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Smart Ways for Self-Storage Owners to Reduce One of Their Largest Annual Expenses: Income Tax!

Tax planning can be confusing and stressful, but when you apply smart strategies, it can reduce your liability and increase cash flow. This article explores several options for savvy self-storage owners to pursue. Learn to lower your annual income tax while capturing lucrative incentives!

Heidi Henderson

October 19, 2023

5 Min Read
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Each tax season, self-storage owners can take advantage of strategies to reduce their liability and increase their cash flow; but not all of them are aware of this. Following are some options that can help dramatically reduce one of your largest business expenses: income tax!

Cost Segregation and Bonus Depreciation

Cost segregation is a tax-deferral strategy that frontloads depreciation deductions for real estate assets into the early years of ownership. A cost-segregation study separates the cost of building components into the proper asset classifications and recovery periods for federal and state income-tax purposes. This acceleration strategy can help self-storage owners reduce their taxable income.

Under existing bonus-depreciation rules,  cost segregation can generate dramatic first-year deductions. These can vary based on the type of self-storage construction, but exterior-storage sites with metal buildings or boat/RV storage could see deductions as high as 60% to 70% of their purchase price in the first year. For interior-storage and climate-controlled properties, this could be 30% to 50%.

Bonus depreciation is based on the year a self-storage facility was purchased or completed. It was 100% from 2008 and 2022. It falls to 80% this year and 60% in 2024. Though bonus depreciation is declining, the value is still quite large.

For example, let’s say you purchase a self-storage facility with boat/RV spaces and metal buildings for $2.4 million. If the value of the land is $480,000, that leaves a tax basis of $1.92 million. Standard depreciation would be $49,230 per year (if purchased Jan. 1). With cost segregation and 80% bonus deprecation in the first year, depreciation could be $800,000 to $900,000 or more.

To take advantage of this, contact a reputable cost-segregation company with experience in self-storage and ask for a redacted study to understand what you’re paying for up front. Be aware that some low-cost providers may not perform a physical site visit, and the actual report may be only a few pages. That type of study isn’t defendable under Internal Revenue Service (IRS) scrutiny and will likely leave 30% to 40% of the benefit on the table. You want your provider to do a site visit and provide a detailed asset listing, which can be anywhere from 50 to 100 pages. This ensures you receive the highest value and the study will withstand an IRS audit.

Energy Efficiency

The Energy Policy Act of 2005 was recently expanded with the Inflation Reduction Act and can be a tax deduction for energy-efficient commercial buildings. This is known as a 179D deduction, and self-storage facilities that meet certain standards can qualify. With a value of 50 cents to $5 per square foot, the deduction can help you reduce your tax liability while promoting energy efficiency for newly constructed properties or retrofit projects.

In addition, the Investment Tax Credit has been expanded to include the installation of energy-generating equipment (solar panels) and is around 30% or 40% for U.S.-made products. This credit, plus a bonus-depreciation write-off, can reduce your out-of-pocket costs and energy costs immediately. A new provision has also made this credit transferrable, so for self-storage businesses without enough tax liability, the credits may be sold to generate additional revenue.

Opportunity Zones

Federal Opportunity Zones were adopted with the 2017 Tax Cuts and Jobs Act. They offer incentive for taxpayers to sell assets and invest the capital gains from those sales in real estate or businesses in areas of economic distress. Though the largest benefit of discounted capital-gains tax has nearly expired, these properties are still allowed a free step-up in basis to fair market value after 10 years. This means they can be sold tax-free!

Of course, there are requirements that must be strictly followed. To qualify, an asset must be in a recognized Opportunity Zone, purchased with capital-gains funds, and substantially improved within the first few years. This is an ideal option for taxpayers with a capital-gains event and no other deferral option. It can also be great for buying vacant land in an Opportunity Zone in which planned new construction meets the substantial-improvement requirement.

1031 Exchange and Other Exit Strategies

A 1031 exchange is a tax-deferred transaction that allows real estate investors to defer capital-gains taxes on the sale of an investment property by reinvesting the proceeds into another asset. A commonly used replacement property is a Delaware statutory trust (DST), a legal entity that allows investors to pool their money to invest in real estate. DSTs offer several benefits like fractional ownership, passive income and limited liability.

When it comes to exit strategies for DSTs, there are several options. One is to enter a subsequent 1031 exchange into another DST or similarly eligible property. This allows investors to continue deferring capital gains while reinvesting their money into another asset.

Another strategy is to cash out and trigger a significant taxable event. This may be appropriate if you need the cash for other purposes or want to diversify your portfolio. Keep in mind, however, that it’s ideal to purchase another property in the same tax year and then utilize cost segregation and bonus depreciation to help offset the gain.

Finally, you can effectuate what’s known as a 721 exchange into a DST sponsor’s umbrella partnership real estate investment trust or UPREIT offering. This allows you to exchange your real estate for economic interest in the UPREIT in the form of operating-partnership units.

Take Advantage While You Can

The complexity of the tax code makes it difficult for taxpayers and even seasoned certified public accountants to keep up with every nuance that applies to each business situation. It’s imperative that you consider tax planning and strategy each year before you make major decisions on behalf of your self-storage operation. You also need to do this before the tax year closes to ensure you’ve captured every possible incentive that applies.

Heidi Henderson is executive vice president of Engineered Tax Services, a licensed engineering firm focused on specialty tax services relating to federal tax incentives and strategies for real estate owners. She has more than 25 years of tax and accounting experience in the real estate finance, development, construction and commercial property sectors. To reach her, call 801.689.0325; email [email protected].

About the Author(s)

Heidi Henderson

Executive Vice President, Engineered Tax Services

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