Successful investors are always looking for ways to lower their tax liability. One of the most impactful ways to reduce taxable income is by owning rental properties directly or by investing passively in real estate syndications. If you go the passive route, in most cases the sponsor will utilize a cost segregation study to maximize and accelerate depreciation. This offers the investor a unique tool to consider in their tax planning strategy. In this post, I will discuss how cost segregation works and how it can affect your personal finances.
Commercial buildings qualify for straight-line depreciation over a 39-year timeline, while residential real estate depreciates over 27.5 years. By using cost segregation, operators are able to accelerate, or pull forward, future deductions over a much shorter time period. Cost segregation aims to divide up the entire property into sub-components and then reclassify those components as real property, personal property, or land improvements. This breaks the individual components of the property down to their respective, estimated serviceable life, which may be 5, 7, 15, or 27.5/39 years. A roof, for example, will typically last for 30 years or so, while carpet may only be in service for 5-7 years before it needs to be replaced.
Furthermore, the Tax Cuts and Jobs Act of 2017 allows for properties placed into service between 2018 and 2022 to qualify for 100% bonus depreciation on 5-, 7- and 15-year replacement items, at which point it will be phased out through 2026. This allows for potentially large depreciation write-offs in the tax year that the property was placed into service (purchased)! In the case of direct real estate investments, this could be a tactic used to free-up cash flow for improvements to the property. For the passive investor, it produces an outsized paper loss that can be used to offset distributions and any other qualifying investment gains made in the tax year. If you offset your passive gains with the paper losses generated from the depreciation and still have some left over, they will carry forward to the subsequent years until they are completely used.
So what does this mean for you as the passive investor? The impact is best illustrated in a stripped-down example. Let’s look at a commercial property with a cost basis of $20 million. Let’s say the land is worth $1 million, which is not depreciable. Using straight line depreciation, the syndicator would be able to deduct $487,179 ($19 million/39 years) off the net operating income that the property earned. This deduction will get passed through to the individual, passive investor, who owns a 0.5% stake in this deal. For the purposes of the investor’s tax return, the investment in this property results in an allowable deduction of $2,436 (0.5% of $487,179).
Now let’s look at how a cost segregation study would impact this same scenario. Using this tool, the study will reclassify things like appliances, carpet, window treatments, etc. into 5 year items. Other items would fall into categories of 15 years, like sidewalks, parking lot, exterior signage, etc. The remaining building structure would remain at 39 years. Let’s say the cost seg study reveals that 21% of the $19 million can be classified as 5- or 15-year items and 100% of those items can be written-off in year-one through bonus depreciation.
The depreciation write-off expense for the property increased to $3,862,559 in year one! The passive investor who has a 0.5% stake in the asset now has a pass-through paper loss of $19,313, which is eight times more than the straight-line depreciation deduction of $2,436. If that limited partner has a combined federal/state tax rate of 35%, that would result in $6,759 going back into the investor’s pocket.
I would be remiss to not mention that these dollars “saved” are not a gift from the IRS. The taxes are deferred until the asset is sold, at which point depreciation is “recaptured.” There is no free lunch! The time value of money proves that a dollar today is better than a dollar tomorrow, however. This concept draws parallels to how a 401K or IRA maximizes growth by deferring taxes on capital gains until money is withdrawn. Accelerating depreciation puts more money in your pocket on the front-end, allowing you as the investor more capital for other investments to earn additional returns. When your capital is returned to you by the syndicator at the time of sale, there will potentially be a large tax liability due April 15th. A simple way to continue this tax deferral is to roll your proceeds from the original investment into another syndication that plans to use cost segregation as part of their business plan. Most do, but be sure to ask during your due diligence. If they do, the new cost segregation study will help offset the depreciation recapture from the original investment. Rinse and repeat.
Cost segregation studies and bonus depreciation can have a massive effect on the amount of taxes you pay. Even if you are not expecting a tax year with significant passive gains, the benefits of cost segregation studies can be immense in the right circumstances because passive losses carry forward indefinitely. Many investors aren’t aware that cost segregation is not limited to just commercial buildings. You can use cost segregation on a portfolio of single-family homes as well. Whatever your situation is, don’t let the tail wag the dog when it comes to considering investments. Tax planning is important, but it has to be a good deal that fits your risk tolerance above all else. However, if you do have gains to offset, consider passive syndications as a route to shelter tax liability, especially now, with the new administration taking office at the time of this writing. These super-charged tax advantages may not be here for long!
Paul Shannon is a full-time active real estate investor, as well as a limited partner in a number of syndications. Prior to leaving the corporate world, Paul worked for a medical device company, selling capital equipment to surgeons in the operating room. After completing a few rehabs employing the “BRRRR method”, he saw scalability and more control over how he spent his time, and left to pursue real estate in 2019. Since then, Paul has completed over a dozen rehabs on both single-family and multifamily properties. He currently owns over 50 units in Indianapolis and Evansville, IN and is a limited partner in larger apartments and industrial properties across the US. You can connect with him at www.redhawkinvesting.com
Nothing on this website should be considered financial advice. Investing involves risks which you assume. It is your duty to do your own due diligence. Read all documents and agreements before signing or investing in anything. It is your duty to consult with your own legal, financial and tax advisors regarding any investment.