Shorten depreciation schedules using cost segregation to save on your next tax bill
The number one rule of investing has always been, “don’t lose money!” We hear it on TV, in discussions with colleagues and clients and in the news, but what about rules 2, 3, 4 …?
Well, for real estate investors, rule #2 has always been to pay as little income tax as possible. There are a few ways to do this with some being more effective than others, however, one significant tax benefit of real estate investing is depreciation. In this post, I’ll share some tips on how you can optimize your depreciation expenses to minimize your tax bill by leveraging the magic of cost segregation.
What is depreciation?
Depreciation is the gradual decline in an asset’s value over time. You may ask, “Wait, I thought real estate values always go up?” While real estate values have trended higher over time, assets tend to have a finite life where the value of the asset eventually reaches zero when the asset’s useful life has expired. To put this another way, if we look at an asset such as a hot water heater, car, lawn mower, snow blower, etc., each asset has a finite life where at some point, they are expected to stop working and will need to be replaced. A hot water heater might have a 12–15 year life while a car’s expected life might be 30+ years. Each asset has a different expected life and deprecation is how we recognize and calculate this gradual decline in value over time.
Depreciation is an annual non-cash expense meaning there is no real cash out flow, it’s just an expense recognized on the property’s tax return. Unlike expenses for property management, insurance, repairs, and maintenance, utilities, etc., investors don’t mind a high depreciation expense as there’s no actual cash expenses, however, it increases total expenses, decreases taxable income, decreases the tax payment, and increases a property’s after tax cash flow.
Higher deprecation -> higher total expenses -> lower taxable income -> lower taxes paid -> higher after tax cash flow.
How can you optimize depreciation?
For as long as real estate investors have been paying taxes (well at least those that show taxable income), depreciation expense has been a crucial part of an investor’s tax returns. Most investors depreciate an asset over a set period of time, recognizing the same annual expense year after year.
However, what if you could shorten the schedule over which your real estate asset depreciates and recognize a larger annual depreciate expense? You can by leveraging cost segregation!
What is cost segregation?
Cost segregation is the process by which components of a real estate property (carpeting, cabinets, HVAC equipment, parking lot, paint, appliances, plumbing, light fixtures, electrical improvements, roof, etc.) are separated and re-classified from real property to separate tangible personal property in order to allow these reclassified assets to be depreciated over a shorter time period (accelerated depreciation), thus increasing the annual non-cash depreciation expense in the early years of ownership. Why is this important? Well, as we mentioned earlier, real estate investors love depreciation as it reduces taxable income, so anytime there’s an opportunity to increase this non-cash expense and reduce taxable income, investors perk up.
Real estate investors typically use depreciation to offset taxable income by depreciating an asset over 27.5 years for residential/multifamily properties and 39 years for commercial properties. Investors cannot depreciate land so they simply take the value of the entire property, subtract the land value, and the value that’s left is the amount that can be deprecated over 27.5 or 39 years.
A simple calculation for a commercial property would be $10,000,000 (total value) — $2,000,000 (land value) = $8,000,000. Then we take the $8,000,000 / 39 years (for commercial)= $205,128.21 annual depreciation expense.
This means that every year the property is owned, there is a non-cash depreciation expense of $205,128.21 that is used to reduce taxable income.
So, what’s the cost segregation process?
First, the investor will contract with a cost segregation services company that will conduct research, analysis and site inspections on the subject property. They’ll determine which assets can be reclassified and issue their findings in a detailed analysis report. This report will detail which assets can be reclassified from real property to personal property and over what time period they can be depreciated (typically 5, 7 or 15 years). By depreciating an asset over a shorter period of time, you are increasing the annual expense.
Here’s an example:
$8,000,000 / 39 years = $205,128.21 annual depreciation expense
$8,000,000 / 27.5 years = $290,909,09
$8,000,000 / 15 years = $533,333.33
$8,000,000 / 7 years = $1,142,857.14
$8,000,000 / 5 years = $1,600,000.00
As we can see, as we decrease the years over which an asset is depreciated (lowering the denominator), we increase the annual deprecation expense.
Don’t Miss Out On Bonus Depreciation
Bonus depreciation takes this process one step further by allowing the investor to deduct a specified percentage (up to 100% in 2022) of depreciation in the year the qualifying personal property is placed in service. In order to qualify for bonus depreciation, the original use of the subject personal property must begin with the investor and the property must meet one of the following criteria: (1) MACRS (Modified Accelerated Cost Recovery System) property with a recovery period of 20 years or less, (2) depreciable computer software, (3) water utility property or (4) qualified leasehold improvement property.
So, when should an investor inquire about cost segregation?
As an investor, you stand to benefit the most if you start the cost segregation within the same year of purchase or soon after. The longer an investor owns the property, the more the asset has already depreciated and the less bang for their buck they’ll get with accelerated (or bonus) deprecation.
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