By Patrick O’Connor, MAI
Apartment owners can face staggering expenses to maintain apartment communities. The upkeep of even a modest community could involve groundskeeping, unit renovation, and replacements, such as parking lot asphalt and fencing. Another steep expense is federal income tax – and in some areas an additional state tax on income – but through an innovative tax-reduction process known as cost segregation, the depreciation of property components can be used to help lower federal taxes.
Depreciation is a key non-cash tax deduction. Increasing depreciation generates federal income tax reduction since taxable income is reduced. Cost segregation increases depreciation by accurately identifying the correct deprecation life for many components of the real estate. Cost segregation is not a tax shelter and is not tax evasion. It is a legitimate, IRS-guided method of accurately depreciating real estate.
Today, more apartment investors, especially those whose occupancy rates are challenged by the nation’s single-family housing, are taking a close look at every possible avenue to lower costs. That’s a frustrating task in the apartment business. One historically underused technique for saving money, in this case reducing federal income taxes, is to ensure that all depreciable items are reflected accurately on tax returns.
Those items are not limited to copiers, automobiles and heavy equipment. The list extends to a wide range of buildings and improvements. In fact, the IRS recognizes 130 items that depreciate over much shorter time periods than the standard depreciation of 27.5 years for an apartment community. Many of those items, such as parking surfaces, landscaping and even certain wall coverings, are present in large proportions on typical apartment communities.
A cost segregation analysis, when reflected on deprecation schedules, increases tax deductions and reduces taxable income. It also defers taxes on capital gain amounts until the community is sold. At that time, the recapture of taxes on the extra depreciation taken can occur at a much lower rate than the 35 percent maximum tax rate that was avoided with the extra losses.
The time value of money by deferring federal income taxes is often substantial. In light of the 130 IRS-identified “short life” items, this conservative tax-planning tool can help apartment owners allocate more costs to five-year, seven-year, 15-year and 27.5-year improvements versus the land value on apartment communities.
Another component of tax reduction is converting income taxable at the ordinary income tax rate (35%) to the capital gains tax rate (15%). The additional tax deductions caused by increasing real estate depreciation defer federal income taxes. When the property is sold, the gain is typically taxed at the capital gains rate because of the way the gain is allocated.
Apartment communities, according to IRS rules, depreciate over the course of 27.5 years. This is more than 10 years less than the depreciation period for office, retail and industrial properties, which generates more federal income tax deductions for apartment community owners. Items that are found in every apartment, such as carpet, linoleum, window treatments and appliances, are categorized as five-year items, meaning that they are typically replaced after five years of use.
Comparing the Numbers
The following example assumes a total cost basis of $1,825,000, less a land basis of $172,000, for a total improvement basis of $1,653,000. It depicts how using cost segregation increased this owner’s depreciation by $223,715 over five years, with nearly $45,000 more in the first year. Using a 35 percent federal tax rate, this represents a savings of $78,000 in taxes.
|Without Cost Segregation||With Cost Segregation
|Depreciation Life Category
(Comm. Res. Max)
|27.5 Year||5 Year||7 Year||15 Year||27.5 Year|
|% of Improvements||100%||13%||0%||19%||68%|
|Total Value Depreciated||$1,653,000||$215,800||$0||$311,200||$1,126,000|
|Year 1 Depreciated Amount||$60,109||$43,160||$0||$20,747||$40,945|
|Year 2 Depreciated Amount||$60,109||$43,160||$0||$20,747||$40,945||$104,852|
|Year 3 Depreciated Amount||$60,109||$43,160||$0||$20,747||$40,945||$104,852|
|Year 4 Depreciated Amount||$60,109||$43,160||$0||$20,747||$40,945||$104,852|
|Year 5 Depreciated Amount||$60,109||$43,160||$0||$20,747||$40,945||$104,852|
Wide Range of Applications
Whether the community was recently purchased, has been owned for a while, is on the market to be sold or was sold 1 or 2 years ago, a cost segregation analysis can help at any stage of ownership by reducing federal income taxes and increasing depreciation. The optimum time to do this is when the property is acquired, whether the property was bought or built. Any commercial property built after Dec. 31, 1986, is eligible, and there are “catch-up provisions” to accommodate higher savings in the first year when a cost segregation study is completed for communities that have been owned for several years.
Communities of all sizes can benefit, from small communities of fewer than 10 apartments to communities that span several city blocks. If the property has an assessed value of at least $200,000, the cost segregation evaluation can almost always produce substantial federal income tax savings.
Tax deductions and tax reduction benefits are amplified when a real estate owner uses the combination of cost segregation and “catch up” depreciation. Real estate owners seeking tax advice from a cost segregation advisor are often astounded at the level of tax deductions which are possible. Further counsel with their tax lawyer, accountant, CPA or federal income tax return preparer affirms the power and legitimacy of cost segregation.
Preparing for a Study
A small amount of an owner’s time (perhaps 15 -30 minutes) is required when working with a consulting firm that specializes in cost segregation. And it is advisable for the owner’s CPA or tax accountant to collaborate with the consultant, ensuring the most advantageous application for that owner’s particular financial circumstances.
The original purchase price of the apartment community is the cost basis, so owners receive savings on their initial investment, as well as on improvements. With research that is both quantitative (square footage of asphalt, pavement, ect., or quantities of wall or window coverings, ect.) and qualitative (judgment of remaining life) a specialized analysis and calculation is conducted before a report is issued. This report becomes the backup documentation for federal income tax returns.
Apartment owners work diligently to provide quality housing for their residents and generate a profit. In many cases, they exert considerable effort to save $500 – $1,000 on lawn care, waste disposal and utility expenses. Some owners completely delegate federal income tax reduction to their accountant, CPA or tax lawyer. While these individuals have specialized knowledge, it generally is not focused on depreciation. Apartment owners should consider a free preliminary analysis to determine if the tax deductions generated by cost segregation fit their situation.
About the Author
Patrick O’Connor, MAI, is president of O’Connor & Associates. The firm, in business since 1974, specializes in state and federal tax reduction services, real estate appraisals and research and consulting nationwide. With offices in Houston, Dallas, Los Angeles and Newport Beach, the firm employs more than 130 people. Patrick O’Connor is frequently acknowledged by national publications as a respected source of information on real estate trends.
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