Episode Transcript
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Speaker 1 (00:00):
This is Daniel, the
founder of Bookkeeping for
Painters.
Speaker 2 (00:03):
And this is Richard,
the advising director of
Bookkeeping for Painters.
How's it going?
It's going pretty good.
You know we're in the well,we're towards the tail end of
fall, kind of right beforeThanksgiving.
It's a great time of yearbecause, you know, the weather
cools off, the leaves fall andthere's football year, because
(00:25):
you know the weather cools off,the leaves fall and there's
football.
I know not everyone's afootball fan, but I do enjoy
watching the game.
Got a route for my miamidolphins.
Speaker 1 (00:33):
Uh, kind of kind of
keeps me um, connected to my
home state of florida yeah, Ihaven't watched football in like
10 years but, uh, I did watchsome sports recently.
I watched the jake paul andmike tyson fight.
Yeah, yeah, just just the fightitself, not the actual, all the
undercards and everything thatwas, uh, it's pretty depressing.
(00:58):
But, um, yeah, I haven't.
I haven't been watching anyfootball, but but I know, um,
you were excited to tell meabout a, uh, a football
commercial and in regards totaxes, which was I thought was a
pretty funny that they'readvertising tax strategies on,
on, uh, monday night football orwhatever.
Speaker 2 (01:21):
Yeah, it was Monday
night football.
Uh, I've seen it a few times,and, as an accountant, you sit
down to watch football and yousee somebody pitching a tax
strategy that they don't reallyknow what they're talking about.
It was a little shocking.
What they were alluding to inthis commercial and maybe you've
(01:42):
seen it is what's called a costsegregation study and a
depreciation strategy, and I'msure if you called their phone
number, they could charge youthousands of dollars to tell you
what we're going to tell youfor free right now on the
podcast.
So hopefully no one's calledthat number yet until you've
listened to this episode, yetuntil you've listened to this
(02:10):
episode.
But yeah, people are especiallyinterested in this because it's
the end of the year and they'relooking for last minute tax
deductions.
They've maybe sat down withtheir accountant and they know
that they've made a lot of moneyand they're going to owe a lot
of tax.
So what can we do about it?
In the right circumstances, acost segregation, depreciation
strategy can be insanelyvaluable.
(02:32):
We just got done doing one withone of our clients, and he is
going to save $33,000 on histaxes because of it.
The trick here, though, is thatyou really have to have the
right circumstances and theright situation in order to
(02:52):
benefit from it.
So everyone on TV and socialmedia is going to tell you to go
out and spend this money on acost segregation study, but can
you actually use it?
So that's what I kind of liketo talk about today.
So how does a cost segregationwork?
Well, if you have real estate,you're probably used to taking a
(03:17):
tax deduction for that realestate through depreciation, and
it's either going to be over aperiod of 27 and a half years if
it's residential, or maybe 39years if it's commercial.
Speaker 1 (03:32):
And that's a long
time, right?
Speaker 2 (03:34):
You take the purchase
price of your rental house, you
subtract out land because landnever gets depreciated and then
you divide it by 27 and a halfyears and that is the tax
deduction that you get.
What a cost segregation does isit is an engineering study that
looks at your property and itbreaks it up into its individual
(03:59):
components.
So now, instead of just lookingat one property, you are
looking at the roof, themechanicals, the flooring, the
window coverings, the appliances, the landscaping, the
hardscaping, on and on and on,and you have all these different
segments.
(04:20):
So cost segregation segregatesout the different costs and
these things can be depreciatedmore quickly.
So, for example, yourappliances would get depreciated
over five years instead of 27and a half.
Your landscaping might getdepreciated over 15 years
instead of 39 if it's acommercial building, and this
(04:44):
allows you to increase yourdeductions, right?
So instead of stretching it outover a long period of time, you
are accelerating those expensesand depreciation up front, and
this is going to create well,it's going to create deductions
for you.
So it's going to reduce theincome that you get off this
(05:04):
rental property and it willprobably produce a loss on this
rental property.
And so that's where the taxsavings come in.
