CEO of Elevate Commercial Investment Group, driving & overseeing the company’s success as one of the top Multifamily Investment Groups
One thing that we as potential and seasoned real estate investors can all agree on is that it is absolutely critical to understand the tremendous value that depreciation gives you as the owner of real property. When coupled with a cost segregation study, the benefit of bonus depreciation can get you close to eliminating your tax liability completely.
Understanding that everything goes down in value, the IRS tax law says that property must be depreciated. Our company is primarily concerned with multifamily properties which, according to the IRS, are considered residential, not commercial property. This means that any multifamily property must use a 27.5-year depreciation schedule, excluding the value of the land. Let’s look at an example:
On a $9,250,000 multifamily purchase with a 15% land allocation ($1,387,500) the depreciable basis is $7,862,500. Using a standard allowable straight-line 27.5-year depreciation schedule, the result is only $285,881 in depreciation each year.
However, if done correctly, the IRS offers a certain tax planning technique called cost segregation that can accurately accelerate the property’s assets into depreciable categories. This allows you to separate items that depreciate much quicker — minus the land — into 5, 7, 13 and 27.5-year depreciation categories on all multifamily assets. Using the same figures above, let’s look at what impact cost segregation has on depreciation value:
On the same $9,250,000 purchase with a 15% land allocation ($1,387,500), a cost segregation study allows you to classify the property into different depreciation categories. In this example, there is $5,680,235 in the 27.5-year category, $555,121 in the 15-year category and $1,627,143 in the 5-year category, giving the owner $2,182,265 in total tax benefit!
In order to take advantage of cost segregation, you must hire a cost segregation specialist engineer to conduct an inventory of everything on the property in order to determine what fits into each lifespan category. The cost segregation specialist will carefully document every item and reclassify the real property expenditures, which will result in lower taxes. Ultimately, the ROI is based primarily on the cash flow an investment creates. When you front-load the depreciation, the time-value of money or internal rate of return (IRR) is increased.
The Tax Cuts and Jobs Act of 2017 made bonus depreciation, or what I like to call “the Golden Goose,” possible. Bonus depreciation used to only be available for new developments, but now it can be used for any new purchase as well. Bonus depreciation allows for 50% to 100% depreciation in the first year of acquisition for anything with a useful life under 20 years — unless you purchase and sell a property in the same year. Then it is not allowed. The primary benefit of this is being able to accelerate the depreciation and create significant noncash deductions.
One caveat is that bonus depreciation can only be used for income-producing purchases and does not apply to your personal residence. Bonus depreciation applies to all real estate owners that pay taxes, including individuals, estates and trusts that pay taxes, corporations, partnerships and limited liability companies.
“The Golden Egg” is if you or your spouse qualify as an active real estate professional. To qualify you must meet two IRS requirements:
1. “More than half of the personal services that you performed in all trades or businesses during the tax year were performed in real property trades or businesses in which you materially participated.”
2. “You performed more than 750 hours of services in real estate during the tax year in real property trades or businesses in which you materially participated.”
This includes any property whether it’s developed or redeveloped, constructed or reconstructed and whether you acquire, convert, rent, lease, operate, manage or broker the property.
If you qualify as an active real estate professional, all active real estate losses, including depreciation losses, can offset all active and passive income. You must qualify every year. If you or your spouse are unable to qualify by meeting the two requirements listed above, you will be considered a passive real estate investor. In this case, your real estate losses, including depreciation, can only offset passive investment activity income. Although this is not ideal, it is definitely better than not having the benefit at all.
Four Best Practices For Investors
With a better understanding of the benefits of bonus depreciation and cost segregation, here are the four best practices I recommend for investors:
1. Be sure to use the estimated analysis provided by your cost segregation specialist to show your lender that, by using this strategy, you are drastically increasing your cash flow by reducing your taxable income.
2. Make sure that you are adding any value-add renovations to your basis and depreciation once you have these items completed.
3. If this is a new concept for you, you can “look back” to previous years, and you don’t have to amend your tax return to do this. Simply file a Form 3115 which changes the way you are planning to depreciate your property.
4. By taking the bonus depreciation on a property that qualifies as an opportunity zone (OZ), you can lower the adjusted basis of the property, decreasing the amount that you have to invest to meet the OZ requirements, but it must match the cost with investment on OZ deals.
Cost segregation and bonus depreciation are complicated topics that all investors should educate themselves on. These two tools given to us by the IRS will not only help investors pay less in taxes and generate more cash flow, but it also has the potential to create generational wealth on a massive scale in a shorter amount of time.