Multifamily Investor Expo - Feb 15th
Cost segregation to achieve accelerated depreciation and can greatly improve after-tax returns for real estate investors. But it can be a an even more powerful tool for Opportunity Zone deals.
Valerie Grunduski, partner and real estate tax specialist at Plante Moran, and Jeremy Sompels, principal and cost segregation senior manager at Plante Moran, join the show to discuss how the effect of cost segregation is particularly powerful for investors in Qualified Opportunity Funds.
Watch On YouTube
- What cost segregation is, and how a cost segregation study can be used as a tax planning strategy to accelerate asset depreciation.
- Why an engineering approach is essential for a good cost segregation study.
- How Opportunity Zone tax benefits can supercharge the impact of cost segregation on after-tax IRR.
- How a cost segregation study at the front end of a deal can significantly reduce the substantial improvement threshold.
- The optimal time to perform a cost segregation study on a real estate deal.
- A walk-thru of a real-world example of cost segregation on an Opportunity Zone project, and the impact that such a study would have on after-tax returns.
- How investors conducting a cost segregation study can benefit from time value of money and tax rate arbitrage.
- Situations in which it may not make sense to conduct a cost segregation study.
- The basics of bonus depreciation and qualified improvement property, and when it begins to phase out in the tax code.
Featured On This Episode
- Episode #47: Opportunity Zone Fund Tax Accounting Considerations, With Valerie Grunduski (OpportunityDb)
- The basics of cost segregation (Plante Moran)
- Supercharge your OZ after-tax IRR with cost segregation (Plante Moran)
- Bonus depreciation and qualified improvement property (Plante Moran)
Today’s Guests: Valerie Grunduski & Jeremy Sompels
- Valerie Grunduski on LinkedIn
- Jeremy Sompels on LinkedIn
- Plante Moran
- Plante Moran Opportunity Zones Resources
About The Opportunity Zones Podcast
Hosted by OpportunityDb.com founder Jimmy Atkinson, The Opportunity Zones Podcast features guest interviews from fund managers, advisors, policymakers, tax professionals, and other foremost experts in opportunity zones.
Jimmy Atkinson: Welcome to the opportunity zones podcast I’m Jimmy Atkinson, how can cost segregation accelerate depreciation, and therefore improve after tax returns for an opportunity zone deal.
Valerie Grunduski joins us today from Detroit and Jeremy Sompels joins us from grand rapids to discuss this very topic with us today.
Valerie and Jeremy are coming to us from plant Moran, which is an audit tax consulting and wealth management firm with a lot of opportunities own expertise.
Valerie is a partner and CPA at the firm and Jeremy is principal and their cost segregation specialist welcome to both you Valerie great to see you again welcome back to the podcast.
Valerie Grunduski: Thank me.
Jeremy Sompels: Hello thanks for having us.
Jimmy Atkinson: Thanks for coming on both of you Jeremy it’s good to have you on for the first time and Valerie.
was actually on this show a little over three years ago now it’s been a while, since you last join me Valerie but on that.
First podcast episode featuring Valerie we discussed some basics on tax, accounting for qualified opportunity funds i’ll be sure to link to that episode in the show notes for today’s episode if anybody wants to go back and.
Listen to that episode from August of 2019, but a lot has changed over these past three years, some of the benefits of opportunities, investing.
have since expired, the marketplace is much more mature and i’m sure your practice that plant Moran has grown considerably since then, with more opportunities own clients, but today let’s focus on today now we’re talking about.
Cost segregation and specifically what impact a cost segregation study can have on after tax returns.
And should always the funds be utilizing caustic studies should all real estate investors use costs egg or there’s some limitations we’ll kind of dive into a lot of these topics over the course of our conversation today.
JEREMY can turn to you, first to start us off really high level what is cost segregation.
Jeremy Sompels: yeah absolutely so cost segregation studies really a tax planning strategy.
So building when you own a building you claim depreciation on your tax return and most buildings will depreciate either over 27 and a half or 39 years, which is a really kind of low and slow way to depreciate a building but it costs.
What it costs it lets you do is accelerated depreciation on certain assets in the building so under the irs tax rules.
