Disclaimer: I am not an attorney and this article is not intended as a substitute for advice from the appropriate legal, zoning, financial, construction and/or tax professionals. This information is provided for educational purposes only and is made without warranties or representations
In the realm of real estate, and particularly commercial real estate, one of the largest (if not the largest) expenses you have is property taxes. Taxes are levied on the value of the property, but there are a lot of complications involved in the calculation, and thus, a lot of loopholes and clauses in tax law that can be used to modify how much you have to pay in those taxes.
One of the most important factors you can utilize to reduce your tax bill is calculating depreciation. Traditionally, any property is divided into two categories: the land and the building on the land. This is a critical distinction. Land doesn’t depreciate, at least legally speaking. Sure, farmland could be tapped out, droughts can make land less viable, and coastline can erode away, but that’s not really factored into the tax code. Legally speaking, land holds its value indefinitely, as-is.
The building, on the other hand, depreciates over time. The IRS sets a schedule of 27.5 years for the depreciation rate of a building; after 28 years have passed, the property is considered fully depreciated. Of course, parts of this schedule are reset as you make improvements and remodels to the building, but that’s a lot of detail for later discussions.
Why 27.5 years? Well, that’s just what the IRS set. It’s also not 100% true all the time. Technically, 27.5 years is the schedule for residential properties, including those you own as commercial rentals. Nonresidential properties have a longer time scale, at 39 years. Both time scales were chosen, while not quite arbitrarily, according to standards and averages when they were chosen. Today, it’s basically just a number you need to memorize.
So, depreciation is pretty easy, right? You take the total value of the property, determine its expected value at the end of its useful life, find the difference, and divide that difference by the number of years of the depreciation schedule. That gives you the amount of depreciation per year, which you account for in your tax filings.
Well, not so fast. First, that’s called straight-line depreciation, which is just one of the ways you can calculate depreciation. Others include declining balance, SYD, and units of production, though whether or not they’re relevant to real estate is another matter.
More importantly, there’s a huge detail I have neglected to mention so far. Not everything about a property is equal.
Above, I mentioned that to calculate depreciation, you divide the total value of the property into two groups: the value of the land, which doesn’t depreciate, and the value of the building, which does.
That’s true, but it’s only part of the story.
Some elements of a building depreciate faster than others.
Each category of item has a particular depreciation schedule. Where a nonresidential property has a schedule of 39 years and a residential property has a schedule of 27.5 years, other categories of items and fixtures can have schedules of 15 years, 7 years, and even 5 years.
Now, it’s not illegal to ignore all of this, calculate a basic long-term depreciation schedule, and only worry about the land vs. non-land values. However, if you do so, you’re leaving a lot of money on the table – or rather, giving a lot of money to the government when you don’t have to.
“Imagine you bought a 4-unit apartment valued at $1,000,000. Let’s say the building is worth $800,000. If you did not do a cost segregation study, you can write off $29,090 per year, as discussed earlier.
But, if you hired a cost segregation firm and it determined that about 30% of the property depreciates in around 5 years, you can write off $60,000 annually from your taxable income for the next 5 years.” – Poplar.
As revealed by the quote above, the process of dividing different items throughout a property into different classes, tracking it all, and using depreciation at faster rates is called cost segregation. Using cost segregation to file many portions of the value of the property into faster depreciation schedules is called using accelerated depreciation.
There are a number of tangible benefits to using cost segregation to determine parts of a property’s value that can be depreciated on a faster schedule. However, there are a couple of drawbacks that can make it less worthwhile for some investors.
The biggest benefit is, of course, tax savings. Accelerated depreciation allows you to write off assets as an expense at a faster rate, which means you pay less taxes in the immediate aftermath of buying the property. That added cash can be used for reinvesting in the property, investing in other properties, or just used throughout your life in other ways.
Related to this, you can also use the information you get from a cost segregation study to save in other areas. Insurance premiums are a big one.
Another benefit is that a cost segregation study usually looks at more than just classifying assets; it often looks into specific ways to categorize assets or otherwise take advantage of clauses in the tax code that let you qualify for grants, tax credits, incentives, and other savings, many of which don’t even have the same drawback as a depreciation schedule.
Another interesting detail is how changing legislation can affect your depreciations.
“The Protecting Americans from Tax Hikes Act of 2015 created a new category of assets called qualified improvement property (QIP). Such assets were assigned a 39‐year recovery period for tax years 2016 and 2017 and depreciated using the straight‐line method.
The Tax Cuts and Jobs Act of 2017 intended to make QIP assets 15-year property under the modified accelerated cost recovery system (MACRS) eligible for 100% depreciation for assets acquired after September 27, 2017 and placed in service after December 31, 2017. However, due to a technical error, Section 168 was not properly amended to classify QIP as a 15-year property. This error meant QIP had a 39-year recovery period and was ineligible for bonus depreciation.
