Written By David Thompson
Multifamily apartment investing comes with some attractive tax efficiencies. I explain these to investors, so they get a general understanding of the key deductions that an operator of an apartment can take advantage of to reduce its tax exposure.
For investors in apartment syndication deals that are generally organized under a Limited Partnership structure, the benefits of these deductions flow through to the individual limited partner (investor). It’s important before I discuss any tax or legal issue in my blogs that my goal is to help you understand concepts. Please ensure that you discuss specific tax questions with your CPA and other experts like cost segregation engineering firms that specialize in the topic presented below.
Most folks understand the basic real estate tax deductions available to them since they are homeowners and can deduct interest on their mortgage and taxes on the property. If they own rental properties, their CPA will also explain that they can take depreciation on the rental property. Now, that means the building only, not the land. Buildings depreciate, land appreciates in general.
Here’s a simple example of what we call straight line depreciation on single family rental property. The IRS currently determines the useful life of residential real estate at 27.5 years. Say your rental property tax assessor’s estimate of the land value is $75,000, and the building value estimate is $125,000. Your depreciation expense that you take each year against rental income would be $125,000 divided by the IRS allowed 27.5 years of useful life (residential real estate) for a depreciation expense each year of $4,545. This is what your accountant will show as a deduction each year for this property you own as a rental.
Now, for apartment buildings, the same 27.5 years of useful life applies. However, many savvy apartment owner / operators take advantage of accelerating the depreciation to more closely match their expected holding period of the asset. Value add operators that look to buy undervalued properties to improve them will do so with a target of holding for say 5 years at the most, often looking to unwind them anytime after the typical 2-year renovation period is complete when the value has been optimized (renovations completed). The ability to accelerate (shorten) the depreciation period is attractive to them as it allows greater deductions during the shorter hold period thus increasing cash flow to the partners / investors and minimizing the tax burden. This is especially important in the first few years of a new investment where the operator has not yet completed a significant number of renovations justifying higher income via rent increases. Now, recapture of depreciation is an important consideration at sale as the IRS is not allowing a free ride but let’s discuss that later in the article.
What is Cost Segregation? Under United States tax laws and accounting rules, cost segregation is the process of identifying personal property assets that are grouped with real property assets, and separating out personal assets for tax reporting purposes. Apartment operators will work with a specialized engineering company that will perform a cost segregation study that identifies and reclassifies personal property assets to shorten the depreciation time for taxation purposes, which reduces current income tax obligations. Personal property assets include a building’s non-structural elements, exterior land improvements and indirect construction costs. The primary goal of a cost segregation study is to identify all construction-related costs that can be depreciated over a shorter tax life (typically 5, 7 and 15 years) than the building (39 years for non-residential real property and 27.5 for residential buildings like apartments).
Personal property assets found in a cost segregation study generally include items that are affixed to the building but do not relate to the overall operation and maintenance of the building. A cost-segregation specialist looks at a building’s walls, flooring, and ceilings; and its plumbing, electrical, lighting, telecommunications, heating and cooling systems. Analysis of capital expenditures is used to determine appropriate asset classifications. Cost segregation reclassifies items that permit a shorter, accelerated method of depreciation for certain building costs. Costs for non-structural elements, such as wall covering, carpet, accent lighting, portions of the electrical system, and exterior site improvements such as sidewalks and landscaping, can often be depreciated faster. Soft costs such as architect and engineering fees may also be included.
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 buildings recently constructed, but it can also uncover retroactive tax deductions for older buildings which can generate significant short benefits due to “catch-up” depreciation.
Catchup Retroactively – 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 to allow taxpayers to take the entire amount of the adjustment in the year the cost segregation is completed. This opportunity to recapture unrecognized depreciation in one year presents an opportunity to perform retroactive cost segregation analyses on older properties to increase cash flow in the current year.
Pitfalls to be aware of:
– Make sure the cost of doing the study justifies the benefits, usually over $750K building would make sense to review.
– The potential triggering of depreciation recapture (see below).
– IRS penalties for aggressively using cost segregation
Understanding Depreciation Recapture
Depreciation recapture is the USA Internal Revenue Service (IRS) procedure for collecting income tax on a gain realized by a taxpayer when the taxpayer disposes of an asset that had previously provided an offset to ordinary income for the taxpayer through depreciation. In other words, because the IRS allows a taxpayer to deduct the depreciation of an asset from the taxpayer’s ordinary income, the taxpayer has to report any gain from the disposal of the asset (up to the recomputed basis) as ordinary income, not as a capital gain.
If the owner sells the property and performs a 1031 exchange, its possible that the recapture be deferred due to the exchange into the new property. See your CPA for more information on these programs including recapture and seek competent experienced engineer-based cost segregation firms to discuss your particular asset.