It is no secret that Real Estate investing is one of the best ways to reduce taxes. This is in addition to the many other benefits including cash flow, appreciation, leverage, etc. For tax purposes, the depreciation deduction enables investors to reduce the taxable income of their properties. The beauty of depreciation is that you get a reduction in income without incurring a cash outlay! In essence, the IRS tax code assumes that property will lose its value due to the wear and tear and allows for this deduction. However, real estate purchased and managed correctly should increase in value over time via forced or market appreciation strategies.
In this article, we cover a key method, known as cost segregation, that if used appropriately, can amplify the depreciation deductions for real estate investments.
What is Cost Segregation?
Generally, the IRS allows for residential rental property, like multifamily, to be depreciated straight-line over 27.5 years. Therefore, about 3.6% of the building cost can be taken as a deduction yearly.
However, the IRS realizes that the building is made up of parts (appliances, cabinets, parking lot, etc.) that can depreciate at different rates. A cost segregation study breaks the building into these parts that can then be depreciated over 5, 7 or 15 years, which thereby accelerates the amount of depreciation deductions as compared to straight-line. These studies are prepared by a team of qualified professionals such as engineers and/or CPAs.
The Tax Cuts and Jobs Acts (TCJA) of 2017 enabled investors to take a bonus deduction of 100% of the 5, 7 and 15 year property in the first year! Let’s look at an example of how these tax deductions would look under the various scenarios:
Suppose a property was bought for $1.25M and assume 20% of the purchase was land value, then the depreciable basis of the building would be $1M (since land does not depreciate).
Straight Line Depreciation
The property owner would get a depreciation deduction of ~$36K each year the property was owned.
Utilizing Cost Segregation
In general, ~30% of the purchase price is allocated to 5, 7 or 15 year property. For example sake, we’ll assume that this property has an equal cost basis in each of the 5, 7 and 15 year property classification. In this scenario, the property owner would get a ~$66K deduction in year 1, which is nearly double of the straight-line method!
Utilizing Cost Segregation with Bonus Depreciation
By using bonus depreciation, the entire cost basis of the 5, 7 and 15 year property plus the remaining yearly straight-line depreciation, can be deducted in year 1. In this example, that equates to a ~$325K depreciation in year 1, which is nearly 10X of the straight-line method!
The advantages of cost segregation should be obvious and it should be clear how these numbers can grow as the size of the property increases!
How Does This Impact Passive Investors?
Most real estate is purchased via LLC’s and as such, the income, expenses and tax deductions flow through to the individual investors via a Schedule K1. As such, the depreciation losses via cost segregation and bonus depreciation will flow through to investors based on their equity ownership. Below are a few key items that passive investors should consider:
- 60-100% Year 1 Loss – Generally, passive investors should expect to receive a loss equal to 60-100% of their investment in year 1 if the sponsors conduct cost segregation and utilize bonus depreciation. To put that into perspective, that is a potential $60-100K loss on a $100K investment that can be used as a tax shelter.
- Depreciation Offsets Passive Income – Generally, losses from real estate are considered passive losses that can only apply to passive income. If the investor qualifies as a real estate professional, the losses may be able to offset all active income as well.
- Carry Forward – If losses cannot be used in the current year, they can be carried forward to help offset future income.
The benefits of cost segregation and bonus depreciation may seem too good to be true but all of what we have described above is legal and per the IRS code. Most of these benefits are accrued upfront on acquisition and upon disposition there is a “recapture” of the previous tax benefits. As we stated previously, the IRS assumes that property will decrease in value due to wear and tear and hence allows for the depreciation deductions. However, most real estate is purchased as investment and if managed properly, it should increase in value when sold. As such, the IRS code states that any benefits (i.e. tax losses) should be recaptured if a property is sold at a gain. Many people may argue that recapture negates the benefits of cost segregation but that is not true due to the following:
- Time Value of Money – This is a basic finance concept in that a dollar today is worth more than a dollar tomorrow. Some of these properties may be held for many years and the tax savings and increased cash flow on day 1 outweigh future tax consequences.
- Tax Rate Arbitrage – Depreciation losses directly reduce taxable income at ordinary income tax rates that can be 35-40% for high income earners. Recapture taxes are capped at 20-25% tax rate and hence, there is a ~10-15% tax rate arbitrage by utilizing this strategy.
- Continued Deferral Strategies – Strategies such as purchasing a new property in the year of disposition or utilizing a 1031 tax deferred exchange will help defer the potential tax impact to the future.
It should be evident that utilizing these strategies can significantly help investors reduce their tax burdens. At our company, we conduct cost segregation studies immediately upon acquisition and take 100% bonus depreciation and have the losses flow to each of our passive investors. If you are looking for ways to reduce your taxes then cost segregation and bonus depreciation are by far one of the best (legal) ways to do so! Please make sure to talk to your tax professional on your particular situation before making any investment decisions.