How Commercial Real Estate Investors Minimize Taxes Through a Cost Segregation Study
Depreciation Schedules. IRS codes. Accounting. Paperwork.
The very thought of these concepts is enough to put me to sleep at my desk.
Well, they 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 not for the IRS codes and schedules and such. But for the surprising power unlocked in this concept. I will never view taxes the same again!
Note that I am not a tax professional (and I don’t even play one on TV).
Accelerated depreciation through means of cost segregation may not be familiar to you, but if you partner with a syndicator/sponsor who utilizes it, your tax savings should be significant.
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.
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.
Depreciation: The Basis for Cost Segregation
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.
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: www.irs.gov/publications/p946/ch04.html#en_US_2013_publink1000107554
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 read this.
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, aka cost segregation.
The IRS audit guide for Cost Segregation may actually be slightly more interesting than the last link on basic depreciation: https://www.irs.gov/pub/irs-pdf/p5653.pdf
Here’s how it works in summary. 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 can be depreciated much sooner.
These may include kitchen cabinets, appliances, plumbing fixtures, shelving and carpet. All of these can probably be depreciated on a 5-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 be 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% 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.
A Cost Segregation Example
Let’s say you’re part of a syndication that purchases a 150-unit multifamily asset for $6,060,000. The land is valued at $1,210,000 leaving a depreciable basis of $4,850,000 for the buildings.
Without cost segregation, the owners will depreciate the buildings on a straight line basis for 39 years. This comes out to $4,850,000 ÷ 39 = $124,359 that can be depreciated for the syndication group annually.
At a 36% tax rate, this results in first year (and every year) deductions of $44,769. Straight line deductions through the holding period.
With a cost segregation study in place, in this example, owners (that includes all investors) will be able to depreciate almost 43% of the $4,850,000 in an accelerated manner. In 5-year, 7-year, and 15-year buckets.
This means that depreciation is accelerated for about $2,080,000 of the total. This results in accelerated depreciation of $1,773,430 in the first five years, compared to straight line deprecation of $621,795 (5 * $124,359) without cost segregation.
At a tax rate of 36%, the accumulated tax savings over the first five years is $638,435 in total. Over $375,000 more than the savings from straight line deprecation alone.
To boil it down to an investor level: If the entity had raised about $2 Million in equity, and you had invested about 10% (about $200k), your total tax reduction should be about $12,769 annually, or $63,843 total in the first five years (10% of total pie). This compares to only $37,500 in tax reduction from straight line depreciation.
This total tax reduction should zero out your taxes for a cash-on-cash return of over 6% annually, which is fairly typical for an investment of this type. (This does not include appreciation and principal pay down, which often lead to total annual returns in the teens.)
Objections to Cost Segregation
If you’ve been in America over a few hours, 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 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 $1.00 and double it daily tax-free for 20 days it’s worth $1,048,576. Take that same $1.00, taxed every day at 30% (before doubling), 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.
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. 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 consider that…
You can get in on this by passively investing with a commercial real estate syndicator.
Investors who passively invest with a 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.
If you would like to discuss the possibility of investing in commercial real estate, please set up an appointment to talk soon. You can book an appointment with us here. Or call us now at 1-800-844-2188.
Real estate investments and securities offerings are speculative and involve substantial risks. Please do your own research, draw your own conclusions, and seek professional advice. The information contained in this article is for informational purposes only and is not intended to provide investment advice. Investors should consult their own tax, legal and accounting advisors before engaging in any transaction.