Cost Segregation Allows Commercial Property Owners to Take Accelerated Depreciation Deductions, Increasing Their Cash Flow
This week, we sat down with Madison SPECS’ Yonah Weiss to discuss the benefits of cost segregation for multifamily and commercial real estate investors. For those who aren’t familiar, cost segregation allows the owners of multifamily and commercial properties to speed up the rate at which they take depreciation deductions. Generally, multifamily properties have an IRS depreciation period of 27.5 years, while non-multifamily commercial properties have a depreciation period of 39 years. By ordering a cost segregation study from a specialized firm, investors can take many of their depreciation deductions over 5, 7, or 15-year periods, greatly increasing their cash flow.
In this interview, we’ll discuss:
- How cost segregation studies work
- Why you should always get an upfront estimate first
- What to look for in a cost segregation firm
- How much cost segregation studies cost
- How to know if your property is a good candidate for a cost segregation study
- How bonus depreciation allows investors to take depreciation deductions even faster
- Depreciation recapture tax and 1031 exchanges
- How cost segregation could impact your personal taxes
*The following interview has been edited for length and clarity.
Thank you so much for taking the time to speak with us today, Yonah. Before we really get started, could you tell us a little bit about yourself and your background?
Sure. I’m part of a large company, Madison SPECS, which is one of the largest cost segregation companies in the United States. We work in all 50 states, and I’m responsible for business development. My background is actually in education; I was a teacher for many years, and I got into the real estate industry about 5 years ago. Since then, my goal has really been to learn as much as I can and share that with other people.
I know what cost segregation is (in general terms), but a lot of people don’t. From what I understand, it involves hiring an engineering company to study your property so you can take your depreciation deductions faster. Am I correct? How would you describe it to a layman?
Yes, that’s correct. If I were to describe it to a layman, I’d say that cost segregation is the process of increasing tax deductions and tax write-offs for real estate owners. It lets them increase their cash flow by front-loading deductions.
So let’s say I’m a multifamily investor and I decide I want to do a cost segregation study, or at least look into doing it. How do I get started? What are the steps?
You need to reach out to a firm that specifically does cost segregation. Most firms will provide a free, upfront estimate of how much you’ll save in taxes. From there, you’ll see the potential benefits and you can make an informed choice as to whether if it makes sense for your individual tax situation.
And what comes after that?
If you do decide to do a full cost segregation study, an engineer will come out to your property and take pictures and measurements of your entire property and everything that's in it. And, in essence, that allows you to take your depreciation deductions faster.
It’s really important to realize that this is something you cannot do on your own, and not something you can do with your accountant. Regular accountants do not do this, and, in fact, most overlook this entirely and are not proactive about telling their clients about this. So, when it comes to cost segregation, you really need to take matters into your own hands.
On average, how much does it cost to order a cost segregation study?
It varies, but the most important thing to know is that it's not contingent on a client’s potential tax savings. It’s generally a flat fee per property, which typically ranges between $4,000 and $7,000. A multifamily property will likely never cost more than that, but for larger commercial properties, a cost segregation study may cost somewhat more.
How do you find a good firm for this?
When you look at a firm, you want to ask yourself a couple of really important questions. Do they have experience; what is there experience in the industry? Are they doing everything in-house or outsourcing it? If a firm is outsourcing their work, this is typically a bad sign. Outsourced work is generally more expensive and the firm will often take less responsibility.
You also want to take a close look at the accountants who work for the firm. What is their experience? Have they worked for a Big 4 firm or a major corporation? Do they stand behind their work? Is it audit protected? If you do get audited, you’ll want to have worked with a firm that stands behind their work 100%.
Our company, Madison SPECS, stands by our work if our clients are audited at no extra charge, which is definitely something you want to look for in a cost segregation firm.
How would an investor know if their property is a good candidate for a cost segregation study?
Any property purchased in the last 5 years for $1 million or over is typically a really good candidate. For properties purchased for less than $1 million, it really depends more on the individual property and the investor’s individual tax situation.
What about retroactive cost segregation? Is it true you can capture some of the benefits of cost segregation retroactively, even if you’ve already held a property for a long time?
