Dave Cain: Welcome to unsuitable on Rea Radio, the award-winning financial services and business advisory podcast that challenges your old school business practices in their traditional business suit culture. Our guests are industry professionals and experts who will challenge you to think beyond the suit and tie while offering you meaningful modern solutions to help enhance your company’s growth. I’m your host, Dave Cain. I have a question for you to think about. Are you paying more in taxes than your fair share? Well, if you own buildings and real estate, you could be and a cost segregation study could provide you with strategy you’ve been looking for.
On today’s episode of unsuitable, we’re joined by Dave McGuire, co-founder of McGuire Sponsel, a regional professional service firm that works with CPAs to enhance relationships throughout innovative tax strategies. Dave is known for his expertise in cost segregation, fixed assets and depreciation law and is often sought after for his insight with regard to depreciation techniques and practices. Today he’s going to break down the topic of cost segregation by shining some light on who can benefit from a cost seg study, what kind of savings are in stake and when business owners should take advantage of this strategy. Welcome to Unsuitable, Dave.
Dave McGuire: Thank you.
Dave Cain: When I think about you guys and Rea & Associates, our firms go back 20, 25 years would you say?
Dave McGuire: I think we started working with Rea & Associate it goes … About 13 years ago I did my first study for you guys and it was your own offices.
Dave Cain: Great. Great.
Dave McGuire: We practice what we preach.
Dave Cain: A little bit.
Dave McGuire: You do. You do. You made me prove myself to you.
Dave Cain: Did you charge us for that?
Dave McGuire: Quite a bit.
Dave Cain: Good. Okay. When I think about you guys, I think of a firm that’s innovative. You guys are thorough with your research and documentation and you help me manage the risk on these studies. I wanted to just mention that working with your firm has been a wonderful experience for Rea & Associates. Let’s talk about cost segregation. Many of our listeners are aware of cost seg or cost segregation, but let’s talk about what it is first at a high level and then we’ll dig deep into some of the other benefits.
Dave McGuire: Well, simply cost segregation is a way to take advantage of time value of money. The whole idea is a dollar today is worth a lot more in purchasing power than a dollar 10, 15, 20 years down the road. Now when you build a building or buy a building or have an asset, typically the IRS says a building depreciates over 39 years. If you think of a $3.9 million building, you get $100,000 in depreciation every year. What a cost segregation study does is it goes into that building and recognizes the assets that the IRS says behave more like equipment than they do building. That could be anything from the carpet to the wallpaper, to the TV on the wall, but also not just that TV on that wall, but all the wiring that supports the power.
The power coming in from the street helps power that TV. When you think of a manufacturing environment, the power and the plumbing and everything else get to be a pretty significant portion of that building. What a cost segregation does is it carves those assets out, which then can be depreciated over five, seven and in 15 years in the case of land improvements, which accelerates a lot of those depreciation deductions into the early years. What that does is it takes that 39 year asset and it puts a large portion of it in those shorter lives, thus reducing taxes in the early years of the asset allowing you to take advantage of that time value of money. Often we get the statement, “It’s just the timing difference.”
I remind people that any financial planner will typically tell you if you get a big tax refund at the end of the year, what do they tell you?
Dave Cain: Don’t do it.
Dave McGuire: Don’t do it. It’s a bad thing. It feels good when you get that big check from the IRS, but they say, “That was a bad thing because the IRS just held onto your money for a whole year.” You want to owe a little bit at the end of the year when you fill out your tax return. The cost segregation is the same general idea, but we’re doing that over 40 years versus just one year. We’re taking that same idea, get your money out now, and utilize it to put money back into your business, pay down loans that you might have. We have one client that just went out and bought a boat.
Dave Cain: Oh good.
Dave McGuire: I mean you can do that, but that might not be the best financial decision.
Dave Cain: Oh well, but that’s good use of the money in their business plan. With that thought and the way you broke that down, I want to move to a case study that you shared with us and I think maybe we’re both involved. Both of our firms were involved with this. I don’t want to go into the name of the business, but let’s talk about this cost segregation study. It was a manufacturer I believe and I think the building was between $2.5 and $3 million. You guys were able to reclassify about 43% of the depreciable property that was going to go or being depreciated over 39 years and you were able to do that and reduce it to five, seven or 15 year property.
As a result, there was an increase of cash flow of $300,000 over the first five years and a net present value of $225,000 over the life of the investment. I want to just kind of go back and think about that. The net present value savings was $225,000 from a cost segregation study.
Dave McGuire: Yup.
Dave Cain: That’s some pretty significant dollars.
