Real estate investing is one of the best ways to lower your tax bill. For tax purposes, the depreciation deduction allows investors to reduce the taxable income coming from properties they own, and they can do it without incurring a cash outlay. The IRS tax code assumes that the property will lose its value from normal “wear and tear,” which is what allows you to take this deduction. But any purchased real estate which is properly managed should increase in value over time through forced or market appreciation strategies.
This article will cover a key method, known as “cost segregation,” that can increase your depreciation deductions for your real estate investments – that is, if you use it the right way.
What is Cost Segregation?
The IRS typically allows for residential rental properties (such as multi-family homes) to be depreciated straight-line over 27.5 years. So, about 3.6% of the building cost can be taken as a deduction early on. However, the IRS realizes that the building is made up of parts (such as appliances, cabinets, and parking lots) that can depreciate at different rates. A cost segregation study breaks the building into these parts so they can be depreciated over 5, 7, or 15 years. This accelerates the amount of depreciation deductions compared to the straight-line approach.
The Tax Cuts and Jobs Act (TCJA) of 2017 allowed investors to take a bonus deduction of 100% of a 5,7, or 15 year property in the first year. Suppose that a property was bought for $1.25 million and that 20% of the purchase was land value. The depreciation basis of the building would be $1 million, because land doesn’t appreciate (in theory). With straight-line depreciation, the property owner would be allowed a depreciation deduction of approximately $36,000 for every year the property was owned.
With cost segregation, about 30% of the purchase price is allocated to a 5, 7, or 15 year property. Assuming that it has an equal cost basis in each of the 5, 7, or 15 year property classifications, the property owner would get a deduction of approximately $66,000 in the first year. This is twice as much as the straight-line method!
By using bonus depreciation, the entire cost basis of the 5, 7, or 15 year property and the remaining yearly straight-line depreciation can be deducted in the first year. This comes out to approximately $325,000 of depreciation in the first year, which is almost ten times more than the straight-line method!
How Does This Affect Passive Investors?
Most real estate is purchased through an LLC. Therefore, the income, expenses, and tax deductions go to the individual investors through a Schedule K1. The depreciation losses from cost segregation and bonus depreciation will flow through to investors based on their equity ownership.
Here are some key items that every passive investor should consider:
- 60-100% Year One Loss – If the sponsors do a cost segregation analysis, passive investors should expect to get a loss that’s 60-100% of their investment in the first year. This will be a potential loss of $60,000 – $100,000 on a $100,000 investment that can be used as a tax shelter.
- Depreciation Offsets Passive Income – Losses from real estate are generally considered passive losses that can only apply to passive income. If the investor is a qualified real estate professional, these losses might be able to offset any active income as well.
- Carry Forward – If losses can’t be used in the current year, they can be carried forward to help offset any future income.
The advantages of cost segregation and bonus depreciation may seem too good to be true, but everything being described is perfectly legal and in accordance with the IRS Code. Most of these benefits are accrued up front on acquisition. And upon disposition, there is a “recapture” of the previous tax benefits.
The IRS assumes that properties will decrease in value due to “wear and tear,” so it allows investors to take depreciation deductions. But because most real estate is purchased for investment purposes, it should increase in value when it’s sold. The IRS says that any benefits (i.e. tax losses) should be recaptured if a property is sold at a gain.
Many people believe that a recapture negates the benefits of cost segregation, but it’s not true. Here are some of the reasons why:
- Time Value of Money – This is based on the idea that a dollar today is worth more than what it will be tomorrow. Some of these properties may be kept for many years, so the tax savings and increased cash flow on the first day will outweigh any tax consequences you may experience in the future.
- Tax Rate Arbitrage – Depreciation losses will directly reduce taxable income at ordinary rates, which can be 35-40% for high-income earners. Recapture taxes are capped at a 20-25% tax rate, so there’s about a 10-15% tax rate arbitrage if you use this strategy.
- Continued Deferral Strategies – Certain strategies (such as purchasing a new property in the year of disposition or using a 1031 tax deferral exchange) will help you to defer the potential tax impact in the future.
If you invest in real estate and want more information about how you can minimize your tax liability, be sure to get in touch with Trevor Shakiba at Shakiba Capital.