Cost Segregation Allows Multifamily Investors To Significantly Reduce Their Federal Tax Liability
When it comes to investing in multifamily properties, investors generally want to take every reasonable measure to increase their returns. One of the most effective ways to do this is to reduce their income tax liability via cost segregation, which massively speeds up the rate at which investors can claim tax deductions. Generally, multifamily real estate has an IRS depreciation period of 27.5 years, while other commercial real estate has a depreciation period of 39 years. However, cost segregation allows investors to take their deductions over 5, 7, or 15-year periods, greatly increasing their cash flow.
For example, if an apartment building worth $1 million was being depreciated over 27.5 years, an investor would be able to take a depreciation deduction of around $36,300 per year. If that depreciation was taken over a 7-year period, the investor would be able to take a staggering $142,000 annual depreciation deduction. While it’s unlikely that an entire building would be re-classified as a 7-year depreciating asset, even $100,000- $200,000 of accelerated deductions can lead to thousands a year in tax savings. However, in order to take these depreciation deductions over an accelerated time period, building owners must order a cost segregation study.
How Cost Segregation Studies Actually Work
Cost segregation studies are typically done by engineering firms, rather than by accounting firms, as they involves a physical inspection of a property and a re-classification of various physical aspects of the building or buildings. Keep in mind, depreciation deductions only count the value of the building, not the land. In the thinking of the IRS, certain parts of a building deteriorate faster than others, so owners should be able to take these deductions at an accelerated rate.
Cost segregation studies can also be performed retroactively on properties acquired, remodeled, or expanded since 1987. This provides an incredible opportunity for property owners to reduce their income taxes, as they can take the entire unrecognized depreciation deduction in the year of the cost segregation study, instead of waiting to take the depreciation over the 5, 7, or 15-year depreciation term of the asset. This is often referred to as a “look-back” study. In general, cost segregation studies are considered to be cost effective for buildings worth $750,000 or more; otherwise, the time and expensive of the study may not be worth the potential tax deductions.
IRS Standards for Cost Segregation Studies
The IRS has limited standards for cost segregation studies, but it does define a quality cost segregation study as possessing the following characteristics:
1. Sorts relevant assets into property classes, including land, buildings, equipment, etc.
2. Justifies/rationalizes why each asset has been sorted into a particular class.
3. States and explains the cost basis for every asset, while reconciling total allocated costs with total actual costs.
This limited amount of detail allows for a wide variation in the ways that a cost segregation study can be conducted; however, it’s generally a good idea for investors to ensure they hire a qualified and experienced firm. This reduces the chance that the IRS will find any issues with the study; and, if questions are raised, the firm will be able to answer them honestly and effectively.
Cost Segregation, Investment Holding Periods, and Depreciation Recapture
Fortunately for multifamily investors, who often hold a building for 5-10 years or less before selling it at a profit, accelerated depreciation can often exactly match the holding period of their investment. This increase in cash flow is especially important in the early years of an investment if the owner is making improvements that may not immediately result in increased rental income.
However, just because an investor can take advantage of depreciation deductions does not mean that are getting a free ride. In order to make things a bit fairer for the government, the IRS counts any capital gains that are made from the sale of a depreciated property as personal income, which must be taxed at the taxpayer’s ordinary income tax rate.
For example, a taxpayer currently in the 35% tax bracket would need to pay 35% on their gain from the sale of a depreciated property, instead of the 15% capital gains tax rate they would ordinarily pay. This is referred to as depreciation recapture. In practice, depreciation recapture can often be significantly more complex than this, but suffice it to say, the IRS will tax you additionally for the right to accelerate depreciation.
Despite the cost of depreciation recapture, cost segregation is still incredibly profitable for investors, due to the time value of money. Time value of money, or TVM, states that a dollar today is more valuable than a dollar tomorrow-- as money in an investor’s pocket now is money they can use to invest in property or other income-generating investments, even if they do have to pay back the IRS at a later date.
Cost Segregation Depreciation Bonuses and the Tax Cuts and Jobs Act of 2017
Starting in 2001, property owners were allowed to take a depreciation deduction for a certain portion of an eligible asset in the year they acquired it. Referred to as a “depreciation bonus”, this was generally limited to new property and other assets with shorter (less than 20-year) lifespans. It permitted taxpayers to take approximately 50% of the eligible asset in the year it was purchased. However, the Tax Cuts and Jobs Act of 2017 increased this amount to 100% of eligible assets, and extended the depreciation bonus to used property. However, it’s important to realize that this only applies to assets acquired after Sept. 27, 2017
For example, if a taxpayer purchased an apartment building in 2019 for $2 million, and a cost segregation study classified $150,000 as 5-year personal property, the taxpayer could deduct $150,000 in that year. At a 35% tax rate, this would lead to a $52,500 in the taxpayers federal income tax liability.
Even without the additional depreciation bonus, cost segregation is an incredibly effective way to reduce investor tax liability, and multifamily investors serious about maximizing their returns should make every effort to utilize it.