You know there’s some positions, we can take or certain components, whether it’s certain finishes or.
Infrastructure related to equipment or plumbing mechanical systems.
They can get a shorter life, whether it be five seven or 15 years and some of those may even qualify for what we call bonus depreciation.
So bonus depreciation lets you do is accelerate even further, instead of that shorter life, taking the entire mountain, even with 100% bonus depreciation that we currently have and claiming that as a deduction on your tax return.
Jimmy Atkinson: Okay, great so without cost segregation you’re essentially depreciating the the asset over what how many years was it that you said typically.
Jeremy Sompels: 2027 and a half years for residential 39 years for non residential.
Jimmy Atkinson: OK, and then so that’s a long time to depreciate so within the first I don’t know 10 or 11 years that’s that’s not a lot of depreciation that.
Correct to bake into that holding period if you’re able to accelerate that and jam, a lot more of that.
27 and a half or 39 year depreciation into those first 10 or 11 years that you’re holding with US investment that can that can really save you a lot of money and really juice those after tax returns from what I understand what about um.
tell us a little more what specifically what goes into a good cost segregation study, what does a good one, look like and then.
Maybe what are some bad ones that you’ve seen or or some bad examples.
Jeremy Sompels: yeah absolutely so so a good cost segregation studies done by a qualified person and uses what we call an engineering approach so valerie’s a CPA my background is not in accounting i’m more focused in construction in my in my.
career so knowing how a building goes together how it comes apart the various components of the building.
Applying the tax rules with that allows us to.
break the building down so a good costume reason studies done with an engineering approach where we’re looking at drawings we’re measuring circuits, we can tell you how many linear feet of piping is in that building how many square feet of carpet.
Things like that so it’s really a it’s not when I sit in my office and people come in and they see a set of drawings up on the screen sometimes they’re confused at what i’m doing a plant Moran but that’s that’s what kind of goes into a Casa is doing doing that level of work.
Jimmy Atkinson: yeah it’s interesting they might they might think you’re a general contractor and architect or.
Jeremy Sompels: or something yeah.
there’s times of roles of drawings that show up in there, people are very confused.
Jimmy Atkinson: Now that’s that’s that’s pretty funny and so you’re actually you’re actually depreciating several different types of items, instead of just the entire building some things you’re actually going down to.
How many linear feet of carpet, you have or how many wiring you have that’s that’s impressive Valerie I want to turn to you let’s bring opportunities zones into the equation you’re the opportunities of an expert or one of the opportunities that experts, at least at plant Moran.
What is it about opportunities zones in particular that may cost segregation even more impactful than they might otherwise be an anon nosy deal.
Valerie Grunduski: Right so so you’ve already addressed the fact that in a non nosy deal there’s two pieces to it, one you’re accelerating those deductions earlier, so there was a time.
value of money benefit to get to take that depreciation deduction and an earlier year rather than a later year.
The other thing we didn’t talk about and i’ll just touch on that really briefly is there’s kind of a little bit of a game, you get to play with tax rates, too, because those depreciation deductions.
You get to use whatever your ordinary tax rate is, which is usually higher than what the recapture rate is on the end so, in addition to accelerating the deduction there’s actually a little bit of a.
tax rate arbitrage happening there as well, that’s beneficial to the taxpayer.
But that compares in no way, shape or form to how great it can be for opportunities zone for exactly the reasons that you highlighted at the top.
of our podcast today, which is that you know you still get that benefit of the upfront deduction.
But because, as we all know, if you hold on to this property for 1011 years, whatever it might be to get to that holding period.
When you sell it you get to step up your basis to fair market value you don’t have to recognize, you know the the recapture on the back end you never have to reverse that deduction and pay tax on it so it’s essentially a permanent tax savings that doesn’t exist in a non ozzy deal.
Jimmy Atkinson: yeah I like to call that the fourth hidden benefit of cozy investing for a while, when we had benefit Number One was the deferral period.
But number two the reduction period which is since expired benefit number three elimination and then benefit number four he there’s no and it was kind of hidden because it wasn’t.
Valerie Grunduski: raining that.
