Tax is something that a lot of people think that we have to pay. The fact is that you don’t. There are certain investments that you are rewarded by the tax laws to do. When you invest in real estate, you are providing a basic life necessity. For that, you are rewarded by the tax laws. This is an area that we have to take the time to educate ourselves and leverage the experience of other professionals. We sat down with cost segregation expert, Yonah Weiss, recently to talk about this very topic.
A lot of people have this misconception, especially people in corporate America, that we are obligated to pay taxes, in fact it's taken out of your paycheck, right? You have to pay income tax. But when you're in real estate, you realize that is not always the case. The money that you've earned are susceptible to a wide range of tax deductions like we're going to talk about today, depreciation and cost segregation. The money that you make, it's yours and you should keep more of it.
You don't have to give that away unless you're obligated to. So in a way, this is kind of a mindset or paradigm shift. Tax is something that you only have to pay if you have a liability. Real estate is one of the best ways to get around those liabilities because the government wants to incentivize people for investing.
Let's start with a baseline understanding for depreciation and cost segregation. First let’s understand what depreciation is. Depreciation is a tax deduction that the IRS says when you buy a property, you get to write off the entire value of that property. Let’s say you buy a building for a million dollars, you can write off a significant amount of that $1M. A certain amount of that $1M, usually 20% of the purchase price is allocated to land, which does not depreciate. The remaining amount, you can now take as a tax write off over time, that you can deduct from your income tax.
The IRS has established depreciation timelines for specific real estate assets. For the assets that we syndicate, commercial residential multifamily, the depreciation schedule is 27 1/2 years for multifamily residential properties. On a normal schedule we are able to take approximately 3.6% deduction each year from the value of the property. This equates to be approximately $22,000 of depreciable deduction every year depending on what amount is allocated to the land value on a $1M purchase.
Depreciation is a weird name, because if you think about depreciate, it means something going down in value. But as you know, the value of a real estate asset appreciates over time. But let’s say the property is not kept up, the value of the improvement to the land will gradually depreciate over time. The IRS says, since things do go down in value over time, let’s offer this tax deduction.
That depreciation deduction starts the day that the property is purchase and it doesn't matter when it was actually built. For example, if you buy a property in 2021 that was built in 1985, you get to take the full depreciation as if the property was built in 2021. Additionally, if you sell that property next year to someone else in 2022 for $2 million, now they get to take the full depreciation tax write off. So it doesn't really matter what the actual building value is. It matters what the purchase price that you actually spent. That's depreciation in a nutshell.
Now, Cost Segregation is a more advanced form of depreciation. Just breaking down the name: Cost, what was the cost of the building? This is determined by the purchase price. That is the easy part.
Segregate (complex part): What are the components of the building and what are their individual useful life limit. This requires experts known as Cost Segregation Engineers. They break down the building into different components and in fact, this precess used to be called component depreciation, which is a much better term, because it makes more sense. The goal is to determine if a component is a personal property or permanent structure. These personal properties are usually depreciated at a shorter time span of 5, 7, or 15 years:
Tangible Personal Property
In Reg. 1.48-1{c}, the IRS defines tangible personal property as “any tangible property except land and improvements thereto, such as buildings or other inherently permanent structures (including items which are structural components of such buildings or structures).”
When segregating the assets, the Cost Segregation engineer uses the six identifiers created by the IRS to establish permanency which determines if an asset is a structural component and not personal property.
Is the property capable of being moved, and has it in fact been moved?
Is the property designed or constructed to remain permanently in place?
Are there circumstances, which tend to show the expected or intended lengths of affixation, i.e., are there circumstances, which show that the property may or will have to be moved?
How substantial of a job is the removal of a property and how time-consuming is it? Is it “readily removable”?
How much damage will the property sustain upon its removal?
What is the manner of affixation of the property to the land?
What does the IRS consider Personal Property Items in Apartment Buildings?
Below is a list of components in an apartment that will past the IRS sniff test to be classified as Personal Properties:
Decorative lighting and Security
Appliances such as refrigerators, garbage disposals, washers and dryers
• Pool equipment including pumps and filtering systems
Gym and other recreational equipment
Security and decorative lighting
Floor and window coverings such as Carpets, drapes, blinds
Furnishing such as couches, lamps, tables and chairs
Each investor’s income from passive investments are different. In that sense, it is impractical for operators to factor in all the passive investors’ exact benefit from depreciation.
We take on the responsibility to ensure that we maximize the allowable depreciation to increase your passive loss.
Key thing to note, Passive Losses can only offset Passive income. Unless, you qualified as a real estate professional.
Due to the size of the properties that we acquire, we know that a professional engineer study of the properties will be required.
When seeking the highest basis of depreciation on our apartment complexes, the engineer that we hire take into consideration the allowable depreciable life span of the assets, they also further segregate the personal property inside the assets.