency and strength of the apex system, then even if I can somehow skirt, the restoration rules, I could still fall into the betterment trap. Yeah.
Unknown Speaker 24:02
To me, it's like maybe the tankless water heater with could be a better man. Yeah. Proving the plumbing system.
Brandon Hall 24:09
Yeah. Okay. That's a good example. So and I guess it's important to kind of pause and just tell everybody here, this so the $7,000 paycheck unit could not qualify for the three safe harbors de minimis safe harbor for small taxpayers, and then routine maintenance, right. And because it couldn't qualify, like if it can qualify, then we know we can deduct it as a repair, right, so we're good. We don't have to move in a step further in our analysis. But in this example, this h fac unit did not qualify for any one of those three safe harbors. So the next step is to analyze the betterment adaptation restoration rules. And if it's a betterment, adaptation or restoration, then you have to capitalize it. And so what Bill is saying here is that this $7,000 H Feck unit on this single family home that only has one H fac unit if I replace it, that's going to be a restoration if it's not a restoration probably going to be a better bet due to that increase in technology, the efficiency strength capacity of the system itself. So that means that I'm going to have to capitalize the $7,000, put it on my balance sheet and depreciated over 27 and a half years, I'll get that $300 annual depreciation or so. So that's the that's the consequence of having a betterment, adaptation, restoration. A lot of times you can't do anything about it, especially on the single family homes, you're doing any sort of major rehab or anything, you're going to be falling into the betterment or restoration buckets, so that rehab is going to be capitalized as a result. But here's a question I have for you. Let's say I have a multifamily home. Let's say I've got a four unit property. And I'm replacing one H fac unit, there's four units, and they're all connected to the same system to four units, one system, I'm replacing one of the four units, still $7,000, I still have an extra $4,000 of repairs and capital expenses and everything like that. So I can't qualify for any of the three safe harbors one H fac unit $7,000. Is that a betterment or restoration?
Unknown Speaker 26:11
So there's generally a threshold that we consider have 30% of the End of property being replaced. And so in your scenario, where 25% of the units are being replaced, we could look to that to be a repair to the property because you're not bettering or restoring a material part of the the unit of property overall. That said, you know, a really great way to determine what your units of property are, is to get a cost segregation study done, because it identifies for you all of your units of property. And it kind of gives your your tax advisor something to work with to be able to say, the unit of property or the system is worth this according to cost segregation study, you're only improving this or a small amount of this property. So it's actually probably a repair rather than a large betterment, or restoration to the property. So these betterman After annotation restoration tests, they consider the unit of property, not necessarily the building overall. So it does, you know, it's very difficult to say, you know, $7,000 is a small part of my building overall, I'm good, they can't really say that, what we can do is, is have some third party evaluate for you the units of property contained within your building. And then you're able to say at that point, well, this is a small expense compared to this entire unit of property, and it's probably safe to deduct it.
Brandon Hall 27:33
So to figure this out, I'm just gonna try to repeat what you said. So to figure this out, you have to take this $7,000 H back unit, you have to look at the actual system that is being improved. And so you're saying you have to look at the H fac system as a whole. And the system on this four unit property is made up of four h fac units, probably some of the electrical that feeds it, and then definitely the ductwork. Right. So if I replace one out of the four h fac units, and when you factor in all the ductwork, it's definitely less than 25% arguable you're at like 20 to 22%. I've replaced 20 to 22% of the entire system. And so you're saying that there's this materiality threshold of 30%. And if you're below that 30% threshold, and you haven't materially improved the system, as a result, you can deduct it as a repair. So if you're hearing this for the first time, and you're like, Whoa, that doesn't sound right, or my CPA, like I think something that we see a lot in the industry is a CPA or advisor that's not familiar with these rules, will see a $7,000 expense, and they'll go well, that's a big expense. And then they'll just capitalize it, depreciate it over 27 and a half years, they won't apply any additional analysis to it. But the reality is, is that if you're running the multifamily deal, and you're doing any sort of rehab, you can keep in mind this 30% threshold. And this applies to your building, your electrical system, your plumbing system, your H vac system, your security system, your fire system, there's like a couple other systems in there that I'm missing. But this applies to various systems like you can break each one of these systems down and look at how you improve the system during the tax year. And if it's less than 30%, then you can arguably expense it as a repair. Now, don't do this without the CPAs help. But make sure that you are working with a CPA that understands these rules and is actually going to deploy that analysis because it can it can save you a lot of money. And if you have had that conversation or if you're like my CPA, I'll never go for it. You need to look at the regulations, or the tangible property regs because there are Treasury regulations that literally give examples of this h fac unit example that I'm using. I think they use two h vac units on a 10 unit building or an eight unit building. It's one of those two, but in the example itself, they say yes, you can deduct the cost of the H facts even though it cost you 18 grand to put them into place to install them because it's not material really improving the H vac system as a whole really
Unknown Speaker 30:04
important stuff. You're dropping it back down to that routine maintenance Safe Harbor. But again, you don't need to put attach a physical statement of the return of keeping that H back system and it's ordinarily efficient operating condition. So not a materially bettering or restoring the unit of property when it's a small amount, like one out of four units.