Dave McGuire: It’s pretty significant. When you think about it, the net present value is really the lowest that someone would save because what we’re doing there is we’re taking that increased cash flow and we’re taking that out 40 years. We’re repaying 100% of it. Most of our clients don’t end up keeping their buildings 40 years, either they retire and they do something else with it. They sell it. They transition to another building or something else. In all reality, they probably saved even more.
Dave Cain: Right.
Dave McGuire: The other thing that that doesn’t take into consideration is we now have what the IRS call the tangible property regulations that came out a couple years ago. That client that we did that study for now knows the value of the roof system. They now know the value of their HVAC systems. They now know the value of different doors that might be replaced. Now if they do those replacements 10, 15, 20 years after the acquisition, not only do they get that depreciation gain, but they also have a basis for all those assets that they might write-off in the future, which will then take that benefit and expand it even more.
Dave Cain: I want to point out and maybe you can chime in on this, this is not a tax loophole by any means. It’s not a tax shelter. It’s a strategy that’s been in the tax code for a number of years. Your firm has taken that, studied it, found ways to fairly implement in the marketplace.
Dave McGuire: When I first started doing this, I remember my boss at the time. We went out on a sales call and we sat down with a client and they said, “Well, what’s the catch? This sounds almost too good to be true.” Really the response is probably the best one I have heard is my boss looked at him at the time and said, “Look, the catch is you have to hire somebody to do it.” The IRS says this is an allowable methodology, but we have to create the back up to do it. The IRS has written a number of papers on this. You can look up revenue rulings. There’s audio techniques guide that the IRS has. There’s plenty of court cases. I won’t go into all the court cases. I mean obviously it started with Hospital Corporation of America versus commissioner that came out in the late ’90s.
The IRS acquiesce to it about two years after it came out and it’s gone from there, but this is something the IRS expects. The problem is you have to have the back up for it. It’s no different from me on my personal return. If I go in and I take a charitable contribution, the IRS doesn’t mind that I take a charitable contribution, but if they ever come in and look at it, if I don’t have my receipts, they’re going to throw the whole thing out. We sometimes get clients, you went over that example, where we reclassified 43%. We sometimes get clients that say, “Well, what if we’re just conservative and we only put down 30%?” Well, the problem is without having the back up for it, that 30% is not conservative.
You have to have the back up for it otherwise the whole thing goes in the garbage can.
Dave Cain: We talked in the opening about the risk. You help us minimize the risk. It’s audit protection basically of what you guys put together, the package that helps with that.
Dave McGuire: Correct. Correct. We come in with a team of engineers and accountants to really break apart the building with that engineering expertise.
Dave Cain: A lot of our listeners and you probably do a lot of things around the house, do-it-yourself. I’m a do-it-yourself kind of person. This is not something that the cost segregation study that you’d want to do it by yourself because it probably wouldn’t stand the audit test.
Dave McGuire: Most likely it wouldn’t stand the audit test. The other thing is you probably leave money on the table. There’s two aspects of that and we see this all the time where someone tries to do a lot of the work themselves and most of the time they’re not maximizing the benefit. The delta between the benefit we would have achieved and the benefit they achieve would more than cover the fees that would have been associated with the study. The other aspect of it is there’s some risk inherent in that because the IRS knows that there is … They don’t have the ability to do it themselves. I myself am an engineer. I’ve been however working in the tax area for 20 years or so. Don’t ask me to design anything from an engineering level, but I combine those two aspects of it.
Dave Cain: The unique approach that your firm uses, civil structure, architectural engineer, and then with the knowledge with the tax law and you guys put the package together.
Dave McGuire: Correct. We’ve been through audit. We know what the IRS is looking for. We have very good reputation both with our clients, but also with the IRS. We want to make sure that anything we do is defendable.
Dave Cain: This cost segregation study sounds like a technique that’s reserved for large companies, large multi location companies. Is that false?
Dave McGuire: It has more to do with the assets that someone has and the desire for cash flow. A lot of our best clients are small sole practitioners, mom-and-pop type companies where maybe they have … It might just be an investor that invest in a few strip malls and he has a strip mall sitting in Dublin, Ohio. He has a strip mall in Dublin, Ohio that he paid a million dollars for and he’s looking for a way to increase his cash flow to work on that strip mall. It could be an auto dealership. We do a lot of work with auto dealers where you might have an auto dealer that’s a family-owned business. They are good businesses, but they’re not huge multinational businesses.
We do that, but then we also sometimes are working with the $500 million manufacturer that’s constantly adding and acquiring facilities. I would say 90% of our client base is that small mom-and-pop type business.
Dave Cain: The strategy there is regardless of what the investment in the real estate, it should get a look for this concept to see if it makes sense.
