In this post you will learn a very useful tip for tax deduction when you buy a property, it’s useful even if you have already bought some properties. We’re going to be learning about what is cost segregation, what types of properties can benefit from cost segregation, we’ll go over an example of how much you’ll be able to deduct on your taxes, and why it’s important to have cash on hand today versus in five years. We’ll also cover what is bonus depreciation and how much a cost segregation study would typically cost.

We are interviewing Yonah Weiss, a business director at Madison SPECS, a national cost segregation leader. He has assisted his clients in saving tens of millions of dollars on taxes through cost segregation.

What is cost segregation?
It’s a tax benefit for real estate investors and it has to do with depreciation. When you own a property, you get a tax deduction called depreciation. The way that depreciation works is, even though it’s an arbitrary number, the IRS allows you to take the value of the building and the purchase price of the property the day that you buy it and then from that day it has a useful life. If it’s a commercial property, that useful life is 39 years, if it’s a residential property (including multifamily) that useful life is 27 ½ years. I said it’s arbitrary because it doesn’t mean when the building was actually built, but depreciation means something’s going down in value. And it’s not really going down in value, in fact we’re investing in real estate because it’s going up in value, it’s appreciating.

Depreciation is just a tax benefit, it doesn’t really have to do with the intrinsic depreciation of the property. It’s a tax write off based on the value of the building on the day that you bought it, at the purchase price. We have to subtract a small amount for land value because it’s the land that the property sits on, and that does not depreciate – the land value is 15 to 20% of the property price. For the left over, you get a tax deduction every single year, a fraction of that value over those 39 years, or 27 years. That’s regular depreciation. This is what everyone does and some people call it straight line depreciation: you’re going to take 1/39th of the property value and subtract a small amount of that every single year from your income tax.

Where cost segregation comes into play is the fact that the IRS determined that things in the property have different useful lives, anything that is not part of the structure of the building depreciates over five years. Then you have another category of things called land improvements and this can be anything like pavement, asphalt, parking lot, landscaping, fencing, anything outside the building actually depreciates over 15 years instead of 39 years. Cross segregation is really breaking out the components of the property into their cost, and depreciating them at a faster rate. In order to do this, you need an engineer who’s trained and that’s why at firms like ours, Madison SPECS, we have a team of 16 engineers on staff that go to the property, they have training in the tax code, they can determine if you have appliances, furniture, wiring, carpeting, switches, HVAC systems. There are many things that actually depreciate on a five year value. They’ll take that entire value, add it up to all the calculations, and we can now allocate that cost to a five year schedule and get huge tax deductions based on those first five years. That’s cost segregation in a nutshell.

As soon as they purchase a property, the cost segregation starts from zero, right? So even though the previous owner may have already deducted the depreciation, the new owner will start from scratch again. 
Correct, and I’m glad you reiterated that because that’s such an important aspect of real estate, even though I own a property, I depreciate the whole thing, then I sell it to you, and you start your depreciation from day one, when you buy it. Not only that, it’s probably much higher today than when I bought it, if I bought a property for $100,000, 20 years ago, I can sell it today for $1 million. When you buy it for million dollars, you get the tax benefits of that $1 million.

What type of properties qualify for this?
Any type of property whatsoever, as long as it’s not your personal residence, it can be commercial, residential and multifamily, office, assisted living, hotels, hospitality, self storage, industrial, shopping malls, golf courses, mobile home parks, etc.

Let’s go over an example. Let’s say that we just purchased a 30,000 square feet office building for $3 million. What can we deduct in the first few years and what should we keep in mind?
We first allocate a certain amount to land, 15%, that’s about $450,000 right off the bat. Now the left over is about $2.5 million dollars. If you were to do a straight line depreciation, we’re taking that value, $2.5 million, and we’re dividing it by 39 years, so we’re going to be depreciating $65,000 every year. Let’s say that the net operating income is $300,000. We’ll subtract $65,000 from the $300,000 NOI, which means you’re only going to be taxed on the remaining $235,000.  Let’s say your tax rate is 35%, that means you’re going to be paying taxes in the range of $82,000 just because you bought this $3 million property.

The cost segregation engineers will be able to reallocate, let’s say a round number, 20% of $2.5 million is about $500,000, we’re going to be able to accelerate the depreciation of that over the first five years, which we get an extra $100,000 each year for the next five years. Alternatively, with bonus depreciation, you can actually deduct that entire amount in the first year. If we’re taking our example, instead of having just $65,000 income tax deduction, we’re going to be looking at more like $165,000 and that reduction could be even more. Every property is different, but usually it’s between 20 and 30% on average.

What is the main benefit of doing cost segregation?
The cashflow. When you have more deductions than you have income, you don’t write a check. We’re not talking about getting free money, what we’re talking about is keeping the money that you made and paying less taxes, or no taxes. In many cases, the main benefit is the cashflow, you’re able to use that money to invest. The second thing is the time value of money because you can take huge deductions early on and make sure that you’re using that money to invest. The time value of money means money today is worth more than it is five years from now. If I were to offer you $50,000 today or $10,000 a year or five years, what would you take? Definitely upfront.

What happens once we sell the property? Does it come back to haunt us? Do we need to pay taxes on it or it’s forever gone?
When you sell the property, there’s something called depreciation recapture tax, which means that you have to now pay tax on the entire amount of depreciation that you took over the course of ownership. That’s capped at 25%, which means there’s usually going to be a spread between – had you not taken depreciation, you would have to pay taxes anyway but at a higher rate. Later on when you sell, you have to pay tax on that amount of money you deducted, but it’s usually going to be less.

