April 15th is coming up. I don’t tend to fret over it like I used to.
Two reasons
- I own self storage facilities and,
- We have had cost segregation reports completed on each one of them.
Real Estate is perhaps the best way to minimize your tax liability. Because I (or you) make all the decisions and work daily in the business, the income and deductions are active income and not passive income. This makes a big difference in reducing what you owe in taxes.
By being active income, there is no limit to the deductions you can take. Even the normal deductions of straight line depreciation, interest write off, and all the operating expenses shelter a lot of the income you make every year.
So here’s the story:
In 2009 I was in a Starbucks having a cup of coffee with someone from a networking group I’m in. He asked me if I knew about “cost segregation.” I said no. He just smiled.
When he told me about it, at first I didn’t believe him. I went back and researched it on my own and was amazed.
In the tax reform act of 1986 (under Regan, I can’t imagine a Republican today ever doing anything like that), commercial real estate lost much of its tax benefits because the depreciation period, among other things, was extending. Straight line depreciation went to 30 years or something (I think).
I was very early in my career in 1986. I didn’t own much of anything then so it really didn’t bother me. The 30-year depreciation is all I’ve ever known, and thought it was a pretty good deal.
Then over that cup of coffee I learned about the story of a Walgreens (I think) that was being built and they sued the government because the fixtures they were installing didn’t have a 30-year life and being forced to use that as the depreciation period was wrong and caused them damages.
And they won!
Now this may not be exactly how it went, but it is a good story and probably close enough for the purposes of this post. So the IRS wrote out guidelines on how to segregate out and shorten the depreciable life of different components in a commercial real estate building.
For example, the wiring to the light fixtures has one depreciable life, the fixtures have another, the framing holding up a demising wall has it’s own, as well as the drywall.
To create all this requires a very complicated report an engineer must complete. But wow, what a difference it makes.
How much of a difference?
Well, for the first self storage project we had a cost segregation report completed on it amounted to over $80,000 per year. In other words, we had over $80,000 more after tax income the first year after that report by shorting the depreciation period.
One project I remember was during the lease up period and we had just finished construction. We distributed $300,000 or so in cash flow to the partners (I owned 25%) and I got a K-1- for a negative $72,000 something. In other words, that year, almost every penny of the cash distribution was shelter by the accelerated depreciation from the cost segregation report.
You can have a cost segregation report completed after a project has been in service for a few years AND you are allowed to go back and amend past years’ tax filings.
If there is ever an audit we’re not the ones sitting with the IRS. The engineer who completed the report and the accounting firm are. (I don’t know anyone who has ever had an audit over this.)
It is our investors who get the biggest bang for their buck because much of the benefits are used up in the first 5 to 7 years of the project. The longer the project is in service, the lower the benefits received each year.
But still, what a problem to have. And if you are putting facilities in service each year like we are now, it is a huge benefit.
I love it. I am very appreciative this exist for real estate investors and owners like we are in the self storage industry.
April 15th has a whole new feel for me today than it used to. And we are following to the letter the IRS compliance guidelines they created for cost segregation.
If you are not using it…well, don’t take my word for it. Do your own research like I did.
