Cost Segregation - Where is my K1?!?

If you are like me, you like to get your taxes done As Soon As Possible. January 1st usually has me putting together the list of forms and actions I need to take to get tax information over to my accountant so that she can process my annual return. I spend the month of March impatiently waiting for the K1s to come from my syndicated real estate investments so that I can get everything completed before the April deadline.

It took me several conversations with real estate professionals to help me understand what is going on that delay our K1s because they usually won't arrive until late March or early April. For some operators, we've seen K1s arrive as late as June. The delay is due to this amazing little tool that the IRS has provided us real estate investors that help us avoid paying taxes. This tool is called cost segregation, but before we explain cost segregation, you first have to understand depreciation.

Before we jump into the details, we want to highlight that we are not tax professionals, and this is not to be interpreted as tax advice. We highly recommend that you consult with a tax professional when it comes to your personal tax preparation. We also want to point out that the illustrations we provide are instructional only; they are not accurate representations.

Depreciation

To understand cost segregation you must understand depreciation. To understand depreciation, you must understand a foundational concept in accounting.

This foundational concept is that a business should recognize an expense when they realize the benefit that comes from that expense.

For an expense like Payroll, this is easy because a company is recognizing the benefit of its employees as they work. It gets a little more difficult for purchases that will last over multiple years. A new $30,000 truck will provide value to a company over several years, so the IRS won't allow a business to expense all $30,000 in Year 1. Instead, the truck's value is depreciated over several years.

Real estate is one of the most valuable and longest lived assets since a well maintained property can provide value for decades or even centuries. The federal government has therefore determined that the depreciation timeline is 27.5 years for residential properties with a couple of notable exceptions like Mobile Home Communities that depreciate even faster. Commercial and industrial properties are depreciated over longer cycles.

Consider a $1,000,000 property. You would be able expense 36,363.63 annually for 27.5 years, or until the property was sold ($1,000,000 divided by 27.5 years). This expense is a paper loss because it doesn't take away from the cash flow of the property. To help illustrate this, see the table below for this $1,000,000 property. We break out the cash flow that the property generates (this is what would end up in your bank account at the end of the year) and then we add in the impact that depreciation expense has:

Without depreciation, the investor is left with $100,000 taxable income. Adding the depreciation expense reduces the taxable income by almost 40%. Table 2 below compares the tax implications with and without depreciation expense factored in:

Factoring in depreciation expense gives the investor over $7,000 in additional income. That's a 9% increase in the investor's annual cash flow from an investment.

Cost Segregation

The illustration above highlights that depreciation helps an investor realize a higher return than what is usually provided in an investment's forecast or budget. Let that sink in. If you are being told that an investment's return is 15%, it is actually going to be higher because of the depreciation expense that gets recognized in reality but isn't modeled by the operator.

The problem with depreciating an asset for 27.5 years is that there are a lot of items on a property that will never last 27.5 years. The IRS has created a legal workaround to address this problem. The IRS has developed separate depreciation schedules for almost every item in a property from the parking lot to the roof from the heater to the light switches. Most of these depreciation schedules are shorter than the standard 27.5 years. The process of separating these items and depreciating each one separately is known as cost segregation.

Cost segregation dramatically increases the depreciation expense early in the life of an investment. In the strictly hypothetical example below (the depreciation for carpet is more complex); we compare the standard depreciation expense vs. cost segregation for carpet in a property:

It is important to understand that ultimately the result is the same. The $20,000 in carpet will be fully depreciated. Cost segregation allows you to book depreciation in the first few years of an investment, but you will probably book far less depreciation in year 25 of the investment. Cost segregation simply allows you to recognize the tax benefits exponentially faster. This means that you get more money early through higher deductions. Your ultimate return will be better because you are getting to keep more money during the initial life cycle of the investment.

In Table 2, our $1,000,000 property had a $36,000 depreciation expense. If we assume the carpet in Table 3 makes up part of that expense, then through cost segregation we realized the carpet's depreciation roughly five times faster. Carry this model to every other piece of physical property on location and the amount of depreciation expense realized in the first few years through cost segregation can be staggering. We've had investments that paid 10% or more each year where we pay almost $0 in taxes for the first 1-3 years. Some investments actually show a loss in the first year because so much depreciation is recognized even though they were paying us a monthly distribution. That's incredible. Money gets made and we get a credit to send the IRS!

…so about my K1?

To do cost segregation an operator must know every physical asset that comprises a property: electrical outlets, faucets, sq./ft. of sheetrock, tile, carpet, air conditioners, cabinets, framing, insulation…the list goes on. You also have to track and depreciate any upgrades made throughout the year. Pull out the carpet and install tile? You have to depreciate the remainder of the carpet's value and then place the newly installed tile on its own depreciation schedule. This process requires organization, good systems, and a lot of time, but in the first year it takes significantly longer because the operator is bringing in engineers and accountants to conduct the initial cost segregation study. Those cost segregation studies need to be finalized after the year is over so that they can capture any repairs or upgrades made at the end of the year.

So, if you are like me and you are impatiently counting down the days until April 15th, know that there is a lot of work going on during the first quarter of the new year to help you maximize your returns on your investment.

A final note

We begin working with the CPA firm almost immediately in January. We let them know of any changes that have occurred within our business and what new investments have been created so that they are ready to begin receiving information. We then spend January and February uploading account and investor information through their secure website. The CPA firm is in possession of all the information they will need from us by early March. That way when the K1s do arrive from each respective investment, they can turn around your K1 in a couple of days.