Cost Segregation: A Necessity for Every Real Estate Purchase
Most property owners have barely heard of cost segregation, and those who have think of cost segregation as a tax issue. Now forgive me for burying the lead, but for this specific article I will lay out a long-term benefit of cost segregation that is often overlooked. This benefit does not require a tax burden for a cost segregation study to be advantageous. This is why I’m making the argument that cost segregation is a necessity for all property owners.
Let’s start with what a cost segregation study (CSS) is so that we can build some context. A CSS is an engineer-based study of all of the individual assets purchased in a real estate transaction. This allows the taxpayer to use an accelerated depreciation schedule resulting in higher tax deductions in the early years of the purchase of a property.
The secondary benefit of a CSS is a full accounting of fixed assets, both personal & real. These assets are given different time schedules, most between 5 – 20 years. These schedules are not just set to benefit the taxpayer, they are set specifically as guidelines to when the asset is likely to run out, break down, or become obsolete. These guidelines provided by a CSS can benefit every property owner.
In most home owners’ personal lives, when do we realize that the A/C unit needs to be replaced? For most of us, it’s the day that it becomes really hot in our house. Most home owners do not set a planned schedule of repairs and upgrades, so an A/C replacement can be an inconvenience. What happens if you own $600,000 worth of A/C units? That is more than an inconvenience; it is a real problem.
This problem gets compounded by the cycle of asset depreciation. Let me explain -- assume that assets have to be replaced according to their depreciation schedule. Also, assume that the property has 5, 7, & 15-year property. Not only is there a required asset purchase in years 5 and 7, but in multiple years more than one group comes due at the same time. For example, in year 15 both 5 & 15-year property need to be replaced. Between years 28-30 all three groups of property need to be replaced. See chart A1 below that represents the planned expenses of a $1,000,000 purchase.
How does this effect the profit of the real estate project? Below are two graphs. Graph B1 represents the gross profit of a rental real estate property. We are assuming a 7% cap rate and have not adjusted for changes in either rents or inflation. Graph C1 represents net profit of the same real estate property. C1 holds the same assumptions but adds a 55% profit margin.
There are two points I would like to make here. First, we would concede that over a 39-year time horizon it is highly likely that the value of the property would easily cover any net profit losses, though that fact would not necessarily effect cash flow needs. Second, a 55% profit margin is a generous assumption. Many property owners experience much lower profit margins, exacerbating the problem.
These planned expenses can be managed if they are indeed “planned” expenses. If, however the expenses are not properly documented and planned, we leave far too much to chance.
Let’s talk about the term “chance” in a real-world situation. Chance is a term of probability, as in, what is the probability the property will need a new roof in the next year? Leaving large expenses to chance can work for a single property. If the single roof has a 25% chance of needing replacement, the owner can squeeze a few years out of that roof without an expense.
This changes when you move from one property to 100 properties. The “25% chance” of having a roof replacement moves to an almost certain chance that 25 properties will need a roof that year. In this light, planning moves from a “good idea” to an absolute necessity.
Cost Segregation is a fantastic tool that offers the property owner some amazing tax benefits, but as we have shown it is also a tool that can be the difference between a successful real estate venture and a failed one. Every property needs a cost segregation study and we are here to help make that a reality.