Jimmy Atkinson: Most people would talk about it was it was a little bit more nuanced but there’s no depreciation recapture if you hold for for 10 years in a day right.
Valerie Grunduski: Absolutely yep and so that you know will later we can kind of go through a numerical example of what that looks like but it’s it’s pretty amazing how significant that can be ideal.
Jimmy Atkinson: yeah i’m gonna let you guys share your screen and show us your your deck with with some real world.
numbers in your example in a few minutes here, I think that will kind of help paint the picture, but before we get there Valerie What about some finer points regarding tax planning considerations.
What what other considerations or or approaches does a real estate investor or a nosy investor need to take with regards to cost segregation study when it comes to tax basis or substantial improvement, are there any any any other dive into for us.
Valerie Grunduski: yeah absolutely so you know the ones that you mentioned on the front end they’re the ones that I think are most important to think about, so I think we all know, where most of your listeners or viewers should know.
That with a qualified opportunity fund, because you deferred your game to make your investment, do you don’t have any basis in your investment until the 2026 income recognition event.
And so, because of that, while what we’re talking about today is this ability to front load these deductions.
that’s all fine and well, but your your investors, you yourself might not be able to actually take advantage of those real time if you don’t have that basis.
To take the deduction so that’s just something to be aware of right.
We would never want to kind of sell to someone like oh here’s this great idea here’s the time value of money and not help them understand that they might not see that today right, depending on how your deal is structured.
You might not see that until you have that income recognition event in 2026 to reestablish your basis so that that’s just kind of just a level setting you know.
We think this is a great opportunity, but I don’t want to oversell it for people who would be in that situation and JEREMY can talk later to about some of the timing and when the Cross leg needs to be done.
But the other piece of it to what substantial improvement, you know there’s there’s two ways to look at a cost sag there’s looking at the cost segregation study on the initial purchase of the building.
And then there’s also looking at the cost segregation, from the perspective of the work that you’re doing in a substantial improvement scenario.
And so you know normally when when jeremy’s doing a cost bag he’s coming in, when there’s been you know some work done there’s a rehab a remodel whatever and.
He would just do one cost side at the end right have a here’s what your finished product looks like.
But in the opportunities don’t space, there would also be the possibility that it makes sense to take a peek at the front end and say well gee if I use the costs egg.
and break down this initial purchase into its various pieces more maybe take a more.
honest approach to what gets allocated to land or what gets allocated to some of the different asset categories.
It might make it easier to pass that substantial improvement test by changing right kind of the threshold for what you have to double your basis and.
Over time, and yet, then that are still would be the additional benefit on the back end of doing across egg study to really get that increase depreciation on the improvements that you make.
And so I do think those are like the two main things, I think that we suggest people think about and you know, look at compared to their deal, instead of just taking.
The advice as though it would apply to every deal, the same and just making sure that you take your own you know facts and circumstances into consideration.
Jimmy Atkinson: yeah sure no that’s that’s helpful to consider those points I let’s let’s touch on substantial improvement just just for one more moment for those.
Who are unaware, can you just explain what the substantial improvement requirement is and how shifting some of those numbers around me made with that with a.
Valerie Grunduski: Casa sure yeah sure, so when you have a property in an opportunity zone, and this, this is whether or not you’re you know the real estate is your business or, if you have an operating business that happens to also hold the real estate.
If you have an asset that you’ve purchased in an opportunity zone that you have not.
newly constructed um you do have to meet the substantial improvement tests, which essentially says okay What was your basis what did you purchase this building for.
You get to carve out the land and so that’s why I was saying things like doing a different allocation of the land could be helpful to change what that you know that basis is and whatever it is, you have to essentially.
Double it, you know and and you have a kind of a substantial improvement timeframe, in order to get that done it’s around two and a half years, give or take.
A month there on the number of some of these are goofy it’s 30 months here 31 months there.
But essentially that’s what you have to do with the idea being that they didn’t just want someone to get to take advantage of buying a building that was already perfectly operational and.
Fully you know least up and in great shape and get this opportunities don’t benefit on the back end they wanted people to come in and make a difference in an improvement in the zones right.
So that’s how they’ve decided, we have to be measured either that you’re building something new, or that you’re taking a pre existing building and making it better, which they determine meant basically like I said doubling those building values.
