By Jerome Kootman, Cost Recovery Solutions, LLC
Property managers and owners typically spend a significant amount of time minimizing expenses while fighting to attract and retain new tenants in order to maximize cash flow and profit. Unfortunately, many of them are not truly maximizing cash flow because they are incorrectly depreciating their properties and overpaying income taxes as a result. Even the most sophisticated owners and property managers unknowingly overpay Federal and state income taxes because they do not have the capabilities to properly maximize depreciation deductions following Internal Revenue Service (IRS) requirements.
Cost segregation is a highly specialized function that should incorporate a specialist to properly maximize depreciation under the latest IRS regulations. Property managers, owners and even accountants don’t possess the required mix of tax, engineering and appraisal backgrounds required by the IRS. The specialist’s job is to examine architectural and engineering drawings, cost data and other project specifications for potential asset reclassification. Their appraisal and construction cost estimating expertise helps properly allocate value to the various building components.
Cost segregation is an engineering-based approach to identifying assets within a building that can be reclassified to a much shorter depreciation class than the building itself. Between 15 and 40% of a building can typically be reclassified to shorter recovery periods. The result is accelerated depreciation deductions and less Federal and state income taxes.
Residential rental properties (and everything in them) are generally depreciated using a straight-line method over 27.5 years. Cost segregation specialists maximize the inherent tax benefit of multi-family properties by identifying, classifying and segregating the personal property components of the building, resulting in depreciable lives of 5, 7 and 15 years using accelerated depreciation.
This is not simply a matter of classifying furniture or equipment to a 5-year recovery period as most owners and accountants typically already do. Items typically reclassified include specialty electrical and plumbing components, certain flooring, a portion of the soft costs and land improvements such as asphalt paving, site lighting and storm drainage piping. Multi-family properties are excellent candidates for analysis because of the abundance of specialty assets.
The table (top, left) illustrates the financial benefits of a $10,000,000 apartment complex acquisition and reclassifying 25 percent of the depreciable basis to a shorter life. The land basis ($2,000,000) remains non-depreciable.
Tax savings of $395,241 are generated in the first five years due to the accelerated depreciation schedule. The net present value (NPV) of tax savings over the life of the property is $223,297. The annual depreciation and tax adjustments over the depreciable life of the property are shown in the table (left, bottom).
Many of our recent multi-family properties include below-market acquisitions that require significant improvements. The first issue to address is how much of these costs are eligible for an immediate write-off as repairs or ongoing business expenses. The next issue is how to properly depreciate the costs that need to be capitalized. It is also important to properly allocate the facility purchase price to the acquired assets that may be removed as part of a future renovation plan.
Proper implementation of the capital/expense regulations is critical to optimizing your depreciation in a defendable position.
The best time for a study is when a property is constructed or acquired but it is also possible to obtain these benefits for properties that have been in your portfolio for up to 15 years. A retroactive study can be performed without amending prior year tax returns or IRS approval. The difference between the allowed depreciation and the amount actually claimed in prior years is realized on the current tax return resulting in a large one-year cash flow increase.
A study is typically economically feasible for properties with a building cost basis greater than $1,000,000 and should be considered by any property owner that has:
• Recently acquired property
• Recently started or completed a construction project
• Acquired property within the last 15 years that did not have a study performed
• Received property from an estate that will have the basis stepped up
• Purchased a partnership share.
Cost segregation professionals make it very simple to determine the feasibility for a property. They will provide a free projection of benefits and projected depreciation schedule based on a brief discussion with you and/or your accountant so that you can see how it will affect the tax return. They will also commit to a professional fee, which is based on the time required to perform the study, so you can compare the cost/benefit of performing the study before committing to anything.
(Jerome Kootman, CPA is managing tax director for Cost Recovery Solutions, LLC, an independent engineering/consulting firm that specializes in cost segregation services. He has provided cost segregation studies for thousands of clients ranging from small businesses to Fortune 100 companies.)