In last week’s podcast with Yonah Weiss, we discussed a concept called cost segregation. I also discuss this concept in Chapter 6 of my book and is one of the reasons that I call multifamily real estate the “Holy Grail”. So what is cost segregation and why would you want to utilize this tool?

A cost segregation study can help a property owner decrease today’s tax burden by accelerating depreciation. Business owners are familiar with this concept through Section 179 of the tax code. Section 179 allows businesses to deduct the full purchase price of qualifying equipment purchased during the tax year. You can deduct the FULL PURCHASE PRICE from your gross income. The government does this to incentive businesses to invest in areas that will help them and the economy grow. We have similar benefits in real estate.

Under current tax law, an apartment building (not the land) will depreciate over 27.5 years. Commercial and industrial properties depreciate on a 39 year schedule. So for instance, if you own a home or apartment building that you purchased for $300,000 and the land is worth $25,000 your annual depreciation would be:

$300,000 – $25,000 = $275,000/27.5 = $10,000

Not bad right? So if you own a rental property with the above values and your net operating income is $10,000 annually, you can offset this with the depreciation which means your tax is ZERO! If you own a single-family rental this is about all that you can do and, unfortunately, if you are a high-income earner you can’t take all of the advantages of this depreciation. However, a lot of properties (especially multifamily properties) have other property aside from the building that depreciates much faster than the structure itself. Things like carpet, cabinets, appliances and even landscaping. The IRS clearly states that you don’t have to wait 27.5 years to take the tax deduction on these items.

Modified Accelerated Cost Recovery System (MACRS) allows you to depreciate property on a 5, 7 or 15 year basis. These 4 categories are:

1. Personal property: furniture and fixtures, carpeting and window treatments are depreciated over a 5 or 7 year life.

2. Land improvements: sidewalks, paving and landscaping are depreciated over a 15 year life.

3. Buildings: as discussed earlier this is on a 27.5 or 39 year schedule

4. Land

A Cost Segregation Analysis utilizes a specialized consultant made up of accountants and engineers that will identify each of these components in a property and allocate them into one of the above categories. They are then reclassified from the 27.5 or 39 years schedule to generate additional depreciation deductions earlier in the hold period. This means that you can shelter significantly more income, earlier.

A Bonus . . . 

The Tax Cuts and Jobs Act was the most significant set of changes to the U.S. tax code in decades. Passed in 2017 and taking effect in 2018 it had not only significant changes to personal taxes, but also businesses and real estate taxes. The one that we are going to discuss is the expansion of “Bonus Depreciation”. This new change allows rental property owners to deduct the entire cost of in the first year! Qualified property must be acquired and placed in service after September 27, 2017 and before Jan. 1, 2023.

What does all of the above mean? If you purchase (or invest in) a property, you may be able to take significantly more depreciation than before to offset qualifying income the year that you buy (or invest in) the property!

Of course, the IRS doesn’t do “free lunches”, so when you sell the property it dictates that you will need to “recapture” the depreciation. Because the IRS allows you to deduct this depreciation, you must report the gain upon disposal of the asset as ordinary income. This is a key component that you want to discuss with your CPA. This is one of the reasons that we favor and employ the 1031 exchange strategy to defer taxes into the future. You can read more about this and the Next-Level Income Strategy in my book. Get a free copy here.