You might not realize it, but your multifamily real estate contains personal property in addition to non-personal (commercial) property. An expert study, called a cost segregation study, is needed to identify those items, and once that’s done, you have the option of depreciating the personal property much faster than the non-personal property. Cost segregation studies benefit rental property owners by making larger tax deductions available to them earlier in the holding period, especially with the passage of the latest tax reform.
The Benefits of a Cost Segregation Study for Rental Property
Depreciation is the process used by the IRS to track the loss of value of property that is subject to wear, damage, obsolescence, and other forms of diminution. In practical terms, it is the annual deduction of a fraction of the value of the property in question. For multifamily buildings, the value of the property is deducted from your income over the course of 27.5 years, and it is mandatory to do so.
The process of identifying the personal property component of your multifamily investment property is known as cost segregation. This involves making a very narrow interpretation of tax guidelines, and relates to equipment, which may be essential to the operation of the building or to the renting of a unit in the building. In the former case, equipment is non-personal property subject to long depreciation under IRC 1250. In the latter case, equipment (which could be something as simple as a pipe) is personal property, subject to faster depreciation (five, seven or 15 years) under IRC 1245.
“Typically we are able to reclassify 20-25 percent of the construction costs and create some significant tax deferral,” Derek Criswell, a partner at the Moss Adams accounting firm, said recently in reference to cost segregation of new construction. Depreciation based on cost segregation can be applied retroactively (as far back as 1986) to the date you purchased the property or the date it went into service, if you are the original owner.
There are a few possible approaches to the task, but engineering-based cost segregation is preferred by the IRS, which considers the concept “adversarial.” This is an indication that the findings of your study will be examined closely by the agency. An engineering-based cost segregation study uses architectural and engineering drawings, as well as an inspection of the property, to classify property elements.
Cost Segregation Under the New Tax Laws
One of the changes made to the tax code as a result of the Tax Cuts and Jobs Act of 2017 is the expansion of bonus depreciation. Previously, major equipment purchases could be depreciated in the year of their purchase by 50 percent. This was called bonus depreciation, since it resulted in a major tax deduction increase. Now, that depreciation deduction has been raised to 100 percent and made retroactive to September 28, 2017. Not only that, elements of used buildings that are depreciable in less than 20 years, such as those revealed by cost segregation, are also eligible for 100 percent deduction, to a maximum of $1 million.
Cost segregation can make a big difference in your tax bill. Keep in mind that it is a tax deferral. You will have lower deductions in the future and there could still be depreciation recapture. Depending on when you sell the property, you could face greater depreciation recapture than you would without cost segregation. Accelerated depreciation can have other implications in the future, as it is often treated differently from linear depreciation. Also, you may not want to take a large deduction, as it could exceed your taxable income. But, unlike linear depreciation, accelerated depreciation tactics like bonus depreciation and cost segregation are not mandatory. You must opt out of bonus depreciation if you do not want it. You can also choose the old 50 percent bonus depreciation deduction.
Cost segregation is a powerful tool for tax optimization, but it must be wielded carefully and with foresight. It is disadvantageous to carry out without the help of professionals, and you should seek advice on making your current tax plans fit into your long-term goals before you do it.
At CWS Capital Partners, we are a fully integrated multifamily real estate investment management firm that offers everything from due diligence and multifamily real estate valuation to transaction support and property management. We specialize in assisting our clients with 1031 exchanges, acquisitions, repositioning, and development. We also own and manage luxury multifamily investment communities in major markets around the country and employ a team of experts who can help you hone your investment strategy.
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