Jimmy Atkinson: Right yeah so these aren’t these aren’t core or core plus type investments they’re more opportunistic because of that substantial improvement requirement, so the idea, there being.
If you can shift more the value of the asset from building value to land value is there a third or fourth type of value that you can play with there is it may only just shifting from building the land.
Valerie Grunduski: There are some aggregation rules that you could use that would maybe make some of the other.
categories I don’t want to say irrelevant, but maybe less attractive, but you know that there’s you know things with like land improvements or equipment and whatnot that you might you know it might be more beneficial to you.
To have you know the values allocated that way, instead of putting everything on the building it somewhat depends on what your plan is for improvement in this space in the first place, but.
Jimmy Atkinson: gotcha well that’s that’s I think I get it now.
You you mentioned briefly that JEREMY might be able to fill us in on some some timing issues so JEREMY, let me turn to you now, what can you tell us about timing with regards to doing a cost segregation study on a nosey deal when is the optimal time.
To do segue.
Jeremy Sompels: For sure so so the optimal time, I would say is the year the buildings placed into service you do the the caustic at that time period.
You get your fixed assets created and that goes on your tax return the first year you file that tax return with a with a completed building.
So that’s the ideal timing information structure it’s easier to get those all the invoicing all the drawings all the information we need to complete the study.
That being said, you know if somebody had an opportunity to Tony opportunities own deal from 2020 let’s say and they did not do a cost segue.
learning about it now and wanted to do one we still would have the opportunity to do that and i’m what we call a look back basis so that would involve filing an irs form.
With the tax return in the current year and it catches up all that depreciation that you could have claimed, have you done at the first year.
So it makes it a very easy process to do it either the same year, or on a look back basis or you know to valerie’s point before if it the the tax deductions aren’t needed right away.
You know, two, three years down the road now you’re paying tax and now might be the time then sure we could do the cost to get that period at that time and that returns well and take advantage of it, then.
Jimmy Atkinson: Excellent well that’s helpful, well, I think the time has come, if you want to walk us through that.
example with those real world numbers and just for our listeners out there if you’re listening to this podcast episode, maybe you’re listening to us on.
apple podcasts or spotify or some other listening APP this this podcast is also available on YouTube and, if you want to actually.
Take a look and see what what we’re doing here and the numbers that Jeremy and Valerie are going to walk us through right now.
Would highly encourage you to find us on YouTube and you can you can watch the numbers that we’re going to show on the screen here so Jeremy and valor without further ado want you to take it away with the with with sharing the screen and.
And walking us through this real world example of how a cost segue study can perform both for a nano Z and then for a nosy deal.
Jeremy Sompels: yeah absolutely so here i’ve got an example of kind of what what it would look like with and without a classic so in this situation here we’ve got.
A $12 million property $2 million land basis and a $10 million appreciable building so without a Casa you’d have one asset for $10 million.
You know, again, going back to the 39 year property 130 ninth every year, essentially, but you’d be claiming.
In this example on the rehab, and this is for the rehab portion not the acquisition piece so you’re improving the property.
And then you might come up with you know $1.5 million a personal property in this example half a million dollars will be called land improvements.
And then $7 million of a category called qualified improvement property which For those of you who don’t know what that is essentially that is.
A somewhat recent category very taxpayer friendly it allows you to accelerate property that might otherwise be considered 39 year property.
And and qualify for that bonus depreciation, which can be huge so in this example right we’ve got basically for a property places service.
Before we’re looking at a $9 million bonus depreciation eligibility for the tax return with this example, so that, obviously, is a great thing to have.
You know we’ve got some kind of assumed tax rates here, obviously, those can vary.
But this kind of shows you what it looks like with and without as far as your fixed assets would go so essentially you’d have for asset well five assets for for the building one for the land, instead of just the one building asset one land asset.
So, then, we kind of go over what does it really mean right so here we’ve got a with and without opportunity zone, so if you had an opportunity zone projects and you did not do a cost thing.
you’d have you know that $2.7 million and appreciation at a 45.8% tax rate that benefit would be $1.2 million with the cost segue obviously you have that much, much higher appreciation number, creating a tax benefit of $4.2 million.
