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If you have any background in real estate investment, you likely already recognize depreciation as a common and useful tool for reducing taxable income over the life of a property. Current IRS guidelines allow a residential property owner to deduct for depreciation over 27.5 years – aka the “useful life” of the property. For some investors, this so-called straight-line method makes the most financial sense. However, standard depreciation can be less advantageous for investors operating on a shorter time table or for those looking for more aggressive tax savings earlier in the lifecycle of a property. This is where a cost segregation study comes into play.
Simply put, cost segregation is an accounting method by which different real property assets – say the building, internal appliances, and external improvements to the building – are dumped into different depreciation schedules based on their usable lifespans. At the end of a successful cost segregation study, the property owner will have a table of various asset classes divided up based on how long the property is expected to last. The building itself may still depreciate over 27 years. But the fence outside can be expected to last for 15. That washing machine won’t last more than 10. And so-on. The percentage of assets that can be written off more quickly than the structure varies from property to property, but it’s not uncommon to see 20-40% of a property’s assets reclassified. By condensing the depreciation schedule on a chunk of a property’s total valuation, owners are able to report a much higher net loss on new properties within the first few years, increasing cash flow.
There’s another benefit worth mentioning. Recent tax law changes allow for an immediate 100% deduction of 5, 7, and 15-year property all in the first year of ownership. In the right scenario, a cost-segregation study can enable a property owner to report a large net-loss in the first year, deferring any tax liability upfront. Some losses may be carried forward to future years as well.
Let’s look at an example:
In Scenario A, a multi-family residence is purchased for $775k. Without cost segregation, the accumulated depreciation amount is roughly $92k after five years. In Scenario B, a study is performed and $232k of the property’s assets are reclassified as 10 year property. Now $543k of the property depreciates over the standard 27.5 years but $232k depreciates at 10 years. Given the same five-year period and original $775k valuation, the property owner is able to report $214k in depreciation instead of the original straight-line method’s $92k. Quite the difference!
“If cost segregation is this useful, why doesn’t everyone do it?” you may wonder. Well, a study requires an upfront cost ranging from $5,000-$15,000. An experienced team of accountants and engineers will need to survey the property and categorize assets based on what the tax code will allow. For many, it’s an absolutely worthwhile expense if the study will realize tens or hundreds of thousands in savings over the life the property. The cost-savings of these studies also tend to scale with property size. Larger multi-family properties and commercial buildings tend to benefit more from these studies, so a smaller property may simply not be able to recoup the upfront cost of a study from the negligible tax savings it’d receive.
Conducting a cost segregation study can be a powerful way to reduce taxes on your multi-family property, especially during the first few years of ownership. If you’re curious to learn more, RCN Capital please feel free to contact us today.