If you’ve been doing straight-line depreciation, lumping everything into 27.5 or 39-year depreciation, you can do a tax adjustment. But you don’t need to amend your taxes. In general, you should never amend your taxes. This is a big red flag for the IRS and they’re more likely to audit you.
Specifically, to adjust your taxes for retroactive cost segregation, you’ll need a Form 3115, Application for Change in Accounting Method.
It’s important for readers to realize that cost segregation is actually the correct way to depreciate property. We are depreciating each part of the property over its real life. For instance, if a carpet depreciates over 5 years, taking it as a 27.5-year deduction simply wouldn’t be accurate. Lumping everything together is actually the wrong way. Of course, the IRS does not enforce you to depreciate items over their real lifespan, as that would result in significantly less revenue each year for the U.S. Treasury.
Is cost segregation only for people who hold onto properties for a long time? You wouldn’t recommend it to, say, someone trying to fix and flip an apartment building?
Cost segregation actually cannot be done on a fix and flip. The depreciation deduction is only for rental property, but a property bought and sold in the same year is not considered as rental property.
Cost segregation is generally a good idea for people who are holding a property for at least 2 years. It’s also great for people holding properties indefinitely. However, it may be even more important for someone holding a bunch of properties, since cash is power, and cash flow is probably really important to them.
I also want people to keep in mind that cost segregation is only for business or rental properties, not for your personal residence. That being said, a lot of people don’t realize that, for people who own the building that their business is using, cost segregation can be a really great option.
For instance, a doctor that owns the office that they work in can use cost segregation deductions to offset the income from their business. Likewise, a manufacturer that owns its own facilities or warehouses can use cost segregation to increase its cash flow. It’s really a beautiful thing.
What about the Tax Cuts and Jobs Act of 2017? I understand that, in some situations, a change in the Act allows property owners to take their depreciation deductions much faster.
Yes, this is called bonus depreciation. Regular cost segregation involves the reallocation of a certain number of property elements. For instance, certain building equipment depreciates over a 5-year schedule, while land improvements depreciate over a 15-year schedule. Instead of taking these deductions over a 5 or 15-year period, we can take the entire amount as a deduction in year one. This is referred to as 100% bonus depreciation.
Is this temporary, or a permanent change in the law?
The Act puts this bonus depreciation law into effect until 2023. In 2023, it will start to reverse itself; investors will only be able to take 80% of these deductions in the first year (2023); 20% will need to be taken over the remaining 5-15 years. In 2024, investors will only be able to take 70% of these deductions in the first year, and 30% will need to be taken over the remaining 5-15 years. The bonus depreciation law totally phases out 7 years after 2023.
People need to take advantage of this right away. We don’t know if this is going to change when someone else comes into office. Since the 2017 Act was one of the largest tax reforms ever, I highly doubt the government will issue any big tax reforms in the near future, but you never know.
When you sell a property, you’ll have to pay back some of these deductions, right? What about 1031 exchanges? Can you put off repaying them by using a 1031 exchange, or am I totally off base?
You’re talking about the depreciation recapture tax; the short explanation is that you need to pay a tax on the amount of depreciation you took. It’s generally capped at 25% of the depreciations that were taken over the life of the property. Just like capital gains taxes can be deferred with the 1031 exchange, they can also be used to further push out that depreciation recapture tax.
It’s important to realize that you’re not paying depreciation deductions back in any way, shape, or form, but you will pay a tax on it eventually.
How does any of this impact an investor’s personal income taxes?
Many borrowers will use an LLC or some other type of holding company to hold their real estate. Even if you own an LLC, that flows through to your personal taxes. And, more often than not properties are owned by an LLC, and depreciation will still flow through the LLC to the individual owners of the LLC according to their percentage of ownership. So it will affect investors personally based on their tax brackets.
What else should people know? This is pretty outside the territory of topics that we usually cover.
Exactly. It’s territory that most people don’t know about. The main thing you need to know is that you need to know about this. You have to be proactive--you should not assume that your accountant is using every strategy possible to pay fewer taxes. Most accountants are just crunching numbers when they file taxes. You need to take matters into your own hands and be proactive about educating yourself.
Thank you so much for your time, Yonah. This was some incredibly valuable information, and I think our readers are going to get a lot from this. How can people get in touch with you if they have more questions?