During tax season, every penny counts. The reality is that anyone can use our tax system to their benefit. That’s why utilizing a cost segregation study might just be the tax strategy that boosts your wealth while reducing your tax burden to Uncle Sam. In this article, we uncover the tax “secret”- cost segregation, used by real estate investors to minimize taxes on their rental real estate income.
What is Cost Segregation?
Cost segregation is a tax deferral tactic that allows real estate owners and investors to employ accelerated depreciation. This strategy aims to bolster cash flow and diminish the federal and state income taxes on their rental income.
The typical useful life for a Multifamily property is 27.5 years. That means that if no cost segregation study is performed, the asset is projected to depreciate over 27.5 years. Although depreciation offers benefits, the annual tax deduction it provides is relatively modest. When a cost segregation study is conducted, the building is further divided into Personal Property and Land Improvements categories which can be depreciated at accelerated rates.
Examples of Itemized Property
- 5-Year Assets: carpet tile, counters, break room sinks, cabinetry and decorative moldings, specialty lighting, dedicated outlets, fire extinguishers and more
- 7-Year Assets: office furniture
- 15-Year Assets: land improvements like drainage pipes, parking lots, landscaping, outdoor swimming pools, protective bollards, sidewalks, and more
Why Use Cost Segregation
Typically, $1M of reclassified assets identified through a cost segregation study can yield approximately $200,000 in after-tax cash savings across various property types. This significant savings is a primary factor motivating investors to utilize cost segregation. And though the cost of the cost segregation report varies per company the typical return on investment is above 10 to 1. The best time to implement this study is for individuals who have recently undertaken construction, acquisition, or renovation projects for a property. The ultimate goal is to maximize which aspects of the property are eligible for bonus depreciation.
Benefits of Cost Segregation
Enhanced Cash Flow:
With the opportunity to defer tax liability and “kick the can down the road”, investors can take advantage of those savings by immediately deploying them into another investment opportunity to make even more money.
Time Value of Money:
By allowing the Multifamily real estate property to deduct a substantial portion of eligible asset costs in the year of service, bonus depreciation accelerates the timeframe for businesses to recoup their investment for that asset. This acceleration can lead to increased revenue and profits for the property, which can then be reinvested in the business or allocated to debt reduction such as the mortgage.
Lower Tax Burden:
A cost segregation study determines the amount of bonus depreciation a property can claim, thereby providing investors with additional passive losses to offset their passive income. The accelerated depreciation creates one of the most lucrative benefits of the cost segregation study.
Bonus Depreciation
By reclassifying assets from longer to shorter tax recovery periods, through a cost segregation study, these assets become eligible for bonus depreciation, leading to even more significant tax savings, particularly those with 100% bonus depreciation. The 2017 Tax Cuts and Jobs Act enables 100% bonus depreciation on qualified property acquired and placed into service after Sept. 27, 2017, and before Jan. 1, 2023.
Although investors and sponsors acquiring properties after January 2023 face a gradual reduction, there’s still a silver lining. The program follows a 20% step-down schedule yearly until its full sunset. However, there’s optimism, with a current Senate bill aiming to reinstate 100% bonus depreciation through January 2026. This provision enables investors who acquired a multifamily investment property between January 2nd, 2023, and the date of reinstatement to access depreciation credits for their next K1 when filing taxes.
How Cost Segregation Accelerates Bonus Depreciation
The Power of Bonus Depreciation
Each property has straight-line depreciation upon acquisition. This calculation involves subtracting the land value from the property value and dividing by 27.5 to determine the annual depreciation amount. When a sponsor opts for a cost segregation analysis, it significantly enhances the value for investors. This enhancement isn’t just due to increased passive losses but provides the opportunity to grow their money tax-free over time.
For instance, consider a $100,000 investment in our latest acquisition, Dawson Forest. Initially, $65,000 was earmarked for depreciation in year one. However, upon completion of the cost segregation analysis, investors gained access to up to $80,000 in passive losses for the same period.
The Art of Compounding
Bonus depreciation provides investors with a remarkable benefit by allowing their wealth to grow tax-free over time. This strategy works by offsetting income and deferring tax liability, often termed as “kicking the can down the road.” Savvy investors leverage this strategy to compound their savings and reinvest them into new opportunities. Thereby perpetuating the cycle of wealth creation. By continuously reinvesting and compounding their savings, they can leave a legacy of generational wealth for their family, mitigating tax liabilities and securing their financial future.
Step-up In Cost Basis
When an investor passes away, their heirs are entitled to a step-up in the property’s cost basis, which is adjusted to match its fair market value at the time of death or an alternate valuation date six months after death. This step-up allows heirs the opportunity to sell the property without facing depreciation recapture or capital gain income tax obligations.
Example
For instance, suppose a father purchased real property for $150,000 (his original cost basis). At his death, the property’s fair market value was $650,000. Upon inheriting the property, the daughter receives a step-up in cost basis to $650,000, reflecting the fair market value on the date of the father’s death. Consequently, the $500,000 capital gain accrued during the father’s ownership is not subject to capital gain income taxes. If the daughter were to sell the property immediately for $650,000, no capital gain income taxes would be owed. Subsequently, if the daughter sold the property later for $1,000,000, capital gain income taxes would only apply to the $350,000 gain.
It’s essential to understand that because the fair market value of the property is considered part of the father’s estate, it might be subject to federal and state estate (inheritance) taxes. As a result, investors should consult with an estate planning specialist to devise effective strategies for minimizing potential estate taxes.
Conclusion
Cost segregation is a powerful strategy that offers remarkable benefits for investors seeking to enhance their wealth. Experienced Multifamily real estate sponsors leverage this tool to reduce the tax burden during property acquisitions. The profound impact of a cost segregation study provides the investment deal with a competitive edge in the market.
