Under Contract for a 12-plex, should I cost segregate?

Question

I've just come under contract for a 12-unit apartment in Spokane, WA that was built in the 70's and remodeled in 2014. Purchase price was $720,000, and I intend to hold on to the property for >5 years. It is not part of a 1031 exchange.

Since I am about to purchase the property, I am wondering: does it make sense to do an engineering study for cost segregation?

The components of  this question then become: What sort of tax benefits would I expect to see from cost segregation? ($1000/yr? $10000/yr? more?)

How much would I expect the cost segregation study to cost?

Thank you in advance for the help!

Steve Vaughan · Answer

I've never bothered. I've always seen it as trading a 15% cap gain for a 25% recapture later.

What is the land value according to the assessor, Jonathan? Spokane shouldn't be too crazy high. Another reason I haven't bothered to segregate is my land values only range from 3-10%. My building depreciation is great already.

I heard a guest on a Joe Fairless say it costs $4-7-12k depending on how good your list and records are. Do you have the original blue prints?

I've heard of large multi-million $ properties costing $30-40k.

Jonathan McKay · Answer

According to tax assessor records, property is $30k, Building is $480k. So extend that ratio to the purchase price, the building value is $677k.

I got one quote for cost segregation, which is for $3k.

Under cost segregation, they claim potential depreciation deductions of 26k in 2016, 59k in 2017, 39k in 2018.

With regular depreciation it would be 4k in 2016, 21k in 2017, 21k in 2018.

Over the first three years, that means  78k (26-4+59-21+39-21) in reduced tax burden. Let's assume that I can take advantage of that to the tune of 30%, I would get 23.4k in tax benefits over the first three years.

If/when I sell the property, I would have to pay recapture so let's assume I'll eventually pay all the 23.4k back.

But, let's put the time value of money as 8%, that would give me $1.8k (23k*.08) value per year return after the first three years. Bringing it back to the cost segregation quote of $3k, that means I'm getting an ROI of 60% (1.8k/3k) for the investment.

Are these assumptions right? Based on this it seems worth doing to me.

Richard Shevak · Answer

Jonathan, the numbers they gave you are in the ballpark of where I'd expect to end up on a typical residential rental property.  One big variable is how much they assumed for land improvements.  Their estimate of depreciation (without the cost segregation) was off a little bit.  I think the annual depreciation on 27.5 year property on $677k would be around $24k.  So, if you do the cost segregation, you'll generate additional ordinary deductions up front (and give up that depreciation later) which you'll use to offset your rental income and then you might have to worry about the recapture issue.  As for recapture, there are some (including some very experienced CPAs) who will ignore the recapture issue (i.e., recognize only capital gain on the sale) if the property was held for at least 5 years.  I'm not sure that's technically correct, but that's what some folks do.  All good questions above (land value, hold period, 1031, etc).

Did the person who gave you the quote give you an "estimate of benefit" (EOB)? That would show you your estimated depreciation by year, tax deferral, and net present value savings.

$3k would be a great fee.  Based on that fee, I assume the engineer doing the study is local (or somewhat close by).  If you want to mess with your cost segregation provider, asking him or her what they think of the Amerisouth case (a cost segregation case having to do with residential rental property)

Good luck.

Karolis Matulis · Answer

That is a very loaded question. It really depends on the property. You have to walk thru the property and evaluate the individual depreciable components. Since the remodel was done in 2014 it is possible that you may be able to get some benefit out of a cost seg if there are a lot of 5 year assets (mostly furniture/equipment and fixtures) that were put in at the time. If the building is mostly bare and only has structural components with 27.5 year asset lives there is likely little to no benefit.

Guillermo Birmingham · Answer

Cost Segregation is a commonly used strategic tax planning tool that allows building owners who have constructed, purchased, expanded or remodeled real estate to increase cash flow by accelerating depreciation deductions and deferring federal and state income taxes.  When a property is purchased, not only does it include a building structure, but it also includes all of its interior and exterior components. On average, 15% to 20% of those components fall into tax categories that can be written off much quicker than the building structure.  A Cost Segregation report for residential investment property dissects the purchase price of the property that would otherwise be depreciated over 27.5 years for income tax purposes.  The primary goal of Cost Segregation is to identify all property-related costs that can be depreciated faster (typically over 5, 7 and 15 years) creating significant additional deductions over the next 5 years.

