Investing in multifamily assets is a highly tax-efficient strategy. We emphasize the key deductions to our investors to help them better understand the levers a syndication sponsor can pull to reduce their tax exposure.
Most syndication deals are structured as a limited partnership. These types of partnerships are flow-through vehicles and the deduction benefits accrue directly to the limited partner (investor).
Homeowners understand basic tax deductions like mortgage tax interest and taxes on property. Rental property owners can also claim the depreciation deduction. The depreciation deduction is just on the cost of the building and not land. As a rule, buildings depreciate, land does not.
For residential properties, these deductions are over a 27.5-year period (straight-line basis). Since, multifamily assets qualify under the residential property classification (even though lenders consider them commercial assets), typically, investors would take deductions over a 27.5-year period.
Here’s a simple example of straight-line depreciation on a residential property. Assuming the property tax assessor’s estimate of building value is $137,500, the expected depreciation deduction would be $5,000 ($137,500/27.5 years). This is what your accountant will show as a deduction, against income, each year for your property.
Many shrewd apartment investors take advantage of accelerated depreciation (or cost segregation) to closely match their expected holding period. Value-add operators typically hold a property for between 2-5 years. They try to unwind properties anytime after the 2-year renovation period when the value has been optimized. The ability to accelerate depreciation is attractive as it allows depreciation to be front-loaded.
In other words, cost segregation allows greater deductions during a shorter period. This increases the cash flow to investors by minimizing the tax burden. This is especially important in the first few years as a significant amount of renovations, which justify higher rents and increased income, have not been completed.
A recapture of depreciation is an important consideration at sale. The IRS does not allow a free ride. But as we all know a dollar received today is worth more than a dollar received tomorrow. Hence, maximizing deductions today is the best route to go.
What is Cost Segregation?
A cost segregation study allows building owners to accelerate depreciation deductions that are, typically, taken over an extended period – 27.5 or 39-years – into a much shorter span – 5, 7 or 15-years.
Cost segregation studies don’t usually create extra deductions over the life of a property. They simply accelerate these deductions. Thus, creating a higher net present value, as deductions are claimed today (leading to higher cash flow today) as opposed to in the future.
Cost segregation studies provide analysis and identification of specific building components necessary to allocation costs into the property categories for depreciation purposes. According to the IRS, there is no standard for cost segregation studies. However, they define a quality cost segregation study as having 3 attributes:
1. Classifies assets into property classes (e.g. land, land improvements, building, equipment, furniture and fixtures);
2. Explains the rationale for classifying assets;
3. Substantiates the cost basis for each asset and reconciles total allocated costs with total actual costs
Real property eligible for cost segregation includes buildings that have been purchased, constructed, expanded or remodeled since 1987. A formal engineering-based study is typically cost-effective for buildings purchased or remodeled at a cost greater than $750,000.
A cost segregation study is most efficient for new or recently constructed buildings. But it can also uncover retroactive tax deductions for older buildings which can generate significant short-term benefits due to the “catch up” of depreciation.
Since 1996, taxpayers can capture immediate retroactive savings on property added since 1987. Previous rules, which provided a four-year catch-up period for retroactive savings, have been amended. Taxpayers can take the entire amount of the adjustment in the year of the cost segregation study.
This opportunity to “recapture” unrecognized depreciation in one year presents an opportunity to perform retroactive cost segregation analyses on older properties. This increase current period cash flow.
This is the IRS’ way of collecting income tax on a gain realized by the taxpayer. This occurs when the taxpayer disposes of an asset that had previously provided an offset to income through depreciation.
In other words, because the IRS allows a taxpayer to deduce the depreciation of an asset from income, the taxpayer must report any gain from the disposal of the asset as ordinary income, not capital gains.
Depreciation recapture can be deferred through the 1031 exchange. Consult your CPA on more information about these programs. Always seek competent and experienced engineer-based cost segregation firms for your properties.
• Ensure the costs justify the benefits. On average, buildings over $750K make sense for cost segregation studies.
• Depreciation recapture• IRS penalties for aggressively using cost segregation