Brandon Hall 30:24
Got it? Perfect, perfect. Well, that is sweet. All right. Well, you mentioned Cost Segregation studies. Tell us what a cost segregation study is, because I think we're going to have a cost segue session. Let me look at my calendar. That is tomorrow 2pm Yona is going to be doing a cost of creation session with us. So until we get to that point, give us a really high level overview as to what a cost segregation study is. And you mentioned that it can help with this betterman adaptation stuff. But let's move beyond that. And let's talk about partial acid dispositions.
Unknown Speaker 30:57
Okay. So high level of cost segregation study is where a independent third party qualified team of engineers, let's say, goes and assesses your property and determines all of the units of property all of the components in your building and breaks down whatever your purchase price is, and compares that you know, rather than deeming your purchase of the property as 27, a half 39 year property as so off singular unit, it breaks it down into different components, the building, and allows you to say that say this age back systems mean worth $20,000, out of the million dollars that you spend on your property, something like that, or that to that effect. And again, the power of that is it not only identifies for you these units of property, but it also you know, there's different class sizes associated with different units of property, different systems, different components. And there may be more favorable tax depreciation class lives, when we know what those different components are to give you more depreciation sooner rather than later.
Brandon Hall 31:57
So it's a means of accelerating the depreciation. And I talked about this a lot in my real estate professional status presentations that I do, you know, across the United States, digitally, virtually, of course, but I talk about this a lot, the time value of money factor, right inflation, everybody would agree that leaving a ton of money sitting in your savings account is a bad deal right now, because inflation is, you know, seven 8%, depending on what reports you read. But the reality is, is that you also have a bank of tax savings sitting in each one of the rentals that you buy, right? In the same things happening there. You can think of it as the same savings account, just tax savings sitting in your rental property. And a cost segregation study essentially extracts those tax savings, and allows you to claim them today, versus claiming them over 27 and a half years via straight line depreciation. So if you don't use a cost segregation study, your tax savings that are predefined, sitting in your rental properties are getting eaten away by inflation every single year. So really, really important to us. But how does this apply to partial asset dispositions?
Unknown Speaker 33:00
Yeah, definitely. So my favorite example, with a partial asset disposition is a roof. And where you if you can say that on my million dollar building, the roof is worth about $50,000. Let's say, we have that, you know, kind of 30% thresholds. So that's where it comes into the betterment adaptation restoration tests. But we're also able to say that if we replaced the entire roof, and a cost segregation study tells us that the roof is worth $50,000, we now know that as long as that roof has been in service for at least a year, we can throw away the old roof, take a deduction for whatever remaining basis is in that roof, put on the new roof. And I appreciate that for 27 and a half to 39 years. So what we're doing is we're not getting any benefit on your new roof, necessarily, that still has to be as part of the structure in the property depreciated over a long period of time. But what we are able to do is get you some cost savings, some tax savings from deducting the cost of the old roof, because it is now no longer in service. And that was something that was definitely clarified and brought to light by these tangible property regulations as well.
