Self-storage owners can reduce federal and sometimes state income taxes through proper depreciation techniques, using the savings to improve existing properties, pay down debt or finance additional investments.
Cost segregation is an IRS-approved depreciation approach allowing commercial property owners to classify certain building and improvement costs into five-, seven- and 15-year cost-recovery types rather than the standard 39-year depreciation for newer properties.
Through an onsite property analysis, trained real estate valuation specialists—including appraisers, architects and engineers—identify and value items that qualify for short-life depreciation. The advantage to this method is higher tax deductions in the early years of property ownership vs. a straight-line method using a longer depreciation-recovery period.
The IRS recognizes more than 130 items in the short-life categories. For a self-storage facility, these can account for as much as 40 percent of the “cost basis,” defined as the original purchase price, including commissions and other expenses, used to determine capital gains and capital losses for tax purposes.
Owners of existing property will find a key benefit to short-life depreciation is the ability to catch up on previous years of under-reported depreciation since the property was originally constructed or acquired. Cost segregation can be applied to acquisitions made on or after Jan. 1, 1987.
Property owners can take additional depreciation during the year the cost segregation study is performed without having to amend prior years’ tax returns. Your accountant can simply make a one-time adjustment to income by completing IRS form 3115, “Application for Change in Accounting Method.” This adjustment is automatically approved by the IRS.
Cost segregation is probably the most accurate way to depreciate personal-property components of a building and land improvements; it doesn’t constitute creative accounting or slipping through tax loopholes. Owners who have an analysis performed by a qualified provider adhering to IRS guidelines don’t have to worry about triggering an audit using this approach.
Below is an example of the increased depreciation a cost segregation study can provide an owner, using a $2 million cost basis (without land):
In this example, the owner claims an additional $54,061 in depreciation in the first year, and $284,866 over five years on his federal income tax form. The next chart gives examples of various short-life items:
Because of the depreciation treatment of short-life items, cost segregation is more than just the deferral of income tax. It represents a net tax savings to the owner when a property is sold. Upon sale, gain on items in different depreciation categories is subject to varying tax rates.
For all asset classes, recapture tax rates are based on the lesser of accumulated deprecation or the gain realized on the sale of the assets. Because the short-life improvements typically decrease rather than appreciate, if a property owner realizes a gain at the time of sale, most if not all is allocated to the land and 39-year depreciable assets (i.e., the building).
The original basis of the building after cost segregation is reduced by the amount of short-life items; therefore, there is more Section 1231 capital gains tax (typically at 15 percent) than without cost segregation. However, the increased depreciation from the short-life items yields additional tax savings at the ordinary income rate (35 percent on average.)
Because the ordinary income rate is higher than the capital gains rate, the tax savings more than offset the additional capital gains tax. Cost segregation yields a significant net tax benefit over the ownership cycle.
Power of Cost Segregation
Section 1031 or like-kind, tax-free exchanges are a popular way for property owners to indefinitely defer capital gains taxes on real estate sales. By combining cost segregation and 1031 exchanges, real estate investors can reap the benefits of reduced income taxes during ownership, and deferred capital gains taxes upon sale.
It’s important to understand the classification of five- and seven-year depreciable items in a 1031 exchange. To comply with the “like-kind” requirement of 1031 exchanges, real property must be replaced with real property to defer gain and avoid an adverse tax impact.
Since five- and seven-year property identified through cost segregation is defined as personal or Section 1245 property for depreciation purposes, there’s some confusion regarding this issue. The IRS defers to state law in defining whether items are real property or personal property in 1031 exchanges. In many cases, state law classifies most of the five- and seven-year fixtures (e.g., wall coverings, carpeting, cabinetry, special-purpose electrical and plumbing systems) as real property. Therefore, while these items qualify for shorter depreciation for federal depreciation purposes, they adhere to the “like-kind” requirement of 1031.
A thorough, defensible and accurate cost segregation study requires real estate valuation expertise and a strong knowledge of federal tax code. By commissioning a cost segregation study, investors can use this IRS-guided form of advanced depreciation to save serious money in federal income taxes.
Larry Brewster heads the federal tax reduction services at O’Connor & Associates, a nationally known real estate service firm providing cost segregation and appraisals nationwide. For more information, visit www.poconnor-associates.com.