Cost Segregation Studies are great, but slightly less interesting in 2023

Let’s start this week off with some tax discussion. One of the reasons why I’m such a big cheerleader in utilizing real estate investment as a wealth building strategy is the immediate tax savings you can realize right after you acquire your property. First we’ll talk a little bit about depreciation, go into the concept of basis, then delve into ways to realize more tax benefits on a quicker timeline. Lastly, we’ll talk a little bit about the changes to the bonus depreciation rules in 2023.

Writing a Check to Mr. Depreciation

Every business has the ability to deduct expenses against its revenue, thus arriving at a “net income” number which, after some adjustments prescribed by the tax code, becomes “taxable income” which is the base we use to determine tax liability. In simple terms and by way of example, if you earn $10,000 of revenue and incur $5,000 of expenses, of which $1,000 of those expenses relates to client meals, your net income would be $5,000 whereas your taxable income would be $5,500 because you can only take 50% of meals as a deduction for tax purposes. If that’s all the income you earned that year (and let’s ignore the standard deduction for a moment), your tax bill would be $550 since your income would fall into the 10% marginal tax bracket. The core point of this entire example is that you actually need to go out and spend $5,000 in real money to get a tax deduction of $4,500, which at 10% is worth $450 of tax savings to you. That helps, but the last thing I’d ever want to do is make a conscious decision to spend $5,000 to save $450. I have better places to put my funds. It’s for this reason that I never prescribe to my clients the idea that you should just go out and buy a Cadillac Escalade or Tesla Model X solely for the purposes of saving taxes. If buying a truck or expensive auto is already in your plans, then we can discuss and utilize the best timing for the best tax outcome. However, engaging in a transaction just to save taxes solely is akin to the tail wagging the dog.

The reason why depreciation is so different from operating expenses is that you aren’t actually going down to the depreciation store and writing a check to Mr. or Ms. Depreciation for the use of your property. The Internal Revenue Code under Section 167 allows you to take a deduction directly, without writing a check, against your taxable income to account for the reduction in useful life of your property. The code assumes that over time, your property becomes substantially less valuable and eventually worth $0 at the end of its useful life. This is probably true for equipment, vehicles, furniture. However, for residential real estate, the Code assumes the building is worth $0 after 27.5 years of life. Have you ever had to demolish your home or apartment after 27 years? Are all buildings that you’ve been to less than 27 years old? We know the answer to this one is obviously a resounding no. This leaves us with the ability to take a loss without actually incurring an economic loss. That’s an awesome outcome in my world.

What Gets Deducted

Let’s now take an example of you buying a residential property for $2,750,000. Using debt financing, you might borrow $1,925,000 (70%) and pay in cash the remaining $825,000 (30%) to complete the capital stack for this transaction. So what’s your basis in the property? $825,000 or $2,750,000? The answer is $2,750,000 because you get basis not only in the cash you use, but the debt you take on as well to purchase property. This ties into the above very neatly — you now have basis in a property of which you’ve only invested 30% of your actual cash and are now using debt financing to generate tax deductions. I have a hard time conceiving of this outcome in almost any other transaction in the Internal Revenue Code, which is why this again makes it such an amazing outcome.

So do we take $2,750,000, divide by 27.5 years and wind up with a $100,000 tax deduction every year? Nope, need to allocate some of that cost to the basis of land, which isn’t depreciable, and then some to the building improvement, which is depreciable. Determining this number is a facts and circumstances concept which requires some analysis, but to help you understand it better, just think about the location. If the property has an ocean view in a nice part of town, most likely the land will receive more basis than the building. Whereas if it’s in a remote area, the reverse is probably true.

Do We Really Have to Wait 27.5 Years?

The answer is yes, and it’s also no! For a residential building for example, you do actually have to wait 27.5 years to recover the cost basis through tax deductions. However, we never stopped to ask ourselves what is the definition of a building! A typical real estate investor will buy a property, do the land/building allocation with their accountant, depreciate the building over 27.5 years (or 39 years if it’s commercial) and then let that run on repeat year after year. However, think about what’s inside of your property. Is all of it really part of the building asset? Fortunately, the Code provides us some guidance under Section 263(a). In short, the Code introduces a concept of Unit of Property. A building Unit of Property is the sum of all of its structural components including the roof, plus 8 building systems - HVAC, Plumbing, Electrical, Escalators, Elevators, Fire protection and alarm, Security, and Gas Distribution. Therefore, if something in your building is not one of those things, it must be something else. If it’s something else, then the depreciable life is less than 27.5 years and therefore the opportunity opens up to take deductions at a greater pace on a quicker timeline. Some examples of items that frequently get recategorized from the building unit of property to the “something else” category are: landscaping, light fixtures, special plumbing, flooring, millwork, cabinetry, shelving, and wall coverings.

Something Else and Bonus Depreciation

Which leads us to the crown jewel of depreciation, bonus depreciation. In tax years before 2022, stuff in the “something else” bucket was eligible to not only be depreciable over 3, 5, 7, 10, or 15 years but actually just immediately depreciable in full in the first year. Let’s use the $2,750,000 purchase as a hypothetical with a $1,000,000 basis and assume that the depreciable basis is $1,750,000, of which $300,000 is actually “something else.”

Price $2,750,000

Basis

Land - $1,000,000

Building $1,450,000

Something Else - $300,000

In this scenario, your building generates a year 1 depreciation deduction of $52,727 and Something Else generates a $300,000 deduction for a total of $352,727 in year 1. At the top rate of 37%, this results in an immediate tax benefit of $130,500. Essentially, your cash out of pocket is now down to $694,500 since you put down $825,000 and got a tax benefit of $130,500. Now you have more money to play with to invest in future deals.

You may have noticed by now that I haven’t said anything about cost segregation studies yet. That’s because I had to explain everything above first! Now that we know how basis works, you will need to hire a vendor who performs cost segregation studies to help you come up with the analysis above. They typically will come to your property, take photos, inspect plans, and then provide guidance on what should be in building and what should be in the “something else” category. We then run an analysis of the costs involved in performing this cost segregation study against the time value of money to determine whether or not to move forward. That’s something you and I will have to discuss together of course.

Closing Thoughts

Sadly however, the value of bonus depreciation is diminishing. For tax year 2023, bonus depreciation is now limited to 80%, which means the $300,000 in the above example is reduced to a tax deduction of $240,000, with the remaining $60,000 depreciable over its respective 3, 5, 7, 10, or 15 year lives.

In 2024, this drops to 60%. In 2025 - 40% and in 2026, it will be 20% So the best time to do these cost segregation studies is right now.

Reach out to us if you find this interesting or want to chat further about it!

-Stephen Morris, CPA, MBT, CCIM