This little-known tax strategy allows real estate investors to dramatically reduce their taxable income… even after receiving cashflow distributions all year!
This strategy supercharges your depreciation schedule and allows for massive write-offs against your income. It accelerates depreciation by breaking down and reclassifying certain interior and exterior components of a building. These components are then depreciated over a shorter “useful life” than the standard 39 years used for commercial properties.
This strategy is Cost Segregation.
Here’s a high-level example:
Say we have a hypothetical 30-unit apartment building valued at $3,000,000. Let’s also assume 20% is attributed to land (land can’t be depreciated) = $2,400,000 for the building’s value.
With the standard deduction:
$2,400,000 divided by 39 years = approx. $61,500 that can be written as a “loss” per year against the income.
Now let’s employ a cost-segregation strategy:
Generally, a cost segregation study will reclassify 25 to 50% of a building as personal property for depreciation purposes. Let’s assume that 30% of the building’s value is from items that include appliances, carpeting, furniture, etc – which have a useful life of 5 years according to the IRS: $2,400,000 x 30% = $720,000
$720,000 divided by 5 years = $144,000 that can be written as a “loss” per year against the income.
$61,500 < $144,000 by more than half!
Now this is only an example, BUT considering we only did 30% of the building’s value… imagine once ALL the interior/exterior items that can be reclassified are completed and added to this new depreciation schedule. Keep in mind, every item has a different “useful life” – not everything can be depreciated over 5 years, BUT you can already see the huge advantages of utilizing this strategy.
WARNING: You have to be very mindful of your business plan for the building:
- How long is the planned hold time?
- If you plan to sell in a few years, will there be enough equity gains from the repositioning efforts to still offer the same returns at sale once the depreciation is recaptured?
What!?! Depreciation recapture?
Yep. Every year that an item is depreciated, the value of that item (for tax purposes) is lowered by that same amount. That’s considered the item’s “adjusted cost basis.” Once you sell, you then pay taxes on what you previously wrote off.
So consider Cost Seg more like a Tax Deferral not a Tax Exemption… you’re not paying today, but you’ll pay it tomorrow (unless you know of some other strategies to defer the taxes indefinitely – wink wink).
But that may not be all bad. If you consider the time value of money, you get to use the tax savings of today, reinvest them into improving the building or acquiring more cash-flowing assets, and maximize your business growth until that future sale date.
Also, the tax rate you’re paying today may be less than the rate you’ll pay on the future recapture.
Although cost segregation can be very beneficial, it is important to be certain the advantages outweigh the disadvantages for your situation. As a passive investor, ask the deal sponsors if they have included cost segregation into their IRR projections and how not accounting for the recapture at sale could affect your returns.
Do you plan to invest in deals where Cost Seg is utilized? Do you think there are more Pros than Cons? Let’s talk about it!