Depreciation schedules. IRS codes. Accounting. Paperwork.
The very thought of these concepts is enough to put me to sleep at my desk.
…or at least it used to be.
Then I learned the power unleashed in the simple but powerful strategy of accelerated depreciation. And when I was evaluating a change in career focus to dive into multifamily investing, it was one of the reasons I actually took the plunge. Well, I didn’t change for the IRS codes and schedules and such. I did it for the surprising power unlocked in this concept. I will never view taxes the same!
In a previous article, I talked about the many tax-saving opportunities a multifamily investor can achieve by hiring the right counsel. Specifically, I encouraged investors to retain a tax strategist to help them legitimately minimize taxes.
Though many of the concepts were familiar, perhaps one of the least familiar was accelerating depreciation through a cost segregation study.
This often allows commercial property owners to offset most or all of their income from an asset through faster-than-standard depreciation. As a result, owner/investors get distribution checks in the mail all year long—then a negative number on their K-1 at year-end.
It’s hard to beat that. And this benefit typically goes on for quite a few years.
This is another reason I specifically chose commercial (large scale) multifamily investing over single family or smaller scale multifamily investing. Before we get into the details of cost segregation, let’s back up and review the basis for this powerful tax-avoidance strategy.
Depreciation is a method for allocating the cost of a tangible asset over its useful life. Since the IRS would not allow a million-dollar tax deduction in the year of that million-dollar purchase, the million dollars is allocated via formula over the projected useful life of that asset. This provides a deduction to the income for the owner in each year the asset is depreciated.
For example, if a machine is purchased for a million dollars and its useful life is 10 years, it would (typically—if straight line) be depreciated at $100,000 annually.
Related: Cost Segregation Case Study: How to Boost Retirement Income Using Real Estate
If a million-dollar building that houses that machine will be usable for decades, it might be depreciated over 39 years. (Typical IRS categories for permanent structures include 27.5 years and 39 years, but there are others.) Land is not depreciable since its value does not typically drop with use over time.
If you’re having trouble sleeping, you can check out the IRS depreciation code for yourself by clicking here.
As a direct, fractional owner of commercial real estate, you get a direct benefit from the financial depreciation of the asset. This means your income will be reduced by the amount of the asset’s depreciation that year. Your CPA undoubtedly knows this. You probably yawned as you skimmed through it.
But you may not have been aware—and some accountants may not have told you—that there is a way to dramatically accelerate your income deductions and tax savings using componentized depreciation a.k.a. cost segregation.
The IRS code for cost segregation may actually be slightly more interesting than the last link on basic depreciation; learn more here.
Here’s How it Works
A commercial real estate asset usually has components that wear out faster and need to be replaced more frequently than the structure as a whole. These components can be more quickly depreciated than the building itself.
Saying it differently, there are real assets (the structure itself) that are depreciated slowly, over a long period of time. But there are elements (tangible personal property) within that structure that are not considered “real property,” and these can be depreciated more quickly. For example, an apartment building may have a 27.5-year life for depreciation purposes. But many elements in and around the apartment may have a much shorter life and may be able to be depreciated much sooner. These might include kitchen cabinets, appliances, plumbing fixtures, shelving, and carpet. All of these can probably be depreciated on a five-year schedule.
Other items like paving and landscaping are considered improvements to the land and can probably be written off over 15 years. And when you trash out a property for rehab, any deductions not yet taken can probably be fully depreciated at that time.
This may not sound like a big deal, but trust me, it can mean an enormous tax savings over many years. My friend, Ted, used to provide cost segregation services to commercial property owners for a living. He showed me some of the numbers, and I’ll tell you that they were quite impressive. I recall that I wished I owned a commercial building so I could enjoy some of these benefits, but at the time, I had an uninformed bias against commercial real estate. (I was flipping houses and waterfront lots in those days.)
Again, it is very likely, after making a new investment in a commercial multifamily property, that you will have many years where you get a healthy quarterly dividend check, but your annual K-1 shows a loss. (This is completely legit and above board, of course.) And when the losses run out, the prior losses are carried over until you are back to zero (no loss carryover).
Many multifamily investors find it takes about five to seven years to get to zero, which is the holding time of some assets. Do you see the power in this?
Benefits of Cost Segregation
According to Jeff Hobbs, Founder of Segregation Holdings, there are many other benefits to implementing a cost segregation study.
- Cost segregation maximizes income tax savings by correcting the timing of deductions. When an asset’s life is shortened, depreciation expense is accelerated and tax payments are decreased during the early stages of tangible personal property’s life. This then releases cash for investment opportunities or current operating needs.
- Cost segregation creates an audit trail. Improper documentation of cost and asset classifications can lead to a negative audit adjustment. Properly documented cost segregation studies help resolve IRS inquiries at the earliest stages and avoid potential litigation.
