THIS Major Tax Benefit Convinced Me to Put My Money Into Large Multifamilies

by | BiggerPockets.com

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 Explained

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.

  1. 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.
  2. 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.
  3. 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.
  4. 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.
  5. 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.

An Example

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.

Objections

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).

apartment-first-deal

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.

  1. 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.
  2. 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.
  3. 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.

About Author

Paul Moore

Paul is author of The Perfect Investment - Create Enduring Wealth from the Historic Shift to Multifamily Housing, leads Wellings Capital , a multifamily investment firm, and hosts the How to Lose Money podcast. Paul was 2-time Finalist for MI Entrepreneur of the Year, has flipped 60 homes and 30 waterfront lots, developed a subdivision, and appeared on HGTV. Paul's firm invests heavily to fight human trafficking and rescue its victims.

41 Comments

    • Paul Moore

      Hi Oscar.

      Thanks for your patience. I was trying to get an answer from my Tax Segregation specialist. He said that one unit of $100,000 or more value will work and provide a guaranteed 2 to 1 return on the cost of the study. If the value of the unit(s) is under $100k each, then you would need to have two or more units in the same location to make sense and assure the 2 to 1 or better return.

      This was good for me to understand. I had always assumed that more units would be needed to make this work, but apparently not. I hope this helps.

  1. Nirmal Khanderia

    Hi Paul, I have invested in a SFR currently, and have been considering investing in multifamily aprtments. Your article has given more fuel for me to think seriously about MF investment.
    Thanks a lot for easy to understand, well-explained article.

  2. Eugene Franco

    “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) deductions of $5,969—straight line deductions through the holding period. ”

    Do you mean reductions of $5,969 in tax? The straight line annual depreciation of $12,436 is a deduction, at a 48% tax rate it results in reductions of $5,969 in tax.

  3. Paul Moore

    Hi James,

    Yes, I do. That is why I really like the possibilities of either (1) holding and refinancing/supplemental debt, and (2) a 1031 exchange to kick the capital gains tax down the road. What about you?

    By the way, James, I am still working on that San Antonio multifamily deal. I will let you know if we are able to get it under contract. Thanks.

    • James K.

      Some of my friends who did cost segregation caution me against doing it as they see it’s ugly head when selling. However, if we are refinancing/supplemental debt or 1031 till death, it does not matter.
      Let me know if you need any help on the SA deal that you working on.

  4. Eugene Franco

    The depreciation recapture will certainly be larger as there was more depreciation but Paul makes an interesting point that one could do a 1031 exchange…in which case the depreciation is also rolled over..and then if it’s left in exchanged property as part of an estate the property would receive step up basis which would reset the depreciation recapture.

    • James K.

      Agree. Keep in mind 1031 is not easy to do even though its sounds cool. I see many investors buy marginal deals to avoid paying taxes in the name of 1031 exchange. The pressure of time forces them to buy whatever available to them.

    • Paul Moore

      Thanks Greg. My Tax Segregation specialist said that one unit of $100,000 or more value will work and provide a guaranteed 2 to 1 return on the cost of the study. If the value of the unit(s) is under $100k each, then you would need to have two or more units in the same location to make sense and assure the 2 to 1 or better return.

      This was good for me to understand. I had always assumed that more units would be needed to make this work, but apparently not. I hope this helps.

  5. Cindy Larsen

    Very interesting article. imhave a question about how dpereciation works with 1031. Assuming you successfully 1031 a depreciated property, how does that affect the new property you bought?

    For example, what if your property A (purchased for $400k with an $80k downpayment), had accumulated $150k of depreciation, and you did a 1031 exchange to buy property B? Assume the purchase price of property B was $500k, and you made a downpayment of $100$ (And for the purpose of this example, that was conveniently the exact amount of equity you had accumulated in property A)
    What would the tax basis of property B be, just after the 1031 exchange? $650k?

    What happens to the if you keep doing 1031 exchanges? A to B, then B to C, then C to D&E?
    Does the growing depreciation just keep carying over? It seems that, with accelerated depreciation, and retroactive depreciation, the depreciation can grow to be worth more than the property you are buying.
    Itbseems that once you start doing 1031 exchanges, you become highly motivated to continue doing them until you pass the properties to your heirs, since the alternative would be to take all of the accumulated depreciation as income in the year you sell the property, at a high marginal tax rate.

    I understand the time value of money, and that people have said that depreciation is essentially a zero interest loan from the IRS of the tax you would have to pay each year on the depreciation amount. Seems like a good idea, until you consider that by avoiding paying 28% tax on the depreciation amount every year, you may eventually end up paying 39% tax on all those yearly amounts added up., in thenyear you sell the property. Unfortunately, if you don’t take depreciation on your tax return each year, you will still owe the tax on the amount of depreciation you could have taken, when you sell the property.

    1031 over and over again seems like the only way to avoid paying the highest marginal tax rate on your accumulted depreciation. BUt, as you said, 1031 is tricky to accomplish. Also, any funds from the sale of property A that you do not reinvest in property B, are taxable income in the year you sell property A, right? How does accumulated depreciation apply to money you do not reinvest when you do a 1031 exchange? If you only reinvest 75% of the equity, you would get taxed on the other 25%, right? Would you also have to recognize (and be taxed on) 25% of your accumulated depreciation at the time of that sale?

    I’m not sure I completely understand 1031 and depreciation. Any light you can shed on this would be helpful.

    Cindy

    • brendon woirhaye

      >> How does accumulated depreciation apply to money you do not reinvest when you do a 1031 exchange? If you only reinvest 75% of the equity, you would get taxed on the other 25%, right? Would you also have to recognize (and be taxed on) 25% of your accumulated depreciation at the time of that sale?

      You would pay taxes on the “depreciation recapture” and the capital gain, it would only be 25% if you had a zero cost basis in the property.

      eg: you depreciate and 1031 a few times and now have a $1,000,000 property with a cash basis of $200k (20%). You 1031 it to a $500k property and pocket $500k. Of that $500k you kept, 80% of it is gain (either capital gain or recaptured depreciation) and is taxable, $100k is just reallocation of your capital and not taxed.

      Caveat: I am not a tax professional so don’t quote me to the IRS

  6. Gianni Laverde

    Paul, Thanks for sharing! The article was very educational. This is definitely something I would highly consider when getting into large MF properties. From the comments, i didn’t even know cost segregation was possible on SF homes. I’ll keep that one in mind as well.

    Thanks
    Gianni

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