There’s another point that’s important to note that when you do a 1031 exchange on the sale of a property, not only are you deferring the capital gains tax, you’re also deferring the depreciation recapture tax. So there’s another way to get around it, which is just that you go to a new 1031 exchange. All of this is very important for us to have cash in our hands to invest in other properties. This is one of the many reasons why people really care about cost segregation, you want to keep as much cash as possible in your own pocket and not give it to the IRS.

What happens after we deduct everything that we can on a specific property? 
When we’re reallocating the depreciation to the early years and we’re taking more deductions early on, you’re going to get less deductions later on. After your sixth year, it starts to reverse itself, and you’re going to have less appreciation. But it’s not a huge amount because we’re only going to be allocating about 20% to take in the first five years, instead of spreading that over 39 years. In our example of the $3 million building, for the following 32 years, instead of taking $65,000 straight line depreciation, you’re going to be closer to $60,000 at year six. It’s not going to be a ridiculous amount because it’s spread out. It’s like taking an interest free loan and then paying it back in a 32 year installment on the money that you borrowed.

Is bonus depreciation related to cost segregation study? And if not, can you share with us what is bonus depreciation? 
Bonus depreciation used to be a rule that when you developed a new property, you could take 50% of the depreciation of that property in the first year of that new construction. The law changed in that it’s now for any property that you buy, not just new developments. All the depreciation that is less than 20 years (in the example that we gave, the five-year personal property and 15 year land improvements) all of that cost segregation is eligible for bonus depreciation, you can actually take 100% of that depreciation in the first year of ownership, instead of spreading it over five years. You have a choice of 100% or 50%, which really gives you a much added benefit to take, to knock off your entire income tax liability in the first year.

What do most people choose?
It really depends on everyone’s situation. Most people choose the 100% bonus depreciation because they take huge deductions, and they may have more deductions than they actually have income, which will put them in a “passive loss”, meaning you’ll just be in the negative for income tax. This is what was in the recent newspaper’s headlines, that president Trump had billion dollars of losses, but it’s paper losses, depreciation, and it means he was not tax liable. Even if you made huge dollars in profits, you wouldn’t have to pay tax on that because of all the losses, so it’s something that carries forward with you, and it goes with you to the next year. Even if you can’t use it this year, it will release itself next year or at the sale of the property.

Is bonus depreciation going to expire at some point? 
The 100% upfront depreciation is only good until 2023, from that point they put it in a kind of reverse. In 2024 it’s going to be 80%, and then the next year it’s going to go down to a 70% bonus depreciation. We’ll see what happens when we get there, but for the meantime it’s good to take advantage of it.

How much would it cost to do a cost segregation study in our example property, our 30,000 square feet office that was purchased for $3 million?
Every firm has different pricing models, so I can speak for our firm. We are one of the biggest in the country, we’ve done over 14,000 studies across all 50 states. We will actually provide a feasibility analysis to anyone that’s interested in seeing not only what the costs would be for that property, because it’s based on the actual square footage, the scope of work that’s involved in the property, and we will tell you our projections of what your tax benefits would be. We will do that just so you can make an educated decision. So, unless the property is massively huge, the cost segregation study would cost $5,000-$6,000 for a type of commercial property. When you’re talking about $100,000 zero tax benefits, it’s a no brainer.

Do you know if some investors are not even aware of cost segregation? If not, what’s the percentage? 
In my experience, I would say the majority are not aware of it, they may assume that their accountants are taking care of it for them, which is a mistake because most of the accounting firms don’t do cost segregation in house. They very large ones will have engineers on staff to do this, but a lot of accountants who aren’t real estate savvy may not really know enough about it to do it for their clients. Unless you’re educating yourself, there really wouldn’t be a way for you to know this. There are so many different aspects of real estate investing that unless you dig in and try to find out, no one’s going to talk to you about it.

One of my mentors was meeting with a friend who is doing a huge project in LA with several housing units, and just by sharing cost segregation with that friend, who had no idea about it, he helped him save something like $25 million, which was insane for someone that is working on something that big, for them to not be taking advantage of it. What are some really important questions we should ask a cost segregation provider before hiring him or her? 
You want to know a little bit more about their experience and want to make sure that they have extensive experience in this field because  we’re talking about taxes. Taxes have to be very straightforward and have to be something in line with the tax code. You don’t want someone who’s new at it, they must have industry experience. The second thing is you want to make sure that they stand behind their work, meaning they’re complying with all the rules set out by the IRS, and that in the event of an audit, they’ll stand behind you.

If something does happen where there was something wrong in an audit, who would be liable for that? 
Both the engineers and the client.

How can the person filing it and be responsible when that’s not their business? When you sign off on a tax return or an accountant signs offered, then you sign it off and you’re taking responsibility for everything that’s in there.

Is there anything else that you would like to share with our audience? 
Anyone that has a property or is thinking about investing in a property – you want to make sure that you find out about cost segregation, reach out to someone like myself to get a feasibility analysis, we’ll show you what the potential benefits would be by doing a full cost segregation study. This allows you to understand a little more in detail, and see what those numbers would look like. What I will leave you with is that it’s not something that needs to be done immediately. You can even retroactively do it for a property that you purchased five years ago. You will be able to retroactively get the deductions that you missed by accelerating depreciation this year.

Yonah Weiss
https://www.linkedin.com/in/cost-segregation-yonah-weiss/
yweiss@madisonspecs.com
(732) 298-9002