The first thought that crosses your mind while you plan for any investment is the return on the investment. If it is real estate investment, the other most important concern is tax liability. If you are a multifamily investor, owner or syndicator, it becomes imperative that you work on the enhanced profitability of the unit i.e., reduced or eliminated tax liability, increased rental income (if you are holding the property) and rate of appreciation.
Multifamily investors can get the rental income while they hold the property and can get the appreciated value as a profit at the time of selling. However, at the same time, investors can also use the cost segregation study as a tool to decrease their tax liabilities, which can help them increase the return on their investment significantly.
What is cost segregation?
Cost segregation is a process of segregating the tangible assets of any real estate unit. The process involves analysing various components of the building and categorizing them under different heads in order to know the depreciated value of each component as per the class life. However, this does not count in the land of the apartment.
Class life refers to the life of the asset or a part of the building taken under a class for sorting purpose.
Tax laws
As per laws, assets can be categorized into two primary classes: Sec. 1250 real property and Sec. 1245 personal property. By following specific guidelines in the tax law, it’s possible to divide property even further within these two categories. This can be achieved by identifying personal property that falls under either five-year or seven-year depreciation schedules, land improvements with a 15-year schedule, and residential and non-residential real property with depreciation schedules of 27.5 years and 39 years, respectively.
Engineers account in detailed physical inspection of the property along with all the assets placed in the property, which can be identified and categorised as personal property or real property. Each aspect such as purchase price and class of each component is analysed. All tangible assets have life and get outdated and degraded with time. Effective cost segregation calculation enables the investor to record the depreciation of the property as a noncash expense.
Investors can opt for a shorter depreciation period like 5 years or 7 years, depending on the number of years they hold the property instead of standard 27.5 years for residential and 39 years for non-residential property.
The amount determined as depreciation is then deducted as noncash expense from the gross income supporting the investor to bring down the tax liability to eventually increase the income.
Suppose an investor owns an apartment building worth $5 million and wants to claim a depreciation deduction. If the building is depreciated over the standard 27.5-year period, the investor would be entitled to a yearly deduction of approximately $181,818.
However, if the investor opts for accelerated depreciation and claims the deduction over a shorter 7-year period, the annual depreciation deduction increases significantly to $714,286. Although it’s unlikely that the entire building would qualify for a 7-year depreciation period.
Now, to accelerate the depreciation considering the components, all the components of the property i.e., real immobile assets like fencing and land improvement, and personal movable items like appliances, are reviewed and depreciated value is determined for them as per their class life. Let’s consider a cost segregation example: Suppose an owner purchased a 100,000-square-foot garden-style apartment complex for $10 million. The property has 300 units, and a cost segregation study conducted in the year of purchase revealed $2.1 million of costs segregated into shorter tax lives, resulting in an increase of $1.2 million of depreciation in the first five years. Assuming a 7% discount rate and 40% tax rate, the owner would receive a net present value tax savings of $50,000 in the first year and $200,000 over the first five years.
Is cost segregation worth it?
Considering the same example of garden-style apartment complex, the first-year net present value savings more than pays for the cost segregation analysis, which can range from $6000 to $7,000 for a facility of this size. This means that it is a cost-effective way for owners to realize significant tax savings and increase their cash flow. By reducing taxable income and increasing cash flow, owners can leverage this financial management tool to achieve their financial goals.
It’s important to note that in order to take advantage of accelerated depreciation, building owners and investors must conduct a cost segregation analysis to properly identify assets that qualify for shorter depreciation periods.
NB: Please consult your CPA on the above subject.