- Cost segregation delivers automatic catch-up of earned but unrealized depreciation through IRC Sec. 481(a) adjustment. This is considered retroactivity. Taxpayers can capture immediate retroactive tax savings on multifamily property (or any for that matter) built or acquired since January 1, 1987. With cost segregation applied, taxpayers are allowed to take 100 percent of their Sec. 481(a) adjustment in the year cost segregation is applied. This opportunity to recapture unrecognized yet earned depreciation in one year represents an amazing opportunity to perform cost segregation studies on older properties to increase cash flow in the current year. This type of cost segregation is called a “look-back” study.
- Cost segregation can reveal opportunities to reduce real estate tax liabilities and identify certain sales and use tax savings opportunities. Additionally, due to cost segregation being applied, property insurance premiums could be lowered since tangible personal property may cost less to insure than real property.
- Cost segregation could reduce the mortgage interest rate. When cost segregation is applied prior to the purchase or construction start, Jeff reports that many lenders will lower interest rates due to the debt service reduction. In other instances a lender may reduce the down payment due to the additional cash flow afforded by cost segregation.
Let’s say you purchase a 15-unit multifamily asset for $606,000. The land is valued at $121,000, leaving a depreciable basis of $485,000 for the buildings. Without cost segregation, the owners will depreciate the buildings on a straight line basis for 39 years. This comes out to $485,000 ÷ 39 = $12,436 that can be depreciated annually.
At a 48% tax rate, this results in first-year (and every year) tax reductions of $5,969. With a cost segregation study in place, in this example, owners will be able to depreciate almost 43% of the $485,000 in an accelerated manner—in 5-year, 7-year, and 15-year buckets.
This means that depreciation is accelerated for about $208,000 of the total. This results in accelerated depreciation of $177,343 in the first five years, compared to straight line deprecation of $62,179 (5 x $12,436) without cost segregation.
At a tax rate of 48%—which I confess is high, but that’s how they structured this example—the accumulated tax savings over the first five years is over $50,000. This is for a study that cost the owners about $5,500. And the study was also tax deductible, of course.
If you know enough to be dangerous, you’ll realize that the IRS is not letting us off that easy. They will get what is theirs in the end.
That is technically true. Depreciation will always total the basis of the (non-land) value in the end. But this misses the power of the time value of money. You know that a dollar saved and/or reinvested today is worth far more than a dollar years down the road. The power of tax deferral is clear and well-documented. It’s just math.
If you take one dollar and double it daily tax-free for 20 days, it’s worth $1,048,576. Take that same dollar, taxed every day at 30% (before doubling), and it will be worth only about $40,640—a loss of over a MILLION DOLLARS! Why is this so? Because with tax-free compounding, earnings accumulate not only on the principal amount of money, but also accumulate on the tax-free earnings as well (“earnings on earnings”). Thus, compounding combines earning power on principal and earning power on interest. Compounding has been called the “8th wonder of the world” (more confounding than semi-boneless ham!). Compounding money at high rates of tax-free return is a definite advantage of real estate, especially with a great tax plan.
Related: How to Use Cost Segregation to Increase Annual Depreciation (& Save Money!)
You may also object that accelerated depreciation lowers the basis on the property and will come back to bite you at the sale. My first response is see my above response. The time value of money beats that argument.
My second response is that some investors utilize a 1031 tax-deferred exchange to kick that tax can down the road. Some even kick it over to their heirs, where it can be reset to zero at their death. Well, that’s a very unpleasant thought, so forget about all that for now and ask yourself (or me).
So, How Do I Get in on This?
I’m glad you asked. There are three ways to do this, and one is illegal—or at least extremely unadvisable.
- Do the study yourself. Go around and count up all of the components of your property and reclassify them on your own. Try to get it done in under a year if you can. This is not only a colossal hassle, but a good way to get in hot water. The IRS has made it clear, through private letter rulings and the code, that a cost segregation study needs to be performed and carefully documented by a qualified professional. So don’t try this at home.
- Hire a qualified professional. CPA firms and consultants around the United States provide this service. It is typically carried out by a team of engineers and accountants, construction experts with years of experience in segregating properties like yours.
- Passively invest with a syndicator. Investors who passively invest with a multifamily (or other commercial) investment syndication firm get to enjoy all of the tax benefits of a cost segregation study without ever giving it a thought of their own. That (and a hundred other investment-boosting strategies) is part of the syndicator’s role.
So do you want to see if you can accelerate depreciation and slash your taxes through a cost segregation study? I will be happy to recommend someone to give you a free consultation. Send me a colleague request or a private message, and I’ll point you to my favorite cost segregation firm.
What about you? Have you used cost segregation to lower your taxes and boost your ROI?
We’d all love to hear about your success.