Brandon Hall 34:01
Okay, so you said a lot there. And let's break that down in I also just realized when I asked you to explain partial asset dispositions, I'm realizing that if you're listening to this, you're probably like, that's Greek to me, I have no idea what that is. So first, explain what a partial asset disposition is, and then we'll break down your roof example.
Unknown Speaker 34:18
Yeah. So again, tangible property regulations really shed light and clarified that if you have a unit property that's no longer in service, you can then deduct the cost of that property. When it's no longer in service. There's no sense say again, go back through. If you have two roofs, there's nothing now that says you have to depreciate two roofs, unless you cannot identify for some reason, the cost of the old roof obviously does not make sense. If you have one roof, you should be depreciating one roof and not to but we might need some information or calculation to help get us there. But in a sense, partial asset disposition is able to say when I throw away that roof, I'm disposing of that roof and therefore I can take it tax loss for disposing that roof, which helps me on my taxes.
Brandon Hall 35:03
Got it. Okay. And this is something that we see a lot on people's tax returns, very few people actually take advantage of partial asset dispositions. But as Billy was saying, if you don't use a partial asset disposition, whenever you rip a component out of your property by replacing it with a new component, in this example, it's a roof. But we can apply the same thing to age facts, windows, carpeting, appliances, countertops, cabinetry, anything that you think of inside of your property fixtures, all that stuff. If you rip out a fixture or anything, and you replace it, and you don't take a partial asset disposition, then you are now depreciating two versions of that component, even though you only have one. And so we're talking about a roof here. And what I want you to do is think about this, like if I buy a property, a cost segregation study helps me identify the value of the roof, right. But even if I don't do a cost segregation study, it is true that the roof component has value, right? Like I buy a property and all the components that make up the property have value, whether or not I do a cost segregation study. So if I then replace the roof, and I don't write off the value of the roof that no longer exists, then in theory, and then I guess, technically, I'm depreciating two roofs, even though I only have one roof. And that disparity is meant to be solved by partial asset dispositions. So those partial asset dispositions, as Billy explained, allow you to write off the cost is basically the expense, the cost of the roof, that no longer exists yet to get the value of that roof. And typically, you'll get a cost segregation study to get that done. You don't need to, but typically you do, but I replaced the new roof, it cost me 50 grand, the old roof, the value allocated to it was 30, I get a $30,000 tax deduction in the year that I replace the roof, because I no longer use this on my tax returns. Otherwise, I'm depreciating in this example, $80,000 worth of roofs 30,000 from the old roof and 50,000 from the new roof. That's an expensive roof to be depreciating over time. So when I write this, this asset off, so let's say I do write off that $30,000. How does that affect depreciation recapture whenever I sell the property at some later point?
Unknown Speaker 37:15
Good question. You'll have your adjusted basis in the new roof. And you'll have to recapture the depreciation taken there. But when you're disposing of the old roof, you've depreciated that asset over time, and you're only deducting what you throw away. So if it was originally worth 30, from the cost segregation study, and you took maybe $2,000 of depreciation, you're just deducting the new amount, and you're throwing away, because it's in the trash, nobody else is getting a benefit from it. So as far as I know, there would be no depreciation recapture there.