Dave McGuire: Correct. People often say, “What’s the dollar amount?” I would say we used to tell people about a million dollars. If you got a million dollars in real estate, it’s worth looking at. I would say it’s probably a little bit lower. As we tell people all the time, the biggest aspect of it is it doesn’t cost anything for someone to review it. We have clients right now we’re doing studies for that only have $200,000-$300,000 worth of real estate and they’ve decided that the need for cash flow is enough to justify the cost of the study. However, it doesn’t cost anything to do that preliminary review. What we always recommend is send us the information. Let us do the preliminary review.
If then the tax payer decides it’s not worth moving forward with the full study, they don’t get charged anything and they don’t move forward.
Dave Cain: I have a confession to make. I made a mistake. I had a client that purchased a new building for just a shade under $3 million about two years ago. We didn’t have a cost segregation two years ago. Am I out of luck?
Dave McGuire: Well, you’re not out of luck, but since you didn’t call me two years ago, I might be mad at you, but you’re not out of luck at this point. No. The nice thing about the way deprecation works is that depreciation is considered an accounting method. With any accounting method, you can change an accounting method and then what the IRS allows you to do is get a catch up adjustment equal to any depreciation you’ve missed. That $3 million building that was purchased three years ago, that’s about one-tenth depreciated. It’s 39 year typically just to make the math easier.
Dave Cain: You figure this out in your head?
Dave McGuire: I’m going to do most of it in my head right now. If we say on that $3 million building that let’s say 20% of it should have been five year personal property, so that’s $600,000. Did you say it was a purchased building or a new construction?
Dave Cain: Purchased. New construction.
Dave McGuire: New construction?
Dave Cain: I’m sorry, purchased. We’ll go to the new construction …
Dave McGuire: A purchased building. If it was five year personal property, that means on that five year property they would have gotten 20% depreciation the first year, 52% the second year and in year three about 16%. That’s about 66% of that $500,000 that was personal property would be depreciated by now. 66% of $6 million, what is that? About $400,000. They’ve only taken about 10% of that, so they’ve only taken about $60,000. That means they’ve missed out on $340,000 worth of depreciation because you didn’t call me. However, what the IRS allows you to do is get a catch up adjustment equal to that $340,000 worth of depreciation.
All that will flow through in the current year’s return and all we need to do is file a change in accounting method, which we will help you fill out that will allow you to get that catch up adjustment once we do the study.
Dave Cain: Those that are listening on our podcast and investors, if there has been real estate purchase or constructed in the past year obviously that’s obvious, but even the last couple years, it needs a look.
Dave McGuire: In theory, we could go all the way back to 1987 when the current depreciation rules were implemented. That was the last time we had a big tax reform was 1987 and that’s when then current depreciation rules were implemented. However, there’s a time value of money.
Dave Cain: Sure.
Dave McGuire: Once you get past 1993 is when they changed the life of a building from 31 and a half to 39 year. Once you get past about there, that’s 20 years old, buildings are going to be mostly depreciated by now. There’s no point in doing that.
Dave Cain: The cost benefit.
Dave McGuire: The cost benefit. Once you get past about 10 years, it’s probably not worth it.
Dave Cain: What about an expansion? A new warehouse to an existing building or expansion to an existing building. Is that fair game?
Dave McGuire: Anytime you’re putting money into real estate, that’s a time you want to look at it. Not only expansion, but a renovation is another one. Under the current rules, anything to the interior of a building … It used to be only if you leased it to someone else, you got that qualified leasehold improvement. Now there’s something called qualified improvement property. We’re sitting here in a building that Rea occupies. If you were to go on and renovate this, anything to the interior that’s nonstructural is eligible for bonus depreciation. If you go in and renovate that building, we can take the bonus depreciation number and that would significantly reduce the amount in that current year.
If you spend a million dollars renovating a building that you occupy and you own and we say that 80% of it is to the interior of the building, all of that’s eligible for bonus depreciation. In the 2017, that’s 50% bonus depreciation, so that means you would get an additional write-off of $400,000 in that first year.
Dave Cain: Again this is not a loophole. This is just a deep dive understanding of the rules, right, that are at our disposable.
Dave McGuire: These are rules at our disposal and it’s something that large firms have been doing for years. What we’re doing is we can now bring it down to a level where that middle marketer, that smaller mom-and-pop type business can access.
Dave Cain: Any industries where this planning technique might work better than another?
Dave McGuire: It typically works better for people that are heavily asset focused. Businesses that have a lot of real estate. Someone that dabbles in it that might be passive in the real estate. For example, if I go out as a consulting business owner and start buying some rental houses, I’m passive in that and then you have passive laws restrictions where I might be limited. However, if manufacturing companies, like I said, car dealerships, professional real estate investors, really anyone that has a large amount of assets on their book tends to be benefit.