So then over here we’ve got the you know, without a.
opportunity zone so costings do make sense, even without an opportunity zone, you know a lot of lot of work, I do is is not necessarily related to an opportunity zone deal so costings can make sense for all real estate investments, not just in this situation.
Valerie Grunduski: And what might be helpful, just to point out here because I don’t know that we explained this on the front end of our example is what we’re looking at here is what happens after 10 years kind of you know if we decide like you would normally in a nosy deal.
Maybe at 10 years or later right that you would kind of step away from the deal decide it’s time to leave or sell.
So this is showing you know what what is the benefit over that time period in depreciation right so in 10 years versus you know oC versus nosy crossing versus no cost segue.
So sorry I don’t know I didn’t know if you wanted to say anything else, Jeremy if you want me to kind of happen to the translates okay so obviously.
JEREMY showed you what the actual depreciation numbers over time would have looked like in each scenario, but then you can see, then, on that you know next line, whether it’s over you’re not.
The tax benefit right again, we have our assumed rates get pretty close to 50%.
In tax rates, these days, once later on your state and local and your net investment income tax.
So, again kind of comparing that using all of that bonus depreciation and getting you to that very high amount of deductions over time.
You know how the tax benefit of over 4 million compared to 1.2 and where it gets exciting and opportunities on is on the bottom half of this page here.
You know if I go all the way to the right on the page for the people who are viewing it no cost segue study when you sell that building that $2.7 million of.
accumulated depreciation that you had overtime, you have to recapture on sale and pay tax on.
You still get a tax benefit of the deductions, but then there’s also this tax that you had to pay in.
If you did a call saying study you know the good news is you got more texts benefit up front, but then there’s also more.
recapture on the back end right, so you still end up ahead, overall, but when you let your the two on top of each other, you know there’s there’s still a tax bill do upon sale.
Jimmy Atkinson: With a non nosy you’re you’re getting the benefit of time value of money and a little bit of tax rate arbitrage too right.
Valerie Grunduski: yep exactly right because you can compare right the tax rates at the top that 45 and a half percent and then, when you look to the bottom, on sale because.
Is that a 25 flat 25% rate for federal purposes, as opposed to whatever your ordinary tax rate is so that’s what causes that difference in rate differential.
But again, then, on the left side of the screen here, and this is what what we were talking about from the front end today is that in an opportunity zone, when you have that sale, there is no depreciation recapture so whatever that tax benefit was.
From depreciation over time that’s that’s a real permanent savings that will not be reversed or reduced in any way and so, even if you don’t do a Cost Study right it’s still.
A benefit in this perfect example or this particular example $1.2 million of tax savings that you had in depreciation that you never have to pay back any portion of that so that’s pretty great.
But what’s even better is the you know $4.2 million that we’re showing in this example by accelerating all of those deductions into the early years.
Using a Casa study, which is it just that I mean when you just look at the comparison between the two, and that goes back to you know what you were saying at the top, and what this does to your rate of return on investment.
And a nosy deal just looking at these numbers here it’s it’s it’s more than impactful.
Jimmy Atkinson: that’s very sizable.
You can really see the difference of the mix of those numbers clean up paint a very clear picture there, I will say, though, that.
This does look like a best case scenario deal to do a cost segue study on.
This is a great example, but what is this what a typical deal would look like, or what what does it more typical deal look like and when might you not want to do a cost segue study.
Jeremy Sompels: yeah absolutely so yeah for in this example, it is yeah very good scenario absolutely.
it’s getting a lot of that qualified improvement property really bumping up those appreciation deductions, but you know a good opportunity for a cost segue.
For me, usually is you know, a $2 million basis at least right anything smaller than that you kind of start you know, trying to figure out if it makes sense or not anything over $2 million typically is going to make sense.
You know, as far as breakout percentages and whatnot of a property, you know it can vary right from a 10% breakout up to the 40% breakout let’s say.
We not not including qualified improvement property type of deals, so if we’re looking at an acquired property or newly constructed property, those are not going to have qualified improvement property as a potential asset.