In 2020, the Coronavirus Aid, Relief and Economic Security Act amended Section 168 to list QIP as MACRS 15-year property. With this change, QIP assets are now eligible for 100% bonus depreciation if acquired after September 27, 2017, and placed in service after December 31, 2017.” – CLA Connect.
There’s also the possibility of “reclaiming” lost depreciation. If you have owned the property for a few years and didn’t bother to calculate the depreciation schedules for everything involved, you’ve left money on the table; a cost segregation analysis can allow you to identify the depreciation you “should” have claimed, and you can reclaim it and play catch-up.
Finally, a cost segregation study is a firm foundation for future record-keeping. Knowing all of the individual assets in a property, their ages, their values, their depreciation schedules, and all the rest, helps provide you with plenty of paperwork for potential audits, as well as records you can refer to when you need to make improvements to see where money can best be spent.
What about the downsides, though? Surely, there are some reasons why not everyone performs a cost segregation study and capitalizes on accelerated depreciation.
Indeed, there are three major reasons why you might not want to perform such a study.
The first is the added expense, in both money and time, that it takes to have the study performed. You generally need to hire a qualified accountant to handle the study, and it takes them time to audit the entire property, research everything about it, classify every element of it, and deliver a full report.
Now, the savings you get from that report generally outweigh the cost, but an up-front cost versus a long-term benefit often means that people skip it due to that price tag.
The second is the added burden of paperwork and the complexity involved in filing taxes with a complex, multi-faceted depreciation schedule for everything in the property. Rather than a few relatively simple values, suddenly, your taxes will become a lot trickier. While this isn’t necessarily a problem if you have accountants doing that work as well, it’s important to remember that every added bit of complexity is an opportunity for a mistake to arise.
All of this also increases the chances that the IRS will want to audit you, going over the paperwork with a fine-toothed comb to make sure you aren’t trying to abuse the system.
Third, and most importantly, is that depreciation is only a temporary savings, and you will need to repay that savings eventually. When you sell the property, all that value you wrote off as depreciation is recaptured as a gain.
“You bought a 4-unit apartment for $1,000,000, and you hired a firm to do a cost segregation study. They found that 30% or $300,000 worth of your property can be depreciated within 5 years. So now you took advantage of the bonus depreciation and were able to write off all your income taxes in the first year.
Five years later, you decided to sell the property at $2,000,000. Normally, you will be taxed on the $1,000,000 you gained. But because you did a cost segregation study and depreciated 30% of the property’s value sooner, you now have to pay taxes on the $1,000,000 capital gain plus the $300,000 you’ve depreciated. In that sense, the depreciation expense you used to reduce your tax liabilities early on has been recaptured.” – Poplar.
The benefits still often outweigh the drawbacks, but it’s a calculation you’ll need to make yourself.
One final note: if your cost segregation is overly aggressive and the IRS determines that you’re exploiting the system, they can levy penalties on you; you’ll need to repay what they deem appropriate, plus as much as a 20% additional penalty on the underpaid amount. It’s not common, but it can happen.
Whether or not you should have a cost segregation study performed is largely up to you.
One important detail is about who can benefit from cost segregation studies. The difference between licensed real estate professionals and non-professional investors is significant. Non-professionals can’t take advantage of the tax benefits right away, and they’re limited in how much they can benefit.
Remember, too, that a study will likely take 1-3 months, depending on the scale of the property, and can cost anywhere from $5,000 to $15,000 to have completed. If you’ve purchased your property close to tax season, you may not have time to take advantage of it right away.
It’s always worthwhile to take some depreciation deductions, as there will always be a recapture when you sell, regardless of what you claimed as you owned the property. How deep you go into it, on the other hand, is also up to you.
As California’s top commercial real estate broker, I’m uniquely positioned to help you out. If you want to buy, drop me a line; I’m always on the lookout for properties for sale and ways to facilitate investors buying in, whether it’s your first investment or just one more addition to an expansive portfolio.
Conversely, if you’re looking to sell, please contact me. Demand is high, and I guarantee I can find a great buyer for your property, getting you the best deal you can get for CA commercial real estate today. Don’t take my word for it, though; the proof is in the past transactions.
Erik Egelko is a veteran of the commercial real estate business with a specialized focus on Investment Property Sales. In 2021 and 2022, Erik was the #1 ranked Broker in California for one of the largest CRE Firms as well as ranked in the Top 1% of brokers nationwide. He has extensive experience in a variety of asset types including: Retail Shopping Centers, Medical Office Buildings, Industrial Properties, and Multifamily Apartment Complexes. Over the course of his career, Erik has closed over $100,000,000 of commercial property sales throughout Southern California.