Generally don't tell you is that, even though you are creating
(05:25):
all these losses in your realestate, you cannot use these
losses to offset your businessincome unless you meet very
specific criteria.
So what that means is, if youhave $100,000 of losses on your
(05:47):
rental real estate because ofyour cost segregation and you
have $200,000 of business income, you're going to pay taxes on
$200,000 of business income andall those losses are going to
stay with the real estate.
They're going to be locked onwhat they call the passive side.
These are the passive losslimitations and you're not going
to get to use them until youhave other passive income from
(06:09):
other real estate or futureyears to offset.
And that's really disappointingfor a lot of folks who think
that they're going to get a bigtax break on their business
income by generating theselosses.
So the trick is you have totear down that wall.
Or you have to tear down thatwall or you have to get through
(06:31):
that wall.
I sound like you know RonaldReagan from the 80s.
Yeah, I'm dating myself, butthat's the catch, right.
So how do you get through thewall?
Okay, here's the million dollarsecret that they're going to
charge you for if you call thephone number.
(06:54):
You have to meet certaincriteria.
That's laid out in the InternalRevenue Code.
So one is going to be you canqualify as a real estate
professional.
So think of a real estatebroker or a house flipper or a
contractor, someone whose dayjob, bread and butter, is buying
and selling real estate.
(07:15):
Now you have to qualify.
You can't just say I'm a realestate professional.
There's tests that you have topass and I'm going to be honest
with you, they're hard tests.
It is not easy to qualify as areal estate professional under
the IRC.
If you have a W-2 day job oryou are a business owner, it
(07:39):
will be incredibly difficult, ifnot impossible, to also qualify
as a real estate professionalbecause there's simply not
enough hours in the day for youto spend in your day job and
buying and selling real estateto meet that test.
I'm not saying it's impossible,but it will be a challenge.
So before you mark that boxthat yes, I do qualify, make
(08:05):
sure that you meet those tests.
It's around 750 hours a yearand there's some other aspects
to it as well.
Another way through that passivewall is that we typically call
this the short-term rentalloophole, and yes, I do use the
(08:28):
word loophole.
I don't use that word lightly,because it takes advantage of
some kind of archaic language inthe Internal Revenue Code.
It is legal, but it is stuffthat needs to kind of be updated
for the 21st century, and untilit is, there is a loophole
there, and this would involvehaving a legitimate short-term
(08:52):
rental, something that you arerenting on average for seven
days or less, so think likeAirbnb, vrbo, that sort of thing
.
There are other tests, too youcan't provide substantial
services, and you also have tohave material participation, and
(09:12):
that's a tricky one.
So we're talking at least 100hours a year that you are
participating in the managementand the upkeep of this property,
and you are participating moreso than any other person.
So this involves keeping timelogs, this involves being very
(09:35):
active in your property, and weare being pedantic here because
this is a tax strategy that istaken advantage of a lot and
this is something that will kindof raise some red flags.
So if you qualify, you shoulddo it.
Speaker 1 (10:03):
But make sure that
you can dot your I's, cross your
T's, keep all your receipts,because you are increasing your
chances of an examination whenyou do this.
And I I think this is thestrategy that a lot of the folks
that we work with that havehave successfully used their
losses on the real estate sideto offset their their income on
the business side.
This is usually what they'redoing is the short-term rental,
(10:24):
having like an Airbnb, makingsure you're actively
participating over the 100 hoursper year and documenting that,
and then, if you're doing that,those losses on the Airbnb if
you maybe did a cost segregationstudy or whatever way you're
getting losses, those can offsetyour painting business income
(10:47):
right.
Speaker 2 (10:49):
Yes, Yep, the
short-term rental loophole tends
to be the one where people gofirst because, like we mentioned
, if you are running a paintingbusiness, you almost certainly
do not have the time to also putin 750 hours a year as a real
estate professional.
One kind of way around that isthat if you are married and
(11:17):
filing a joint return, onespouse can qualify as a real
estate professional, and thenthat would benefit both spouses.
So you may be running yourpainting business and your
spouse may be a realtor and theymay qualify as a real estate
professional.
Now you've got that way throughthe wall.
