In December 2016, we bought a small brand new fourplex in Provo for $550K. Our straight line depreciation amount would have been $700. After using a combination of powerful tax saving techniques, we were able to bump it up to $98,000, with a very little cost. Here's how we did it.
Read the previous article - Part 1: Bonus Depreciation
#2 - Cost Segregation
Whether you own a fourplex, an apartment building or a hotel, there are substantial tax savings that are hidden beneath your feet, within the walls and even in the landscaping and paving outside your building. By doing a cost segregation study, you can:
We invited our trusted cost segregation expert Brett Hansen from Cost Segregation Authority who have been a tremendous help to us and our clients to explain exactly what cost segregation is, and how the process works and how it could benefit you.
WHAT IS COST SEGREGATION?
Cost segregation is a highly beneficial and widely accepted tax planning strategy utilized by commercial real estate owners and tenants to accelerate depreciation deductions, defer tax, and improve cash flow. Once used only by big-4 type accounting firms and the nation’s largest real estate owners, this practice has now become routine for commercial property owners of almost every size.
A Cost Segregation Study (CSS) is based on a detailed engineering-based analysis that is used to support the acceleration of depreciation deductions by identifying costs that can be allocated to shorter recovery periods; primarily 5, 7, and 15-year, as opposed to 27.5 (residential) or 39-year (commercial).
A quality study provides the documentation needed to defer substantial tax payments and greatly improve cash flow. It is important to note that a cost segregation study does not create new deductions, but increases deductions in the early years of ownership. This front-loading of depreciation allows the taxpayer to take advantage of the time value of money.
Cost Segregation is applicable to ANY income property, including leaseholds and can be applied retroactively to any building purchase or construction back to about 1987.
By increasing your depreciation deduction, you reduce your taxable income resulting in lower tax payments. Smart developers and investors use this savings to reinvest in more properties. See apartment example below:
For property that is constructed (original use) and has an asset life of less than 20 years, a congressional stimulus inducement known as Bonus Depreciation will apply allowing you to take 50% (thru 2017) additional depreciation in Year 1. See example above. This is being phased out through 2019 so now is the time to take advantage.
By having your building costs segregated, an investor can now allocate the sales price of the asset to the land and structure (appreciable components) and reduce the recapture on personal property (i.e. carpet) that was not sold at a gain.
Cost Segregation and 1031 Exchanges work hand in hand to further defer the payment of taxes.
The chart below shows the industry average reclassification of total capitalized costs based on asset type.
Each study is priced according to its cost, size, complexity, location and other internal factors. These prices range anywhere from $2,000 to $200,000 or more depending on the investor/developer’s portfolio.
On average, a single, 4-story building study with moderate complexity will run about $15,000. The IRS prohibits pricing based on tax savings, but we do like to see at least an 8-10x return on the cost of the study whenever possible.
We will always run a benefit analysis on the property at no cost to determine if the cost segregation study is appropriate and provides enough benefit. About 95% of the time it does.
Cost Segregation Authority
A real-life example: a brand new fourplex built & placed in service in December 2016