So you know those situations, you know 20% might be an average breakout let’s say half a million dollar property, so you could end up with a $200,000.
breakout depreciation asset accelerated on something like that so.
that’s something to consider right and that’s something that you know your tax CPA could help you kind of look at and help you.
figure out what makes the most sense or should you be looking at it, or you know many providers will provide estimates on the front side to have hey how much you think you could set your date so that’s a good time to get somebody else involved.
Valerie Grunduski: And I also think you know when you think about the I guess the the asset type right, so this example, we were using a.
Non residential building which not to bore anyone too much, but qualified improvement property that really only applies in a non residential.
Building context until that’s part of the reason to why Jimmy you are probably like.
This might not pass the smell test it’s too good to be true, but that’s you know, in a non residential building, we were able to say that that much could be qualified improvement property, but even with.
You know, residential so you’ve got apartments.
Obviously the LIFE isn’t quite as stifling because you get 27 and a half years instead of 39 on the front end you don’t get qualified improvement property, however.
Just thinking about the sort of assets that are usually inside of an apartment complex when it is rehabbed or are built by a drop or there are a lot of things that can meet these tests that you know, Jeremy would be looking at.
To be treated a shorter life lived assets, you know getting five and seven year property.
it’s the same assets right replicated however many apartment units, there are the building, so the benefit, I think, is there, you know, regardless of the asset type it’s just the bang for the buck, if you will, could.
Could differ based on.
The type of asset.
Jimmy Atkinson: sure that makes that makes perfect sense well thanks for being forthcoming with with that and being transparent.
And and tell us a little bit more so the $2 million, a good general rule of thumb maybe maybe an asset that that’s that’s less than $2 million, you might end up paying more for the cost SEC study and the the additional tax.
Jeremy Sompels: And it still could make sense for sure, but it’s it’s worth investigating.
Jimmy Atkinson: yep very good, well, what about the tax code, are there any changes forthcoming to the tax code that might impact this.
Jeremy Sompels: yeah one one area would be the bonus depreciation, so, as I mentioned hundred percent bonuses in effect until the end of 22 and then under current legislation in search phasing out so in 23 we’re looking at 80%.
Then 60 4020 and then zero so that’s one consideration of just the timing that’s something that’s kind of out of our control right depending on when you buy these deals are investing these deals but.
You know that 100% deaths they’re phasing out so there’s something to be aware of that makes the depreciation number a little bit less kind of going forward.
Valerie Grunduski: But what I guess, I want to touch on with that is that just because when we roll into 2023 were subject to an 80% bonus instead of 100.
As JEREMY mentioned, maybe you have a property that you bought last year, the year before whatnot you get to use the bonus depreciation number percentage that was.
In effect, when that property was placed in service, and so, even though maybe you don’t come and say hey I want to do a call segue until 2324 25.
You still get to use 100% bonus if it was an asset that was placed in service in you know, a year, where there was 100% bonus, so I don’t want you to think that if you don’t do something, this year the the benefit is lost because it most certainly is not.
Jimmy Atkinson: Good okay well that’s that’s good to know well, I think we’ve run a time here today and really impactful.
episode, I think I didn’t know anything about cost segregation, or hardly anything about it, an hour ago, so it’s great to talk with both you today Valerie and JEREMY thanks so much for joining the show.
Valerie we’re going to listeners go if they’re interested in learning more about you and the services that you provide at plant Moran.
Valerie Grunduski: Sure, so you can visit us at plant maria.com and we do actually have plant ran COM backslash opportunities zones, if you want to see any of our specific context.
context on opportunity zones, including the article that we did with these examples for cost segregation studies.
Jimmy Atkinson: Perfect yeah and i’ll make sure we link to that article in the show notes for today’s episode and our listeners and viewers out there can find those show notes at opportunity db.com slash podcast.
There we’ll make sure we have links to all the resources that Valerie Jeremy and I discussed on today’s episode and also, please be sure to subscribe to us.
on YouTube or your favorite podcast listening platform to always get the latest episodes Valerie thanks again great chatting with you again JEREMY great to meet you and chatting with you as well, thanks so much.
Valerie Grunduski: Thank you.