Cash is king in the real estate investing world. It is the fuel needed to grow your portfolio and your bank account. And luckily their are tax strategies out there to put more of that cash back into your pocket.
Successful entrepreneur and podcaster, Nick Huber, provides listeners with advice on a variety of topics in real estate and business investing including self-storage facility ownership, talent acquisition, how to structure property management, and what you need to know about real estate taxes. So this week, we will be the vessel that carries the wisdom he shares in Episode 75: "Real Estate Tax 101 - Cost Segregation and Bonus Depreciation" with guest, Mitchell Baldridge.
Let's take a look at how to maximize depreciation dedications and minimize the tax burden for commercial property owners.
#1 - A Cost Segregation Study
Cost segregation studies could save you a lot of money but are often underutilized and overlooked by real estate owners, investors, and tax advisors.
What is a Cost Segregation Study?
A cost segregation study is a process that looks at each element of a property, splits them into different categories, and allows you to benefit from an accelerated depreciation timeline for some of those building components. Generally the depreciation periods for residential rental property is 27.5 years, and 39 years for commercial property. But because your property is more than structure alone — plumbing fixtures, carpeting, windows, HVAC, sidewalks, and more — you can depreciate each asset individually over five, seven, or fifteen years.
Why Does a Cost Segregation Study Matter for Commercial Property Owners?
You'll want a cost segregation study for your commercial real estate because despite the upfront cost, the tax savings from accelerating depreciation deductions can significantly increase your cash flow over the years.
However, this is only the case for real estate investors planning to hold on to their property for the long term. You may not get any benefit from having a cost segregation study done because any up-front gains reverse upon implementation of your real estate exit strategy.
How Does a Cost Segregation Study Work?
As mentioned above, there is an upfront cost to conduct a cost segregation study on your property. This is because the analysis is done by a third-party team of tax advisors and engineers working together to decide with building components should be categorized where and for how much.
Hiring out these services can cost a couple thousand dollars, so Nick Huber recommends Mitchell Baldridge with Re Cost Seg because it can all can happen from the convenience of a Facetime call. Mitchell also uses the IRS's ironclad and accepted audit appraisal method of the county appraisal district to conduct their cost segregation study.
#2 - Bonus Depreciation
Bonus Depreciation was created to encourage investment by small businesses and stimulate the economy. Here's how...
What is Bonus Depreciation?
This tax strategy allows a business or real estate investor to immediately deduct a large percentage of the cost of eligible assets, rather than depreciating them over the "useful life" of that purchase. Also known as the additional first-year depreciation deduction, bonus deduction reduces a company's taxable net income and therefore, tax liability. Especially when considering potential impacts to tax brackets.
Qualifying Assets for Bonus Depreciation
Bonus depreciation is only applicable to certain business and real estate assets. Property must have a maximum usedful life of at least 20 years and can be used for commercial or residential use. Under the Tax Cuts and Jobs Act, the taxpayer revisions to the eligibility stipulate that:
- The asset was not used by the taxpayer prior to acquisition.
- The asset was not acquired by a related party to the taxpayer.
- The asset was not formerly owned by a component member of a controlled group of corporations.
- The asset's basis is not figured in reference to the adjusted basis of the property when under ownership of the seller.
- The asset's basis is not figured in reference to a basis acquired from a decedent.
Disqualifying Assets for Bonus Depreciation
The IRS also explicitly disqualifies certain types of assets from being able to claim bonus depreciation. Assets are not eligible if they are:
- Primarily used in the trade of furnishing or sale of electrical energy, water, or sewage disposal services.
- Primarily used in the trade of furnishing or the sale of gas or steam through distributed systems.
- Primarily used in the trade of furnishing or the sale of gas or steam by pipeline.
- Used in a trade or business that has had floor-plan financing indebtedness under certain circumstances.
- Qualified improvement property such as leasehold improvements acquired after Dec. 31, 2017.
Final Thoughts from Nick Huber
Accelerated appreciation and depreciation are your best friends when it comes to real estate tax strategy. Tax deduction coupled with capital outlay means you're still going to have this nominal depreciation every year off of an income-producing asset.
Something that will never depreciate though? Land. Keep that in mind when making investing decisions.
The IRS is incentivizing the people who own, maintain, build, and invest in our infrastructure. As a commercial property owner — or soon-to-be commercial property owner — it is time to take advantage of that by implementing a tax strategy for 2023 and beyond. Find out how our team of real estate lenders can help you do that.