David Moore with Equity Advantage asks the expert Jonathan Frizzell with CBRE about cost segregation. Understand how cost segregation works and the way it applies to different types of properties as well as its impact on your potential ROI. Get expert advice to make the most of your investments.
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What Is Cost Segregation?
David Moore: We’re in Portland today, but that’s not home for you. Where are you based?
Jonathan: I’m based in the Seattle area. I’m a third generation native of Seattle. I live in the Olympic Peninsula across the water, but I do properties in all 50 states.
David Moore: Let’s get a basic understanding of what cost segregation is. Let’s think of it in terms of a rental house: cost segregation is the delineation between dirt and improvements on that, right? And a property such as a rental house has a 27.5-year depreciation schedule, so what happens with the return on that investment if you increase or decrease the allocation of the improvements? If you increase the improvements, your ROI obviously increases dramatically, and vice versa
David Moore: Often we find that someone’s first investment property is a home that they’ve outgrown. They start off with a rental house and slowly grow their investment portfolio from there. And often people start out with residential property but ultimately end up branching off into more industrial type property, or retail. But if we look at a rental house, who makes that allocation for dirt and improvements, typically? You deal with this every day. It’s your business; you’re talking to tax people and legal people all the time. In that most basic example, Jonathan, who makes those allocations? And then, give us just a quick, broad scope of what cost segregation is.
Is Cost Segregation Different for Different Property Types?
Jonathan: Cost segregation is nothing more than acceleration of depreciation, which increases one’s cash flow. By reclassifying those buildings into shorter depreciable lives, from 27.5 years on multifamily, and 39 years on commercial, we give them smaller lives of five and seven years, which is personal property.
David Moore: So if we look at a rental house for example, we’re talking dirt, which you’re not going to depreciate, and the improvements, which you’re going to depreciate.
Jonathan: That’s right.
David Moore: A rental house is typically 27.5 years.
Jonathan: Yes, I have done countless single family rentals, and we have a model for that. We don’t even have to do a full-blown cost segregation study; we can still get a study done, a report that the IRS will approve. It’s important to note that the owner and the tax professional will allocate what the building land cost base is; the IRS frowns on us doing that. They want it to be an arms-length transaction. And whether it’s a 1031 or not, once we get that net building access basis, and the land cost basis with a physical address, I can run the analysis for them at no cost to them.
David Moore: You made a comment earlier that cost segregation does not create more depreciation; you’re just accelerating it.
Jonathan: That’s right. We’re accelerating the depreciation. So if you have a million-dollar basis, I know with certainty regardless of product type that I’m going to accelerate anywhere from 25 percent to up to 50 percent of that cost basis. You’re looking at $250,000 $500,000 of that million-dollar basis.
David Moore: What is a typical property for you? If there was a single property group that makes up, let’s say 25 percent of your business, what would that be? What’s the most common asset that you do a study on? And a value maybe too? I guess my question is sort of a leading question because I think historically people look at it and apply it to something like a big office building. But, if we just crank it back to its most basic sense to that rental house, we talked about dirt and improvements. In a rental house, what would you bust it up into? How many components?
Jonathan: Even then you’re still going to break it down into its hundred components, even in a little single family. You’re looking at the wiring in the house, you’ve got the flooring. If there’s any base at all on the walls, wall coverings. You go in and take a look at the bathroom. Even the driveway is going to be 15 year. We’ll look at the landscape, which is 15 year. The good news about cost segregation, regardless of product type, is you can also use as an asset management tool. Our studies here at the cost seg group of CBRE, we give expanded detail, not only on the 1245, the personal side, we’re going to break down the roof, the HVAC, fire suppression. So, therefore when the client, the owner, has to replace that unit of property, that component, they’ll be able to know what the value of that, and then get it off the books and have another write down condition going forward. That’s very important to note.
David Moore: What is the most common asset that you do?
Jonathan: Multifamily has been the darling product for the last nine or ten years. For multifamily, it depends if it’s surface parking or not. If it’s surface parking, you’re looking at anywhere from 15 to 21 or 22 percent at a five year. And then surface park anywhere from 7 percent to as high as 25 or 26 percent at 15 year. Again, it ranges. 25 to 45 percent. It’s important that light industrial as well as distribution buildings, and flex buildings, they might not be as sexy as a dental office, or a fancy medical office. In my perspective they’re very sexy because there’s a lot of five year in them. I love dental offices.
David Moore: And when you’re talking years, you’re talking about the life of that asset.
Jonathan: Yes, the depreciable life. That’s right. And so, even self-storage, heated self-storage, there’s an important note: The HVAC systems for the self-storage—usually HVAC is sucking 39- or 27.5-year lives. While on self-storage, that heated storage, the HVAC is specific to the business activity that that IRS talks about. So that becomes personal property when you have a full-blown comprehensive cost seg study done. There are a lot of ways to skin the cat, but some of my biggest yields (yields meaning wonderful acceleration of depreciation) has been on buildings like FedEx distribution centers. And they’re not as sexy and pleasing to the eye as maybe a fancy office, or a dental office, or a medical office, but there are a lot of yields on those. Marinas are another one.
David Moore: Give me an example of what you do with a marina.
Jonathan: You’ve got all the clutches.
Jonathan: You’ve got those electrical hookups.
David Moore: And the plumbing.
Jonathan: The cabling, the water/sewer. You’ve got those 20, 30, 50 amp switches specific to each slip. You’ve got those wonderful, all different sizes of clutches.
David Moore: Sometimes pump valves.
Jonathan: And those are all personal property in nature. The marina itself (marinas and gas stations), at the end of the day when we get done with them, they all end up in 5 and 15 year, and there’s nothing left over. There’s no 39 year. So there’s a lot of yield on those particular types of property. But you name any kind of building, and I’ve delivered it. I’m pretty excited about any kind of product type.
David Moore: How were you made aware of cost segregation? What happened?
Jonathan: A childhood friend asked me if I had heard of cost segregation, and this was in the late summer of 2006. He knew me in the wholesale lending background and the hospitality industry and knew I was very customer service driven as well as numbers driven. He thought it was something for me to look at. That’s when it all started.
David Moore: Although Jonathan works out of Seattle, he can do things coast to coast. Keep in mind that before you take action on anything presented here, you should consult your tax and legal counsel.
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