Brandon Hall 37:48
Excellent. So I've got a $30,000 roof as identified by the caustic study, the old roof that I ripped out, that's no longer there, it was 30 grand, I depreciated it too. So my adjusted basis is 28k. So I actually write off the $28,000 on my tax returns, not the full 30. And then if I sell this property five years later, I only have that 150 $1,000 roof on so I'm only looking at depreciation recapture. Related to that 150 $1,000 refund however much I've depreciated the 50k. But the 30k is gone, it's off my books. So really, this partial asset disposition suite because you get the upfront tax deduction, of ripping out that component. And then later on, you don't have to pay depreciation recapture, which is nice. Really nice. Like really nice. That's awesome. Okay, well, can I do this in the first year of ownership, the first tax year of ownership? Like when can I start taking partial asset dispositions? Yeah, so
Unknown Speaker 38:45
so definitely after the first year, you can use a cost segregation study, no question because you have to have business property in service for a year to be able to take advantage of this. Now, maybe, technically speaking, it's a tax year. But we at the real estate CPA like to walk the line of conservative and aggressive, and would probably require that you have the property in service for at least a year before doing these improvements. So like I said, you have to have a property in service for a year to take depreciation on it. And therefore it it has to be in service for a year to take advantage of partial asset disposition. And then also, you know, there's an alternative calculation without cost segregation studies. But that's generally for longer periods. So So you might ask the question, does it make sense to get a cost segregation study on a property I've owned for 10 years in order to take advantage of this partial asset disposition technique? And we would say no, we'd probably want to do the math for you use the alternative calculation. It's not aggressive at this point. If it's been in service, if you've had two groups in service for 10 years to be able to say, let's just use the calculation and the IRS might side with us and say that's, that's close enough. So
Brandon Hall 39:52
awesome. Awesome. So I can't I can't use a partial asset disposition on this rehab that I do in the first month of ownership.
Unknown Speaker 40:00
because you have to have business property in service for a year in order to be able to take advantage of partial asset disposition.
Brandon Hall 40:06
Okay. All right, well, we covered a lot. We went over the three safe harbors de minimis Safe Harbor routine maintenance Safe Harbor safe harbor for small taxpayers, if you don't qualify for one of those three safe harbors, you move on to the betterment, adaptation, restoration test the bar tests, if you don't have a betterment, adaptation, restoration, then you have an expense. If you do have a betterment, adaptation, restoration, then you have a capital improvement. And if you have capital improvements, then you can look to partial asset dispositions, to write off the cost of the component that you're ripping out or the remaining value of the component that you're ripping out. And I think one thing that we failed to mention on those partial asset dispositions, you do have to capitalize the replacement property. So like, if for whatever reason, in our roof example, we were able to write off the $50,000 of roofs, that I could not also write off the $30,000 of old roof. So you always have to have think of it think of it as like, I always have to have one version of the component capitalized on my balance sheet and depreciating at all times. But a really, really powerful strategy that we see very few investors really utilize and take advantage of, I think it's just lack of knowledge, honestly, and not knowing what questions to ask CPAs. So you know, if you're getting your tax returns back, as we know, this, the end of February, people can start getting their tax turns back, you did any sort of major improvements, rehab or anything like that. Send your CPA an email and just ask, Hey, I just want to double check. I just got off this summit, the tax legal Summit, learned about the tangible property regulations. And I just want to double check to make sure that we've optimized my tax position for my rental properties. Under the tangible property regulations, just send that email, start the conversation, see where it goes. Some of you might be surprised, you might be missing some pretty big deductions, especially if you did some large rehab after the property was placed into service. So Billy, where can people find you?
Unknown Speaker 41:59
Very good question. So I'd love to connect with everybody on LinkedIn, please send me an invite. You can link to my profile through the real estate CPAs LinkedIn, as I'm employing here, and then also you're always free to email me and Billy dot weathers at how CPA llc.com And we can go from there. I can answer any questions you have about anything we discussed today. Awesome.
Brandon Hall 42:18
Thanks so much for being here. And if you enjoyed this session, and you enjoy all the other sessions and you want to get recordings, you can go to recordings dot tax and legal summit.com and purchase them there. Next session we have coming up is evictions and legal issues with property management. So we've got an attorney coming on to talk to you about that. And this one was a big hit last year. So make sure that you stick around and we'll see you back here in about 15 to 20 minutes. So thanks a lot. See on the next session. Thanks for listening to today's show. If you enjoyed the show, please find us on iTunes and leave us a review. You can also email us at contact at the real estate CPA comm with any feedback or topic suggestions, we are always taking on new clients and with the new tax laws in play. You really don't want to navigate this alone. Let us help you save money on taxes with your accounting and CFO needs. To become a client navigate to our client page at the real estate CPA calm and fill out a webform with as much detail about your situation as possible. Thanks so much for listening. Have a great rest of your week.
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