A question that I am frequently asked is whether or not passive investors are able to benefit from a cost segregation study. The strategy is more often talked about relative to active investors, however with the right approach, passive investors are able to capitalize on a cost segregation study as well.
Let’s start off with discussing what a cost segregation study is. A Cost Segregation study is an IRS approved federal income tax tool that increases near term cash flow by utilizing shorter recovery periods for depreciation to accelerate return on investment. For newly constructed, purchased or renovated properties and also retroactive generally over the last 10 years, building components are properly classified into individual units of property and accurate recovery periods for computing depreciation deductions. The study identifies with forensic engineering detail the immediate Bonus Depreciation 5, 7 and 15-year personal property class lives qualifying portions of a building that are normally buried in 27.5 year residential or 39 year commercial categories. The use of the accelerated depreciation strategy helps real estate investors to reduce the tax liability immediately which therefore increases their bottom line due to the offsetting of income. An additional benefit of a detailed engineering-based Cost Segregation Study is that it can increase potential insurance premium savings as well as provide support for the property tax appeals process. Additionally, it can help maximize renovations and improvements.
With the right tax plan and expertise, passive investors can benefit from significant tax savings through accelerated depreciation schedules without the daily involvement required of active investors. Two examples of investment vehicles that passive investors can utilize:
- Real Estate Syndication: If you are invested in a real estate syndication, be sure to understand whether or not the benefits of the cost segregation can be passed on to the investors. This can usually be found within the syndication agreement.
- Real Estate Investment Trusts (REITs): If you’re invested in a REIT, the dividend payouts could potentially be increased by performing a cost segregation study on the underlying assets thus accelerating depreciation. A key point to make is that not all REITs are qualified to benefit from a cost segregation study as it depends on the structure and the properties that the REIT holds. If you are looking to benefit from a cost segregation study through a REIT, be sure to ask this question on the front-end.
- The types of properties that really benefit from a cost segregation study are commercial properties, vacation rentals and multi-family residences.
Let’s walk through an example. Let’s say you invest $2,500,000 into a passive syndication that uses investor capital to purchase a multi-family property. The land is valued at $500,000, so your depreciable basis is $2,000,000. Multi-family property depreciates at 27.5 years. However, a cost segregation study was performed and $400,000 of assets qualify to be depreciated over 5 years rather than 27.5. If the study had not been performed, you’d deduct $72,727 each year based on the $2.0M value ($2M / 27.5 years). However, with the cost segregation study, you could deduct an additional $80,000 annually for the first 5 years due to the assets being reclassified ($400,000 / 5 years). Let’s assume you are in the 24% tax bracket. The accelerated depreciation schedule could save you $19,200 per year in taxes for the first five years for a total of over $96,000 in savings. The ability to front-load deductions provides major benefits for passive investors who want to maximize returns. Cost segregation unlocks substantial tax advantages that would otherwise be left on the table.
Key limitations to keep in mind:
Income Thresholds to Watch
The IRS rules for passive losses can be complicated. For instance, losses from one passive investment can offset gains from another, but only up to a certain point. Depending on your AGI levels, your usage may be limited.
Passive Activity Loss Rules
The accelerated depreciation is considered a “passive activity loss.” Wages, business income, etc. are not able to be offset by these deductions - only streams of passive income. Here’s a great article explaining the passive activity loss limitations: Passive loss limitations on rental real estate - Journal of Accountancy
Long-Term Impacts
Cost segregation front-loads deductions into the early years of property ownership. This leaves fewer depreciation benefits down the road. Factor the long view into your overall investment strategy. Many investors who utilize this strategy plan to continue to invest in real estate to be able to continue to capitalize on this tax strategy.
Long story short, both active and passive investors are able to benefit from cost segregation studies. Are you a passive investor that has benefited from a cost segregation study? We’d love to hear your story!
