One of the best things about owning investment real estate is the tax advantages, especially self-storage. Let’s discuss some of the benefits today.
Now, I am not a tax specialist, and if anything I say goes against what your CPA or accountant says, always go with your tax professional.
A Brief 40-Year History of Tax Reform
I can remember back in 1985, when I was brand new in the business world and real estate business, I sat in a presentation from a syndicator trying to sell my father shares in a “Tax Sheltered Syndication.” The entire presentation was focused on how to not pay taxes.
He may have talked about ROI or income, but I don’t remember anything about that at all. The entire booklet (no decks or PowerPoint at that time) was on how to buy enough shares not to have any tax liability for your yearly tax returns.
Then in 1986, Reagan brought an abrupt end to that. There were three main aspects of his bill that affected real estate investing. First, it closed the loopholes that the syndicator was using to try to sell my father shares in the syndication. It also had the capital gain portion of the capital gain tax calculation (two parts are depreciation recapture and profit, i.e., capital gain portion) taxed at ordinary income rates.
Next, depreciation was extremely cut back. In essence, it went from accelerated depreciation (what was being primarily sold to my father) to straight-line depreciation of 39 years for commercial real estate. In other words, the tax basis of the property (improvements less land value) is divided by 39, and that was the yearly depreciation allowed. By the way, whatever you depreciate is recaptured and taxed at the current capital gains rate in the capital gain tax calculation.
Finally, the Passive Loss Rule, which is still in effect, limits the loss a passive investor can deduct to their income from passive investment activity, not against active income.
Cost Segregation
Then in 1997, a landmark case, Hospital Corporation of America v. Commissioner, gave concrete birth to cost segregation. In that case, the tax court ruled that the Hospital Corporation of America (HCA) could classify certain parts of its hospital buildings (like electrical systems serving medical equipment, specialized plumbing, decorative finishes) as personal property rather than real property. Those components could be depreciated over 5, 7, or 15 years instead of 39.
This is still one of the main tax advantages we in self-storage can take advantage of. Here is a basic table of how depreciation can be altered from 39-year straight-line to accelerated portions of the project:
Component Typical Recovery Period Examples
Personal Property 5 years Security systems, cameras,
interior lighting, office fixtures, HVAC split systems, roll-up doors
Land Improvements 15 years Asphalt paving, fencing,
landscaping, driveways, etc.
Building Structures 39 years Foundation, walls, roof, and main structure
By using cost segregation, one can usually, in the first few years, deduct 20–40% of the building’s cost in the early years of ownership rather than spreading it over decades.
I remember the first time I used it was in a project where a 50% owner was not on the loan. She would get one half of the NOI as a cash dividend, and we would use the other half to service the debt, and the remaining portion was ours. The first year we used the revised depreciation table from the cost segregation report, we distributed $300,000 to her in cash, then sent a K-1 for that year to her for -$72,000.
But remember, one has to recapture that at the time of a sale unless there is a 1031 tax-deferred exchange involved.
1031 Tax-Deferred Exchange
Investment real estate, which can be any type of real estate except a single-family home you live in, can have the capital gain tax due upon a sale deferred if you “exchange” it into another real estate investment.
This rule in the tax code (Section 1031) has been responsible for untold wealth creation since 1939.
In essence, your tax basis is rolled into the acquired “replacement” property, thus deferring the capital gain tax due upon the sale of the “relinquished” property. This can be done over and over.
In theory, one could do this over a lifetime of investing, then upon your death, the tax basis of the owned properties at that time is stepped up to the then-market value for estate tax calculations.
So in theory, one could beat the capital gain tax by dying. Just kidding… but not really. Many have done just that in their long-term real estate investing strategy.
Bonus Depreciation
Lastly today, let’s discuss bonus depreciation. One of my least favorite people, the person in the White House now—has helped us in the self-storage business.
In his 2017 tax reform bill, bonus depreciation was allowed. Bonus depreciation allows you to immediately deduct a large percentage of the cost of qualifying property in the year it’s placed in service.
- Under the 2017 Tax Cuts and Jobs Act (TCJA):
- Investors could deduct 100% of eligible 5-, 7-, and 15-year property in the first year.
- This included all assets identified by cost segregation as short-life property.
Then in that bill, before the BBB Bill of 2025 (I just can’t say it), the phase-out portion of the original bill, listed next, was ended if the “qualified property” was placed in service after January 19, 2025. (I wonder where that date came from?)
If the property was placed in service before that date, the schedule below applies:
- Phase-Out Schedule (as of 2023+):
- 2023: 80%
- 2024: 60%
- 2025: 40%
- 2026: 20%
- 2027: 0%
Let’s look at an example of how bonus depreciation could help tax-wise.
Example:
A new $5 million self-storage facility might have $1.5 million in assets classified as 5-, 7-, or 15-year property in a cost segregation report.
With 60% bonus depreciation in 2024, that’s a $900,000 immediate deduction, often wiping out income taxes on early-year cash flow.
Item Amount Purchase price $5,000,000 Land value (non-depreciable) $500,000 Building & improvements $4,500,000 Cost seg reclassifies $1,500,000 into 5–15-year property Bonus depreciation (60%) $900,000 immediate deduction Marginal tax rate (35%) $315,000 tax savings in Year 1
What Changed Under the BBB Bill
- Under the 2017 bill, the bonus depreciation rate was set to phase down.
- The new bill reinstates 100% bonus depreciation for “qualified property” placed in service after January 19, 2025.
- The kick-in date matters. If the property was acquired (or under binding contract) before January 19, 2025, it may not qualify for the full 100% under the new law. It may still fall under the old phase-down rules.
- For our self-storage projects, the important question is: what counts as “qualified property”? Generally, it means tangible property with a recovery period of 20 years or less as identified in a cost segregation report, rather than the entire building, which is typically over 39 years.
For us in the self-storage business, the interplay of cost segregation and bonus depreciation is a strategic lever. But be cautious: although the deduction is large in year one, the “tax basis” will be lower going forward, so less depreciation in future years, and you must consider recapture risk. Also, passive activity loss rules for investors in syndications still apply.
Always work with a qualified CPA and/or tax strategist (I am neither) to create your tax strategy. But know that a full picture of the “returns” self-storage can offer must include the tax implications of the strategy you decide to deploy on each project. Take advantage of all possible tools at your disposal. Given the current interest rate and construction cost environment, a good tax strategy may be the difference between “go” or “no go” on a project today.
