One of the most commonly cited benefits of a commercial real estate investment is the potential tax savings that come with it – and one of the ways that real estate investors can reduce their tax bill is through the use of an accounting concept known as “depreciation.”
In this article, we will describe depreciation in general, with a specific focus on a depreciation maximization technique known as “cost segregation.” We will define what it is, how it works, and how it can be used to minimize investor tax bills. By the end, readers will have a strong understanding of cost segregation and should be able to use this knowledge in their pre-investment due diligence efforts.
At First National Realty Partners, we specialize in the purchase and management of grocery store anchored retail shopping centers. As part of that effort, we actively seek to maximize depreciation for our investors, which can lead to a reduction in their personal tax bills. If you are an accredited investor and would like to learn more about our current investment opportunities, click here.
What is Depreciation?
Depreciation is an accounting concept that allows investors to “expense” a portion of a property’s value each year to account for its physical deterioration. For example, if a roof has a cost of $100,000 and an estimated useful life of 10 years, then the property owner could expense $10,000 each year to account for the degradation in the roof’s condition each year.
This “expense” is listed on a property’s income statement and serves to reduce the amount of taxable income produced. But, and this is key, depreciation is a non-cash expense so it does not reduce the amount of cash available to be distributed to investors.
To illustrate this point, consider a hypothetical income statement for a property with and without depreciation. In scenario 1, suppose that an office building has $10,000 in rental income and $5,000 in operating expenses, not including any depreciation. The resulting “net operating income” is $5,000. In scenario 2, the property has the same $10,000 in rental income, but now has $7,000 in operating expenses, including $2,000 in depreciation expense. In this case, the net operating income is $3,000, but the amount available to distribute to investors is still $5,000 because depreciation does not represent cash actually coming out of the property owner’s pocket.
So, the bottom line is that depreciation benefits investors’ income tax bill because it reduces the amount of taxable income produced by a property. As such, property owners and managers have every incentive to maximize it to the extent allowed by the IRS. One of the ways they do this is to utilize a technique called cost segregation.
What is Cost Segregation?
Cost Segregation is an accelerated depreciation technique that allows property owners to maximize the depreciation taken in any given year.
How Cost Segregation Works
The details of how Cost Segregation works can be tricky and complicated, but it is best described with a contrast to traditional depreciation techniques. Suppose that an investor purchases a multifamily commercial property for $1,000,000. In a traditional scenario, a property owner would treat the entire property similarly and depreciate the entire property over its estimated useful life.
In an accelerated scenario, a real estate investor may order a “cost segregation study”, which carefully reviews the individual components of the property – land, land improvements, roof, air handling systems, personal property, etc. – and “segregates” them into individual buckets that are depreciated at different rates.
Cost Segregation Calculations
IRS rules dictate that a commercial rental property can be depreciated over either 27.5 or 39 years. But, a cost segregation study can break the property up into its individual components and depreciate them at an accelerated rate. For example, interior fixtures and finishes can be depreciated over five years or land improvements could be depreciated over 15 years.
Again, the specifics of the cost segregation process can be tricky, but the key point is to remember that it allows real estate owners to accelerate depreciation in an effort to reduce overall tax liability. But, it is best performed by an expert, with the input of a CPA or tax professional to ensure it is being completed correctly.
Tax Benefits of Cost Segregation
As described above, the major benefit of utilizing cost segregation as part of a tax strategy is that it front loads depreciation in the first years of ownership, thereby significantly reducing investor tax liability – especially for high earners.
But, it is important for real estate investors to remember that this same depreciation can be “recaptured” upon the sale of the property, resulting in an unexpectedly large tax bill. Fortunately, with some simple tax planning, this tax bill can be deferred using another strategy known as a 1031 Exchange.
Who is Cost Segregation Right for?
As a general rule, a cost segregation strategy is a good fit for all commercial property owners and/or investors who are actively seeking to minimize their tax bill.
Cost Segregation and Real Estate Syndications
Cost Segregation is an advanced strategy that may be more difficult for individual investors to execute given the expertise and resources required.
For this reason, it tends to be a good fit for those who participate in a commercial building syndication, where individual investors partner with a professional real estate firm to purchase and manage a property. In such a scenario, the investors provide the capital necessary to purchase the property and the real estate firm manages the asset, ensuring that depreciation tax deductions are maximized to the extent allowable by tax laws. For investors, the benefit of this structure is that they are able to leverage the real estate firm’s expertise and experience, while collecting their pro-rata share of the cash flow and income produced by the property.
Summary of Cost Segregation in Real Estate
One of the major benefits of a commercial property investment is the tax benefits that come with it and one of the most notable tax benefits is the use of an accounting concept known as “depreciation.”
Depreciation is a non-cash expense on a property’s income statement that represents the estimated cost associated with the physical deterioration of a property’s condition. Because depreciation helps to reduce an investor’s tax liability, property owners are incentivized to maximize it to the extent allowable by tax law.
One of the ways that is commonly used to maximize depreciation expense is through a strategy known as cost segregation. This real estate strategy seeks to take an entire property and divide it into its building components, which are then depreciated individually at an accelerated rate.
In other words, cost segregation seeks to front load depreciation write-offs in the early years of property ownership in an effort to maximize the benefit for individual taxpayers.
Implementing a cost segregation strategy can be complex. For this reason, it can be a good idea for individual investors to partner with a syndicator (like us) to manage the process.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. With an intentional focus on finding world-class, multi-tenanted assets well below intrinsic value, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
If you are an Accredited Real Estate Investor and would like to learn more about our investment opportunities, contact us at (800) 605-4966 or firstname.lastname@example.org for more information.