One of the most common questions my investors ask me is how cost segregation can impact passive real estate investors from a tax perspective, particularly in a multifamily syndication.
First, let’s define the term. Under United States tax laws and accounting rules, cost segregation is the process of identifying personal property assets that are grouped with real property assets, and separating out personal assets for tax reporting purposes. That’s why I wouldn’t classify it as a tax loophole. It’s a common practice that has been around for decades.
Here’s how it works: The IRS allows you to, essentially, write off a paper loss from your taxable income. Typically if you have a rental property, you can write off the entire value (of the property) over the course of 27.5 years. Which is great!
You have the income generated from the rental property, and you have your related expenses: your mortgage interest, management fees, and expenses that come up, like having to replace a boiler, for example.
When you deduct those expenses from your income, what’s left is taxable income. But wait – you’re not done yet!
You still have the depreciation of that property, which you can count as a loss on your tax return. This, again, shrinks your taxable income. It’s one of the best tax advantages out there, and it’s where cost segregation comes into play: Cost segregation allows you to accelerate the depreciation schedule.
I mentioned earlier that without cost segregation, you can depreciate the value of the apartment building over the course of 27.5 years. With cost segregation, you can accelerate that timeline and take your depreciation MUCH sooner.
How much sooner, you ask?
Watch the video below (or keep reading).
Here’s how it works. You send an engineer to your property, and the engineer has a giant spreadsheet where he/she breaks the entire building into its constituent parts: roof, electrical wiring, carpet, appliances, furniture, etc. You get the idea.
The IRS allows you to depreciate these different items over various time schedules. For example, a carpet might depreciate over a five year period. A roof, maybe 15 years. Electrical wiring, perhaps another 15 years, or whatever the case may be. More on this can be found in IRS Pub 527.
By using this spreadsheet, applying the tax code to each of these elements, about 90% of the value of the building is depreciated in the first seven years or so.
That’s very powerful, right?
Now, it goes a step further. Donald Trump is a real estate investor. When he was elected as President, he passed a slight tweak to the law which now is called “bonus depreciation.” This basically allows you to deduct nearly 100% of the value of the building – in the first year.
It gets better.
Previously, bonus depreciation would only apply to new equipment. (Like that boiler you had to replace). But this tweak allows for the bonus depreciation to be applied to used equipment as well. The amazing part is, now, you can deduct almost the entire cost of the property bill.
So, you end up with this giant taxable loss in Year 1. That’s why for all of the properties that we purchase at Nighthawk Equity, we do a cost segregation analysis and pass that bonus depreciation on to our investors.
Managing Taxes on Deal Income
Here’s an example for you.
Let's say you invest $100,000 in one of our multifamily syndications and suppose we distribute an $8,000 return on that money. That’s an 8% cash-on-cash return. You're putting that money in your bank account, you're going on vacation with it, you're spending it or doing whatever you want to do with it.
And then comes tax time.
You get your what's called a K1, which is your tax statement. (The K1 is what you give to your CPA to do your taxes as well.) On that K1 it shows that you received an $8,000 distribution but – magically! – your taxable loss was $40,000 (or some giant number).
You're thinking that your CPA is going to look at this and go – “What the heck happened? You lost money on this. This was a really bad deal!”
Don’t panic, and don’t worry. While you show a taxable loss, you still made money. And this is the exact reason why people attack President Trump. They think that because he shows a taxable loss, he must be a bad investor. Meanwhile, he’s putting millions of dollars in his pocket. That’s the part the average person does not understand.
The multifamily investor gets to put money in their pocket and defer taxes. That's really the beauty of this bonus depreciation. You have a taxable loss and you can use it to offset other passive income strategies that you may be using (investing in other businesses, oil, whatever it may be).
And if you don't use the depreciation that year, you can roll it forward to the next year. So let’s say you have income from your investment the following year, another $8,000. You can offset that gain with any kind of passive losses you haven't used yet. Brilliant!
Nighthawk Equity knows a lot of full time investors that basically pay little to no taxes. The government has really set this up to incentivize real estate investors.
Tax Deferment vs. Tax Avoidance
As the saying goes, there’s only 2 things in life that you can’t escape: death and taxes.
Depreciation, in one sense, avoids taxes. It avoids taxes because the IRS considers it as an expense and, therefore, reduces your taxable income right now. In that sense, you're literally avoiding taxes.
However, when you sell, you may have to pay taxes on the gain. And this is where you could argue that the appreciation could be a deferred tax.
For example, when you pay taxes, you have to pay taxes on the gain. You buy a property for $1 million. Years later you turn around and sell it for $2 million. There’s a $1 million gain that you pay taxes on.
But, because of the depreciation, it lowers your basis. So in other words, when the IRS calculates your gain, it's not on the full price. Rather, it’s on the $1 million minus whatever you depreciate it.
Purchase Price – Depreciation = Basis
If I depreciate $800,000 from bonus depreciation. My actual basis (my starting point) is $200,000. As far as the IRS is concerned, they're going to tax me on a gain from $200,000 to $2 million. It’s a $1.8 million gain that you’re taxed on, which is called depreciation recapture.
You're getting the benefit of the depreciation now, but you may have to pay for it later.
Now there are mechanisms to defer that tax as well. For example, there is something called a 1031 Exchange. It essentially allows you to take the gains you've made and roll it into an equal or greater piece of real estate.
You're in the Bay Area of California and you own a house. You have $500,000 of equity in the house because you held it for 10 years. You don't want to pay the gain on that, so you can do a 1031 Exchange and take that $500,000 in equity and profit and roll it into a small apartment building, without paying taxes on it.
There’s a process and procedure for all of this, which we will discuss in a future post.
Playing Your Cards Right
The way real estate is constructed; if you know the system and have a good tax advisor, you're going to pay very little in taxes at all.
I've been working with Tom Wheelwright from Wealth Ability. I had been looking for a tax strategist for a while to help me with some of these things. Normally, a CPA just prepares your taxes. But Tom’s firm is amazing because they help you in the planning of these things.
They will look at what you've done: your entities, your previous and also future activity. And they will advise you on what to do.
For example, his experts will look at operating agreements, how depreciation was structured in past deals. They will give you an analysis of how it could have been structured differently and how should you structure your deals moving forward.
These are areas where you really want to work with someone who is an expert in real estate investments, because the tax benefits are enormous. The question isn’t if you’re going to save money–the only question is how. It takes real experts like those at Wealth Ability to help you answer that question.
If you’re interested in investing in multifamily properties but not quite sure of the next step, I invite you to check out this report I’ve created. It makes a great case for why everyone should be interested in passive income through multifamily investing.
Check it out here: www.TheMichaelBlank.com/report
If you’re already convinced and want to be involved and hear about our deals, join the Night Hawk Equity Deal Club. Go to www.NightHawkEquity.com and click the join button to setup a call with us. We look forward to getting to know you and building a relationship.
*Michael Blank does not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.