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Protecting Yourself From IRS Audits Through Cost Segregation with Bill Smith
Our guest is Bill Smith. Thanks for being here, Bill.
Thank you for having me, Whitney.
I’m honored to have Bill here. He’s an expert in his field and we can learn a lot from him. He’s the National Sales Director for ELB Consulting, Inc. He works with commercial real estate owners and investors to reduce their federal tax burden and improve their cashflow for future investments. After spending twenty-plus years in executive sales, marketing and management positions for both Fortune 500 and entrepreneurial firms in real estate, finance, technology and services, Bill teamed with ELB, a specialty tax solutions business in 2013. They utilize a proprietary engineering methodology to maximize the allowable IRS tax deductions and provide bulletproof protection in the event of an IRS audit. Bill, thanks again for being here. Bulletproof protection, we all want that, especially in the event of an IRS audit. I want you to tell the readers a little more about who you are in case they haven’t heard of you, what you do and then we’re going to get into this thing called cost seg. Elaborate on who you are and then we will get into that.
I’m a Regional Director and National Director for ELB Consulting. I’ve been doing this for a number of years. I’m the product expert for our firm. Cost segregation, for those people who haven’t heard of that in the past, some know what that is or have heard of it, have some general understanding or maybe a misunderstanding, which I find quite a lot when I’m talking to people, don’t know what it is. Cost segregation is a method to dissect the building down to all its component parts and short life them into ways to accelerate the depreciation. I like to say optimizing the depreciation schedule. You can get in there, optimize depreciation schedule, which creates those tax deductions, which in turn creates cashflow. The real goal for cost segregation is cashflow.
I’ve had clients that want it for strictly tax deductions. They got a high tax liability and they say, “Bill, help me out.” They say when I’m done, “I didn’t pay taxes.” They were very happy. Many firms and many people like it for not paying the taxes to free up cashflow to then buy more properties, which that’s what your readers want. They’re looking to buy more properties and they’re buying syndications. The syndicators are using this as we know. Also, some people are buying a small apartment complex. They’re starting out two or three rental homes, a lake home they’re renting. That’s where the real benefits lie and breaking down the components for tax strategy.
I look forward to getting in more depth about cost seg and why we need to know what this is. When does it make sense to have a segregation study done? Maybe you can elaborate on what that is a little bit, even more in-depth to the actual study itself.
I will get into that in some more details. When does it make sense to be done? There’s some debate about that. A lot of people will say it’s good to do it when you purchase the property or when you build a property. Some CPAs even have a misunderstanding because we were providing information and a report that the CPAs use to mitigate the tax liability. We don’t do it, we just provide the details for the CPA. The best time to do it is now. You could have bought a property five or ten years ago and we can do a look back study. You’ve been doing straight-line depreciation on these past five or ten years and it was a large enough property. There was enough meat on the bone, so to speak. We can do a look back study, catch up what you’ve taken a straight line to accelerate all the current properties, and then you get a lump sum of deductions in the current tax year.
People said, “If I get $1 million in tax deductions, that’s more than I can use this year. I’ve only got up $300,000 tax liability on my properties.” It carries forward. You never lose it. It’s not a use it or lose it. If you’ve got excess depreciation, you can certainly use that. It’s good to do it in the year that you buy it. It goes into service, but you can always do it where you can do a look back. Another point is if you’ve had a property for a while, you did significant improvements, capital improvements. If you’re putting $1 million into a property upgrade or repurpose, then there’s a cost seg on those improvements. You may or may not have done it on the property originally. If not, we can go back into the original property from five years ago, and then the improvements, this particular expense and then put those in the right tax buckets and apply those for the CPA to mitigate tax liability.
Is there any time that we wouldn’t need to do a cost seg study or wouldn’t want to?
If someone’s flipping property, some of your readers will say, “I’m buying a property, I’m going to upgrade it and I’m going to turn it over in a few years.” You have to need to hold period because the IRS will have a recapture rate and they don’t want you to double dip. If you took excessive deductions in this first couple of years, then sold it, then they’re going to have a recapture rate. Recapture is the spread on the gain on sale and your basis value. If you depreciate, you reduce your basis value. On that spread of basis value to your acquisition price, you’re going to pay ordinary income tax and you pay capital gains on the capital gains rate, which is lower. Some people choose not to do it when they don’t have more than a five-year hold period. Some do though. They may not know, but because of the cashflow strategy, you’re going to have recapture anyway. They will do it if they’re using the cash for more properties. If you’re not using it to keep your investments going, then it doesn’t make sense. I would suggest someone not doing it. The only time that it makes sense not to do it is if the property is too small.