Dave Cain: There’s a lot of franchise fast food buildings where they go very quickly and there’s all kinds of equipment inventing and things like that. That would be another industry that may benefit from a cost seg?
Dave McGuire: It would be. With restaurants, there are some preferential lives for real estate in restaurants. Sometimes the time value of money’s not going to be as great, but the difference there when we talk about restaurants is because they have to do so many renovations to keep up with what the franchise holder wants or the franchise owner wants them to do, they have to go in and completely renovate these. The more they know about those buildings, the more beneficial it is. That’s why I’ve brought up auto dealers a couple times. Part of the reason that we’ve brought that up is that for example, a lot of the US auto companies require that the dealerships renovate in recent years.
Well, not only were they able to access the cost seg benefit from those renovations, but they could also dispose of all the assets that were removed from service if we looked at it correctly at that time.
Dave Cain: I’m thinking about investing in real estate. A cost seg study may make that decision a little easier upfront if I know that going in.
Dave McGuire: It’s amazing that when we talk to a lot of companies, they go through a whole bunch of planning and prospectus when they’re going through and buying a piece of real estate. They’ve got spreadsheets and they’ve got analysis as to how much the rent flow is going to be, everything else, and they often don’t take into consideration the effect that this has on their tax payment. We’re talking about something that could reduce their tax payments by hundreds of thousands of dollars a year. It should be one of the biggest things that they’re looking at early on when they’re deciding do I buy property A or do I buy property B.
We actually have clients that will call us and ask us to run the numbers on two different properties because that might help them make the decision as to which property to invest in.
Dave Cain: Would this technique work in a 1031 or like-kind exchange transaction?
Dave McGuire: It does, but we have to look at things a little differently. 1031 for those that are listening that don’t deal with it, 1031 is an exchange of basis. You basically roll the basis of your old property into a new property. Because you have to exchange like-kind for like-kind, real estate has to be sold into real estate. We can do a cost seg study on it, but typically what we’re going to do is we’re going to look at the increase in basis. For example, if you sell a building for $3 million and you do a like-kind exchange into a $4 million building, we can do the cost segregation study on the $4 million building.
If we find 20% personal property, that’s $800,000, remember I sold my one building for $3 million, I bought one for four, I have a million dollars worth of additional basis I can play with. However, we can’t then get into the basis. We can’t drop that basis below that $3 million mark. If we find $1.2 million, we have to be careful and we have to then talk to the client and do some other planning.
Dave Cain: Sure. One final question before we wrap up, I want you to look in the crystal ball. This technique and some of the examples we talked about too good to be true is in the President Trump’s tax overhaul plans, is there anything that you’ve seen, heard, read, feel that this benefit maybe taken away from us?
Dave McGuire: I don’t see this benefit being taken away. There’s a chance that it might change how it’s done. It’s difficult to say with President Trump because most of what’s come out of the administration has been very basic in terms of the fundamentals. If we look at what Ryan was pushing for a long time, and that’s probably the better way to look at it is what’s been the Ryan plan, Paul Ryan has pushed for immediate expensing of business assets, which would include real estate, which means you don’t have to do a cost seg study if you get to write the whole thing off. Based on the current environment, we don’t foresee that happening.
We see what’s more likely to happen is potentially an extension of bonus depreciation where that would make it more beneficial, where you’re allowed to write-off more equipment right away, maybe an increase in bonus. Right now bonus depreciation starts trickling off after 2017, but we don’t really know. Likely your story right now is at this point that we’ll see some type of temporary rate drop. If we do see a temporary rate drop, what we do tell people is don’t hold off on doing the study because of a temporary rate drop. Let’s say the temporary rate drop happens in ’18. It is important to accelerate any depreciation deductions that we can into ’17 because you get to take advantage. However, if then you go and do it in ’18, it’s still beneficial.
You still want to do it because you still get access to that time value of money. If we know it’s coming, go ahead and accelerate it into the year before that rate drop occurs.
Dave Cain: Great insight. Our guest today has been Dave McGuire, co-founder of McGuire Sponsel. Dave is as you can tell a national expert in cost segregation studies among other business credits and incentives. Put him on your radar. Look at their website. Some good information there. We talked to Dave about the cost segregation study and who benefits, what are the benefits, and when businesses can benefit by the study. If you want to hear or see or read any additional information, go to the Rea website at reacpa.com/podcast. If you ever wanted to see a podcast in action, now you can. Check out the Rea & Associates channel on YouTube to watch episodes of this podcast and other great videos from Rea.
You can also check out our website at www.reaca.com for additional articles and insight and pay close attention to the cost seg information. You’ll enjoy it. As always, don’t forget to subscribe to unsuitable on iTunes. Until next time, I’m Dave Cain, encouraging you to loosen up your tie and think outside the box.