The secondary goal of Cost Segregation is to establish the depreciable tax value for each major building component that is likely to be replaced in the future (such as roof, windows, doors, bathroom fixtures, HVAC, etc). When a component is replaced, taxpayers need this information to claim a “retirement loss” or “partial disposition” deduction for its remaining depreciation.  The potential benefits of having a Cost Segregation report varies based on circumstances.  On average, it is estimated it will provide $8,000 of additional deductions in the first 5 years for every $100,000 of basis you have in the building. For example, a rental property with a $300,000 purchase price (not including land value), could generate $24,000 of additional tax deductions in the first 5 years.   Cost Segregation works well on properties acquired anytime in the last 15 years.

While, the above can be very technical and confusing at times, the implications are clear, cost segregation studies can benefit real estate investors by deferring taxes (i.e., helping them keep more money available for future deals).

My accounting practice can provide a Cost Segregation report on Residential Rental Properties up to 6 units with a depreciable basis of $500,000 or less (not including land value).

We provide a full report that includes the following:

• Summary of tax benefits and additional deductions generated from Cost Segregation.
• Detailed schedule of the property's major costs organized by tax category (used to complete your tax return).
• Excel export in depreciation schedule format (that can be directly imported into many tax software programs)
• Summary of all information used to produce the report

• For an additional fee – 481(a) adjustment  “missed deduction” calculation schedules  (needed for properties acquired in prior tax years).

For investors with properties, such as commercial or extensive multi-family properties, etc., I can recommend a firm with a Nationwide presence to work on these types of engagements.

If you are interested in learning more, please message me.

Dave Toelkes · Answer

Let's say your purchase price allocates $600K to the improvements and all the appliances in the building.  Let's say that your cost segregation study assigns a present value of $50K to the five year assets and $20k to the 15 year assets

Now you have a 27.5 year asset at $530K ($600K-$50K-$20K) with an annual depreciation of $19273.  Add in 10K (average per year) for the five year property, and $1333 for the 15-year property and your annual depreciation expense for the first five years comes to 29273 compared to the $21818 depreciation expense without the cost segregation.  At the end of five years, you lose the 5-year depreciation expense until you replace that property.  At the end of 15 years, you lose the 15-year depreciation expense until you replace that property.  For the last 12.5 years on your depreciation schedule, your depreciation expense is $19273 assuming you never make any improvements.

At the end of 27.5 years, your total depreciation expense with the cost segregation study will be exactly the same as it would have been just by taking a 27.5 year straight line depreciation on $600K.

You have to run the numbers to see if the first five years tax savings on your annual taxable rental income with the cost segregation study vs your tax liability without the study justifies the cost of the study.  I say to consider only the first five years, because that is the depreciation life for the five year property that you are accelerating.  After the first five years, you would be replacing that original five year property anyway and taking a depreciation expense for the new replacements.  Quite a few investors decide that the cost of a cost segregation study exceeds the benefit for most smaller residential dwelling unit properties, but does pay for itself for commercial property with longer class life property.

Until you run your own numbers, you won't know whether there is a true cost benefit to a cost segregation study.

Jonathan McKay · Answer

@Marco G. you are correct to point out that the costs of a 1031 are minimal. When I say transaction costs, I mean costs of selling the building, which I peg at about 9% the value of the property. (Washington state has a ~2% excise tax). Never sell? That's tough to say, but in the time horizon that I can calculate (~10y), I don't think I would sell.

But you're right -- let's talk in a few years.

Marco G. · Answer

@Jonathan McKay are you saying you don't intend to ever sell?

I don't believe 1031 costs are very much. I've never done, but I've purchased from sellers who were, and the costs as listed on the closing statement on a $600k purchase was around $1,500 if I'm remembering correctly. I'm sure there're costs on the buy side too (maybe?), but if it's even 5% (a deductible cost I imagine), it still beats paying depreciation and capital gains taxes.

Let's talk in a few years 😜

Jonathan McKay · Answer

@Richard Shevak - thanks for the info! You're right that the straight depreciation looks a bit off. Maybe they were deducting additional land value? I'll find out.

They gave estimated tax savings, and calculated an EOB based on full depreciation of the property and NPV benefit. They came up with $21,569 total NPV benefit over the life of the loan, but that is also based on 39% tax rate, which is a bit optimistic for me.

Under Contract for a 12-plex, should I cost segregate?

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