Does it cost anything if I called or connected with you and said, “I gave you the details about a property,” and you did say, “No, that’s not probably a property that would be worthwhile doing a cost seg on?”
No, it doesn’t cost you anything. Our firm, like pretty much every other firm, some do charge for a proposal. We do what’s called a feasibility analysis. It’s the terminology in the industry. It’s a fancy word for proposal. What our firm does, and some use a quick model and some numbers, but we will be going to evaluate that property and identify a conservative projection of tax benefit, cashflow and an optimistic benefit. We’ll give you a range of where it’s going to fall. You can look at that. We can have a conversation about those benefits if it doesn’t make sense. We can talk to your CPA and tax professionals like, “Do you need it?” Let’s say you have carried forward losses for something else and you’re not paying taxes. That’s the other thing. If you don’t have a tax liability, it doesn’t make sense to do it. Going back to that last question, that’s one thing I left out. If you’re not paying taxes, good for you and it won’t help you.
What size of the property should we start to consider a cost segregation study for?
There are a lot of these investor boards and things out there and people are arguing. There’s a lot of argument over that. We can do a property as low as $300,000. You’re looking at a warehouse, there are not a lot of special purpose components. It’s the special purpose components, mechanical, electrical, plumbing, flooring, lighting and all the specialty items that make a big difference. If it was a small doctor’s office in a smaller community in place like Raleigh, Roanoke or somewhere like that, doctor’s offices are $800,000 to $1 million. You’ve got a lot of specialty components like built-in cabinets, specialty lighting, specialty flooring. There’s an opportunity to go down as low as $300,000 but typically, $1 million is a cut-off.
The larger the property, the greater the benefit. We look at it and say what makes sense for a property is the cost-benefit analysis. We’ll say, “Here’s the price. Here’s your net present value on a cashflow, the cash you’re not paying the IRS. Does that make sense?” Most firms will provide some level of evaluation like that. The higher, the better. There is the discussion about single-family rental homes and we do a lot of those. We will sometimes do a desktop version. We’ll have the appraisal and we will have the closing statement. We will ask the homeowner or the owner to take some additional pictures because they probably have pictures for renting but they don’t have pictures of the mechanical systems and the breaker box and stuff that get cost seg people excited.
[bctt tweet=”When you depreciate, you reduce your basis value.” username=””]
We had done those on some rental properties when they’re large enough. There are also automated models out there. There are several of those. We have a division that has one of those. We create an automated model. That will support properties up to $1 million and it doesn’t have to be just residential. We can do any number of properties on our platform. It’s a modeling platform based on the 14,000-plus studies we’ve done to date. It supports properties under $1 million. One of the things I want to mention about that is I’ve had people call us where that makes sense for a $600,000 or $700,000 property. On the flip side, I should have fully engineered and instead of paying $1,000 for that without an offense, or on a residential it’s $400, you want the asset detail. There are benefits to that. Having the asset detail in some properties provides value and that gives you future value for the cost. It depends. Under $1 million, you may want a fully engineered report and sometimes you don’t. It depends on the investor’s goals in what they’re going to do with the property.
I want to get into that asset management detail that you’re talking about, but what about the automated model that you’re talking about? How does that differ from what you normally do and is that something that would stand alone or is that something that would get you started the automated model, and then for you to do a more detailed report?
Several of our competitors have them and they all provide it. Everybody looks a little differently. We think ours is better and we use a modeling platform. Some will go up to $500,000. Some are only residential. You do some more work, they plug in some numbers and do some modeling. In our case, I can speak to that specifically. You just input about ten key fields on the property and you put in your tax name. It will spit out a report in seconds. It looks at that, it models that, it compares it to square foot and building type. We have dentist’s office, doctor’s office, apartments, hotels. There are about 40 options of properties that you can select, which all have different criteria. The size of the lot makes a difference, how much land improvements they would be. We model it and we air the conservative. We clearly air the conservative because we will defend it. In the defense, and that’s one of the things I see on these boards, is how you’re going to defend an automated model? We have an extra fee for defense. It’s like an insurance policy. Audit doesn’t happen very often, but when it does happen, you don’t like it.
