As real estate investors, we keep an eye on equity appreciation (how our money grows) and the cash flow (profit after collecting income, paying operating expenses, and setting aside cash reserves). Another aspect of investment that should be on our radar because it affects our bottom line is depreciation and the tax savings it gives. One strategy used to maximize tax savings is cost segregation.
Depreciation and Cost Segregation
In real estate, depreciation is a tax deduction from the value of the rental property over time. Residential properties, including multifamily rentals, are depreciated over 27.5 years. So, from the day the property is bought, a percentage will be taken off every year with taxes paid over 27.5 years. The most common way to determine how much depreciation is deducted each year is to use the straight-line method where the cost of the whole property, minus its salvage value, is divided over its useful life of 27.5 years.
Now, you may ask, “If depreciation of property value means lower taxes and more money saved, can depreciation be fast-tracked so expenses can be written off faster and save me more money?”
“Yes. Cost segregation or accelerated depreciation is the key,” says Yonah Weiss, a cost segregation expert with Madison SPECS.
How Cost Segregation Reduces Taxes
Cost segregation allows property owners to separate the components of the property to identify items that depreciate on schedules different from the IRS-prescribed 27.5 years for the whole property.
For example, items in the property that are not essentially part of the physical structure such as appliances, shelving, flooring, special purpose-wiring, and special purpose-plumbing have depreciation lives of 5 years. Land improvements such as fencing, pavement, landscaping, parking space, walkway, or driveway depreciate over 15 years.
Breaking down the property into these tiny details and then taking the value of these smaller items that depreciate over a faster life allows the property owner to reduce tax obligations and enjoy more tax benefits in the early years of ownership.
Tax Savings from Cost Segregation
Multifamily properties can save between 10%-30% of tax value when cost segregated says Yonah Weiss of the often-overlooked tax benefit. A cost segregation study on a $1million property could result in a $40k annual deduction over 5 years or $200,000 in total savings.
DIY Cost Segregation vs. Hiring a Firm
Anyone may be able to do a basic cost segregation study but doing it right is the issue. A study involves a detailed engineering approach and an Internal Revenue Service-approved process for reclassifying real estate components. Hence, a reputable cost segregation firm is the best bet for a thorough and successful study.
Weiss advises that most cost segregation firms will do a feasibility analysis for free to help clients do a cost-benefit analysis (potential tax deduction vs. cost segregation study cost) and make an educated decision.
Cost Segregation Firms Fees
Weiss says that firms doing cost segregation studies typically charge based on the scope of work. Costs are upwards of $5,000 regardless of how much tax deduction the client obtains. He warns property owners of some firms that take a contingency fee or a certain percentage of the client’s tax benefit which is not according to IRS guidelines.
Not for All
Weiss says that cost segregation is not for every property owner, adding that it is ideal for properties valued at $1 million and above. It is advised against rental properties that are vacant or not earning, with high CapEx expenditure because it would not make sense to get a tax deduction with no income stream. However, cost segregation can be done retroactively allowing companies that become profitable in the future to submit to the process if they choose to.
Right Timing for Cost Segregation
Ideally, firms should be contracted immediately upon purchase of a property for maximum tax deduction benefit during the first year of ownership. Under Section 179 deduction, business owners may take a bonus depreciation of 100% for qualified assets in the first year rather than depreciating the assets over a longer period. Again, cost segregation can be done retroactively for other properties.
Are you considering cost segregation for tax purposes? Consult with your accountant to determine if it would be worthwhile. Partner only with a reputable firm and qualified professionals who work in accordance with the IRS standards and audit techniques.
Reach out to us if you’d like to learn more about passive investing in multifamily real estate. Our team will be glad to assist you with any questions you have about deals you’re considering. Please email us at [email protected] or call to see if LifeBridge Capital’s investments are a fit for you.