When it comes to accounting and taxes, self-storage owners and investors should keep a few planning strategies and reporting considerations in mind, particularly around items like depreciation, cost segregation and income reporting. Let’s dive into a few important concepts of which you should be aware. These will help you make the most of relevant tax laws, possibly even potential savings.
Depreciation refers to the amount an asset decreases in value over time. This reduction is due to wear and tear from typical use. In an accounting context, depreciation is estimated by considering the generally accepted useful life of an asset. For example, let’s say you bought a townhome. You can’t take the full purchase price as a deduction all in year one. Rather, you have to spread the cost, or depreciate it, over 27.5 years. Here are some other examples of specific items and their typical time for depreciation:
- Residential building: 27.5 years
- Commercial building (including self-storage facilities): 39 years
- Gate or fencing: 15 years
- Landscaping: 15 years
- Gate system: Five to seven years
- Security cameras: Five to seven years
- Kiosks: Five to seven years
Assets that depreciate over five to 15 years are generally eligible for something called “bonus depreciation,” which means you don’t have to write them off over their useful life. Thanks to the Tax Cuts and Jobs Act of 2017, you can take 100% bonus depreciation in the year you acquire the assets.
Cost segregation is a strategic tax-planning mechanism that allows a company to increase immediate cash flow. How? By accelerating depreciation to defer federal and state income taxes. It puts as much depreciation on an asset as possible during the first year. Self-storage facilities are among those that may be able to take advantage of cost segregation. Owners and investors may be eligible to leverage this strategy if they’ve recently constructed, purchased, expanded or remodeled a facility.
Cost segregation is a specialized service. Once you reach out to a provider, a representative will visit your facility and segregate all your assets. Essentially, they’ll break everything down, so a commercial building that would be depreciated over 39 years is instead depreciated over five to 15. This allows you to take bonus depreciation on these smaller assets.
Using this strategy potentially saves you tax dollars and puts more money immediately into your pocket; but to be clear, it doesn’t stay there forever. When you eventually sell your self-storage facility, you’ll recapture the depreciation. This means you’ll have a bigger profit on the books on which you’ll have to pay capital-gains tax. It’s important to understand that cost segregation only defers taxes. Though there are other strategies you can use to keep delaying them, they’ll never completely go away. Still, in the meantime, the money you saved can be used for other investments.
There are some drawbacks to cost segregation. First, it isn’t free. The typical fee is around $3,000 and could be as high as $5,000. If a provider quotes you more than this, reach out to a few more suppliers. They should be able to quote you their fee plus an estimate of how much depreciation they can create and how many tax dollars you’ll be able to save.
There are also some scenarios that would diminish the benefit you would receive from cost segregation. Before we jump into this, however, it’s important to understand that there are two types of income: active and passive. Self-storage facilities generate passive income, so you can’t use cost segregation to offset active income. Additionally, depending on the size and cost of the storage facility, you may not have enough assets to segregate. Or, you may not be able to create a loss big enough to save sufficient tax dollars, or even to offset the cost-segregation fee.
Because of cases like these, it’s important to talk with your tax accountant or certified public accountant (CPA) before a cost segregation. These professionals can help you determine whether it would be beneficial in the way you’re anticipating.
One of the most common tax mistakes self-storage owners make is to report activity from their company on Schedule C (Profit and Loss From Business) rather than Schedule E (Supplemental Income and Loss). Again, this comes down to understanding the differences between active and passive income. Here are a few things you should know:
- Again, income from a self-storage facility (rental income) is considered passive.
- Active income is reported on Schedule C, while passive income is reported on Schedule E.
- If you report you income on Schedule C, you’re paying unnecessary taxes!
- Active income is subject to self-employment tax, while passive income isn’t.
To further drive the point, let’s look at self-employment tax. If you’re a W-2 employee, 7.65% of your income is automatically withheld from your paycheck by your employer for Medicare and Social Security. You may not know this, but your employer has to match this amount. When you start your own business, the Internal Revenue Service considers you both the employer and the employee, so you have to pay both sides of this equation. Remember, though, this tax is only applicable to active income.
There are whole bunch of tax considerations that relate to self-storage businesses, so speak with your CPA or accountant to determine what’s right for you. While there are some tax-planning strategies that work for all facilities, many will vary in effectiveness based on your company’s individual circumstances.
Martha Anderson is a marketing account manager at Easy Storage Solutions, a provider of Web-based management software for small- to mid-sized self-storage operations. She works every day to help facility operators build visible websites with search engine optimization in mind. Connect with her on LinkedIn. For more information, call 888.958.5967.