In our audit case, if an audit comes up, we will go out and do our fully engineered study like we would do for anyone else for a big property. We will go back because the IRS wants to see every single asset management detail. How did you get that? On our automated model, we give you five, seven, fifteen and 27 and a half or 39 years. Those numbers are out in five minutes. That’s what all the CPA cares about. They don’t want the asset detail. Sometimes they do, we provide that but it gives you a quick answer. You can do it immediately and it’s very inexpensive and it’s audit protected. It’s bulletproof because we’re going to go out if there’s an audit. We’re going to go out and do the full engineering report, which will suffice any audit. Plus, it’s going to air to the conservative. We can certainly meet those guidelines.
Elaborate on the asset management detail report. What is that? When is that going to come into play going through this process?
For a cost segregation, you’re breaking down a building into its component parts. Asset management detail is very important. I want to be more educational when I’m talking about our reports, a little bit of a commercial. Breaking down all the components, breaking down the wall systems, the flooring systems, the plumbing system is a specialty. For example, in a building, you need the core components: roof, windows, walls, bathrooms, HVAC for human comfort. You might have HVAC for a clean room, especially like you have a room with a data center, your computer room. That’s specialty air conditioning. You have raised flooring. Those things can accelerate. Bathrooms can accelerate, but you might have some specialty hot water heater for the lab or an auto dealership for the customer service waiting room and the employee waiting room. They have all those specialty components, millwork, specialty lighting at each doctor’s office. There is an exam room, sink cabinet, electric on the walls, there’s plumbing if it’s a dentist. All those specialty things are what makes a difference.
The asset management detail breaks down every component in our case. We call our engineers and accountants. We look at everything, price at every component. Some of the competitors give some asset management detail, but to get the full detail on the straight-line property, there’s an extra fee for that. Because of our methodology and the way we started right after the tax law changed in 1986, and our principal was hired out to Anderson Consulting who is one of the pioneers in the industry. He just went to the asset detail from the beginning. We’ve always done that asset detail. The real value proposition, that’s what it is. It’s breaking down every single component, both straight line and accelerated. However, let’s say your roof blows off and it might be an insurance claim, it might not. Maybe you need to repair it. You bought a property and that’s only going to be good for a couple of years, but as the IRS looks at it, it’s got a 27-and-a-half-year life on that apartment building.
You might replace that in three or five years. Because we’ve broken out the asset detail and we know exactly what the cost of that roof is by building or the entire, if it’s a single building, then most people will hit the roofers in there. They will scrape everything off. They will throw in the dumpster and they haul it away to the landfill. That’s a dumpster full of cash that they’re throwing away because they haul it all off and they capitalize it, “We spent $25,000 or $100,000 on a new roof.” That’s a new capital expense. However, when you dispose or abandon that asset, whether it’s a straight line or accelerated, having the asset detail lets you peel that off your basis value. That example, that dumpster load of cash, that’s an expense in that year.
When you’re replacing that roof, that’s a great value proposition. We like to say our report is a three-in-one value. You get the costs seg benefit, asset management detail for future disposition abandonment. During this study, when we’re inspecting, if these things have been done already that we can recognize, we’ll include disposition abandonment in that study. The asset detail is really important to give you that future value. Some properties are borderline. It doesn’t make sense if you’re planning a roof or redoing the parking lot, the full report might be $3,000 or $4,000 more, but if you’re going to replace $10,000, then you’re going to pay for that. The value of that is right there because you tuck $10,000 for exemption tax.
If we’re buying a property and we get to cost segregation study, we contacted you or we’ve landed up to have it done when we’re buying the property. Three years later, unexpectedly we have to replace the roof. Are we going to contact you then as well?
No, you’re not. You will have all the detail report. However, for clients that are new to our report, it’s very detailed and might say, “How do I delineate where that roof cost is?” They call us and we will show that. They go, “I get it,” because we have ad nauseam spreadsheets. We also provide the asset management detail, which the CPAs love. It’s an Excel spreadsheet that they can load up into their platform. Depending on who it is, they can figure that out. For apartments, we will also do the components, the asset level detail by unit floor plan because people are buying apartments and as they’re turning over, they’re putting in new carpets, new flooring, new kitchens maybe.
They will know exactly what to dispose of and abandon as that goes through the process. That’s very important. If it’s a strip center, some people will do this as well, I’m not sure. In offices and multi-tenant retail, any multi-tenant building, we will break down the components by tenant because they change. The asset detail, if that tenant leaves, new tenants come in and say, “I need some totally different.” Owner’s going to rip all that out. They may or may not fund the new stuff, but they can dispose of and abandon those assets. That’s an expense. That’s where the asset detail comes in multi-tenant and can certainly end up in apartments, which for a lot of your multifamily audience, that makes sense for them.