(11:41):
Now you can start talking aboutcost seg, depreciation and that
sort of thing.
So maybe we could run someexamples to kind of help
understand whether a costsegregation would make sense or
not.
You know, you imagine you knowa business owner who owns a
(12:02):
painting business.
Maybe he's not on the brushanymore, he manages it, but he's
still contributing.
You know a good 30 to 40 hoursa week on that business and he
has, you know, some rental realestate he's renting out
long-term to some folks.
It's residential.
Should he look into getting acost seg?
(12:26):
Well, it's probably not goingto be worth his money because he
does not have a way throughthat wall because he's not a
real estate professional and hedoes not have the short-term
rental loophole to fall back on,have the short-term rental
(12:48):
loophole to fall back on.
So in this case a cost segwould probably be a waste,
unless maybe he's got a lot ofrental real estate and a lot of
passive income, because realestate or rental real estate is
passive, Then we might havesomething to talk about.
But for most folks who own onlymaybe one or two properties,
it's not going to be worth it.
(13:09):
How about another example?
Here's a painting businessowner who has definitely taken
himself out of the day-to-day ofhis business.
He's able to devote maybe 10 to15 hours a week because his
business is firing on allcylinders and he's got his key
people in place and he just kindof is able to sit back in a CEO
(13:31):
role.
He buys a rental property closeto him because he lives in an
area that is frequented bytourists it's kind of a popular
vacation destination and hespends his time cleaning the
property, doing maintenance onthe property, booking
(14:02):
appointments, collecting rent,that sort of thing, and he flips
that place to renters at leastevery seven days.
Nobody stays there longer thana week.
Well, now you have a short-termrental and you have an owner who
has material participationbecause he's doing more work on
the property than anybody else.
That's a situation where a costseg really could come in handy,
(14:23):
because he's got a bunch ofsituation where a cost seg
really could come in handybecause he's got a bunch of
non-passive business income fromhis pending business and he's
got a way to take those passivelosses, get through that wall
and offset those, those businessum, that business income.
Uh, so you know before you,before you go and you buy a cost
(14:45):
seg, definitely talk to youraccountant.
Uh, try to make sure that youunderstand what the goals are
here, what you're trying toaccomplish and whether you can
qualify to do it.
Uh, I know I mentioned thisearlier, but I do want to
emphasize if you are going to dothis strategy, it's a wonderful
strategy, but it is one that isabused frequently and it is one
(15:09):
that the IRS is definitely gotan eye out for.
So make sure that if you'regoing to claim material
participation, you have an hourlog so that you can prove that
you spent more time than anybodyelse on that short-term rental.
Make sure that, if you're goingto try and qualify as a real
estate professional, you canshow at least 750 hours a year.
(15:32):
And, just as a side note, thisis active participation.
This is material participation.
So, listening to podcasts aboutreal estate, reading books
about tax strategies, browsingthrough properties on Zillow,
(15:54):
those are investor hours.
They do not count towards yourreal estate professional status
or your material participationhours.
So we're talking about hourswhere you are actively on the
property.
So, yeah, I mean there's.
We could go on for hours aboutthis, but just the big takeaway
(16:16):
is make sure that you are goingto be able to accomplish your
goal before you spend your moneyon a classic, because these
things are expensive.
They can be anywhere from.
You know, I've seen them on thelow end for about $750, all the
way up to several thousanddollars, depending on how
detailed they are.
And before you give your moneyto, you know, a phone number on
(16:40):
a TV commercial, you know, makesure that this is something that
you can really benefit.
Actually, don't give your moneyto a phone number on a TV
commercial.
You know, make sure that thisis something that you can really
benefit.
Actually, don't give your moneyto a phone number on a TV
commercial.
Talk to your accountant,because they're going to give
you good advice.
They're not going to push youinto something that you can't
benefit from.
Speaker 1 (16:55):
Awesome.
Well, if you have any questionsabout cost seg, does it make
sense for your situation?
Or maybe you've done a cost segand like to share your
experience with it?
Go to Facebook, type in growyour painting business and join
the group.
Love to hear your thoughts orany thoughts for future episodes
(17:16):
.
And with that, we'll see younext week.