Generating Large Depreciation Expenses With Positive Cash Flow

[Bryan Hancock]

We're doing some planning for next year to reduce taxes and I was hoping some of our more astute investors could give me some ideas about generating large depreciation expenses to reduce passive income.  The following is desirable, but not necessary if some elements are hard to get all in one type of project or strategy:

• Large depreciation expenses in early years.  A chattel appraisal or cost segregation study comes to mind, but there are probably other ways to do this
• Preferably something I can invest in passively and avoid management headaches
• Hopefully decent real yields, but something that avoids negative cash flow for sure

Any ideas?  I was thinking of small apartments where we can do cost segregation and later exchange to larger buildings and repeat the process.  I am not sure if the chattel becomes part of the deferral during a 1031 so that may not work.  

Any ideas?  Note that the project does not have to be real estate related.  

[Brandon Hall]

@Bryan Hancock I think a cost seg study fits the bill pretty well here. If you want large depreciation, cost seg is an excellent way to go. 

One caveat though, if you cost seg Building A, and after a few years you 1031 Building A into Building B, Building B will maintain the same adjusted basis as Building A once had, so a second cost seg study will not help or be effective unless the rolled over basis is still significant. 

Cost seg can generate massive benefits for investors. The best buildings that qualify are those with an unadjusted basis of >$500k, purchased within the last five years, or new construction. 

Assuming a 5% discount rate and a 35% marginal tax rate, each $100,000 in assets reclassified from a 39-year recovery period to a five-year recovery period results in approximately $16,000 in net-present-value savings. Of course that can range drastically depending on building type and how much can be moved to 5 or 7 year personal property and 15 year land improvements. 

Commercial properties (read: not apartment buildings) tend to generate more value from a cost seg study. How much of the building's basis can be re-allocated: up to 60% of golf courses, 50% hotels, 45% resorts/manufacturing/restaurants, compared to 40% apartments. However, apartments are also depreciated over 27.5 years vs. commercial 39 years. 

Cost seg studies can also be used very strategically - say you want to sell a building and you will realize a large cap gain but you also own another building. You cost seg the second building to offset the cap gain on the building you are selling. This allows you to transfer money out, and back into, real estate without the time constraints of a 1031. That only scratches the surface with cost seg strategies, but it a relevant example.