Getting started in this business, and I know a lot of the audience have either bought multiple multifamily buildings or a lot of them aren’t getting started. What do we need to ask somebody like yourself when we’re looking at firms evaluating which one do you use, what do we need to be thinking about? If we’re not familiar with cost segregation, I’ve never been through that before, we’re not going to know unless we do a lot of research. We’re going to talk to many, but what should we be asking?
There are a lot of people who do cost segregation. Some CPAs do it and they will do pretty good. They can do pretty decent results, but they don’t get into the mechanical systems because they’re not trained for that. They’re not engineers. You’re looking for an engineering-based report. Ever since the 2004 Regulations came out, the Audit Technique Guidelines published by the IRS, which made this official, everybody says they’re engineering-based. There’s a real blend of modeling systems that have some engineering blended into them. Some people are doing different methodologies. We use our own proprietary technology. We don’t use an off-the-shelf system. We go into engineering.
When you want to talk to somebody, there are a couple of things that you would want to ask for. Did you get asset detail included? Other companies will do asset detail and that’s on the straight line, but you’ve got to pay extra for that or embed them in this position. In the ELB’s case, we include it all and that’s because of our methodology, how we do it. It is a byproduct and it always has been. When the Tangible Property Regulations came out or the Final Repair Regs came out, a lot of people change, “We have this new methodology.” We didn’t have to. We always did what was required because that’s about the asset details. That was what the IRS cared about in that particular component.
The other things are they use their own people, their own engineers to go out and inspect and do the takeoff work in the engineering. That’s very important. There are companies that offshore to other countries the engineering and they would send people out to take pictures. Even companies here, they have a modeling platform that works pretty good. It’s going to get decent benefits, but their inspections are mostly picture takers and it may not be engineers. Our methodologies, we use our engineers and our trained staff to go out there. We use tablet computers. The other components you might want to ask is about their audit defense. As I talked about before, bulletproof protection. You asked about how is their audit defense work? Most people say, “We’ve done thousands of reports and we have a perfect record.” We have that well. US tax court authorized our principal as an expert witness, if that comes up. We’ve done well over 14,000 studies. It’s a perfect record with the IRS. What they look for is that asset detail. When we get an audit, we come in and say, “What about this?”
We usually audit for another reason and this cost seg gets rolled into that. We point that out, we send them the regulations because the audits are usually new kids out of school that don’t know that much about it. They go, “Check,” and then they’re done with the audit and then we go on to the next thing. For us, that’s important. That’s key. You look at the pricing. You’re going to get the pricing. There are times when we might be higher or times when we’re lower, but it’s the value proposition and what are you going to get with that. We’ve audited many reports and depending on who’s doing it and what type of property, it could be 5% to 20% variance on additional depreciation above and beyond that because of the mechanical systems. It’s what’s in the walls. I call it treasure hunting where people don’t see. That’s what ELB is. Ad nauseam and we split components, which other people don’t do. That’s what you want to see. Even if it was $1,000 more, you’re going to get on a $5 million property, 10% more, $500,000 more in depreciation. What’s the cash benefit of that $500,000 in deductions? Let’s say it’s 25%. That’s $25,000. You can save $1,000 now or you can have $125,000 in the next five years. That’s a pretty good trade-off.
What’s the hardest part for the syndicator or deal sponsor in going through the cost segregation study?
I don’t want to downplay a lot of competitors, but there are a lot of good competitors and you’re always going to get good value. They’re very supportable. We think we go deeper. There are a few out there that go pretty deep, but we go as deep as any, if not deeper than most. For the syndicators, it’s good to evaluate those, to look at what the benefit is and the asset detail. Is the asset detail easily identified by unit type? By program? We have asset detail, but I’ve talked to so many to say, “It wasn’t that easy to find. That didn’t work out and they had to do more.” What we’ve done in those cases is we do it by floor plan. That’s what makes sense for the syndicator. The most important part for them is the asset detail because they’re doing a value upgrade. They have a five to ten-year hold period. It makes sense for cost segregation. It gives better returns to the investor in there. You get some expenses and so all in all people win by having that asset detail easily being able to dispose of an abandoned asset, that’s the key that I think is most important for especially multifamily or multi-tenant investors.
Is there anything else about cost seg that our audience need to know that I haven’t asked you?
[bctt tweet=”Audit doesn’t happen very often, but when it does happen, you won’t like it.” username=””]
We could go on for hours and I could get boring and sometimes I get excited about this stuff. That’s the key components. The core is it’s a cashflow strategy and the way the cashflow comes in. That’s one question that we didn’t touch on. You’ve got all these deductions. Once you’ve done this, whether it’s an older property or a newer property, and your CPA files your depreciation with the IRS, then your next estimated payments are reduced proportionally. The cashflow comes in and you’re not paying the IRS. You’re not waiting for next April. If we did one now and had it done and it might have been a look back study, your next cashflow component is going to be September 15th on your September 15th estimates. You get your quarterly estimate you send in. That’s where the cashflow comes in. People will buy properties and they might accelerate their acquisition and growth because they have more cashflow to invest in more properties. That’s the sweet thing.
What’s the number one thing that’s contributed to your success?
The ELB, our methodology and approach, honesty and integrity, I tell them like it is. If people use it, great. If they don’t, I wish them the best. We have a website where you can reach me. I welcome you if you want to do an evaluation for anybody. Looking at others, compare them and look at the reports. That’s the most important thing. If you have an asset, look at the report. If the report shows a half a door or half an outlet, say, “How did they go a half?” That’s a modeling system. There are some things out there that are computer generated. You’re still going to be pretty good if you say, “How did they get a half? That’s interesting.” Humans are doing it.
Years ago, they used to have those half doors.
You have the half doors. I don’t think that’s what they’re talking about. It’s a pricing mechanism that comes up and breaks down a building in distant counterparts. It still is a decent report and there’s still benefit. Having humans and having licensed engineers do the work is very important, and having a project management and the managers of process. One of the last things I will say for ELB is they don’t require a lot from the clients. If you were to buy an apartment complex, we need the closing statement, the appraisal and the survey. If you have a demolition plan or improvement plan and doing some stuff, that’s it, and we’re going to go out and do the work. If it’s a new build, the plans and specs and your final pay application or AIA document, we need to access the property. We do the inspection. A lot of people say, “You had to give so much information. It was a pain in the neck. I don’t want to do it again.” What are the requirements? You just give us the basics and then we take over from there with our project management team.
How do you like to give back?
I contributed to a lot of the charities here in Raleigh that help kids. I know you’re big with the kid’s stuff. It’s going to be fine here. I contribute to that. I contribute to our church and help people where I can. I pay it forward and help whenever I can.
You’ve been a great guest. I appreciate your expertise and sharing with the audience on cost seg. How can they get in touch with you?
Thanks for having me and I hope I didn’t bore people to death. I hope I answered the questions appropriately.
It’s an important topic.
I get excited about it and can bore people because it’s boring engineering. When I network, they say, “What do you do?” I say, “Nothing, I’m a treasure hunter,” because then I’d go on because I can bore people. To reach me, I’m at [email protected]. Our website is ELBCostSeg.com. You can go on there. You can research us. You can request a quote. You can say, “I read about Bill Smith,” and they’ll direct it to me and I will reach out to the individual. My phone number and direct line in Raleigh is (919) 858-6140, and cell phone is (480) 747-5547. I’m going to talk to anybody who would like to learn more and let me evaluate their property for them.
I hope all our audience will call you, Bill. Why not talk to more people that are doing it and learn as much as you can? I appreciate the audience being with us. I hope you will also go to Life Bridge Capital and connect with me. Go to the Facebook group, The Real Estate Syndication Show. I hope you are learning a lot. I hope you’re sharing this. I would appreciate it.
Important Links:
- Bill Smith
- ELB Consulting, Inc.
- [email protected]
- ELBCostSeg.com
- The Real Estate Syndication Show – Facebook group
About Bill Smith
Bill Smith, National Sales Director for ELB Consulting, Inc. works with commercial real estate (CRE) owners and investors to reduce their federal tax burden and improve their cash flow to invest in more properties.
After spending 20+ years in executive sales/marketing and management positions for both Fortune 500 and entrepreneurial firms in real estate finance technology and services, Bill teamed with ELB in 2013 turning his considerable experience to the specialty tax solutions business.
As a specialty tax firm, ELB utilizes a proprietary engineering methodology to its client solutions. This approach maximizes the allowable IRS tax deductions by documenting all building components, both accelerated and straight-line. This level of detail provides bullet-proof protection in the event of an IRS audit.
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