Make U.S. tax law work for you. Self-storage operators can benefit significantly from using cost segregation because of the unique types of construction and exterior improvements found on a storage site.
Although taxes are supposed to be one of the only two things that never change in life, tax laws are morphing all the time. As a CPA and an expert on how tax law relates to commercial real estate (including self-storage facilities), I’d like to share some changes to current tax law that could put substantial money in your pocket, especially via cost segregation studies. With a little strategic planning, you can drastically reduce your tax liability and generate retroactive refunds for extra cash flow.
How Does Depreciation Work?
Depreciation calculates an asset’s reduction in value as time passes, owing to wear and tear. The asset is allocated over a specific period when it’s expected to be useful. According to the IRS, commercial real estate, including self-storage, has a useful period of 39 years; land improvements such as asphalt, parking, landscape, and security fences have a useful allocation of 15 years. Land is considered an asset that doesn’t devalue over time.
Here are the two main options for depreciating real estate:
- Straight-line depreciation, which takes your entire building and depreciates it evenly over 39 years
- Modified accelerated cost-recovery systems (MACRS), which analyzes different parts of a building as individual assets, such as the roof, concrete, asphalt, carpet, appliances, doors, and signage. These may be depreciated over five, seven, 15, or 39 years.
How Does Cost Segregation Work?
Cost segregation (also known as cost seg) is a federal tax methodology that uses MACRS to accelerate the timetable for property-depreciation deductions. To determine depreciation schedules, a cost seg study identifies and reclassifies personal property assets to shorten depreciation time. Engineering and tax professionals can help you identify real property assets and uncover which portions of those costs can be treated as real property for accelerated depreciation.
Under the MACRS methodology, you can identify and reclassify assets in five-, 15- and 39-year class lives, depending on the IRS determination of their actual useful life. Here are some examples:
- 39-year property: Windows, walls, doors, roofs, HVAC systems, plumbing, and electrical components;
- 15-year property: Exterior improvements such as fencing, exterior signage, asphalt, curbs, landscaping, and exterior lighting;
- Five-year property: Carpeting, appliances, specialty lighting, woodwork, unit partitions, individual unit locks, security, business-specific heating, and ventilation systems
By commissioning a cost segregation study, you can retain additional cash flow for capital improvements, repairs, or expansion. Self-storage operators can benefit significantly from using it because of the unique types of construction and exterior improvements found on a storage site. The following table shows how depreciation increases drastically when you apply cost segregation vs. straight-line depreciation. And if your tax bill is lower, you can carry forward any unused depreciation amounts until they’re used up.
*To calculate the direct tax savings, take the depreciation amount shown above and multiply it by the effective tax rate you calculated earlier. For example, $556,822.68 x .30 = $167,046.80 in income-tax savings.
The Bonus Depreciation Windfall
Bonus depreciation (a.k.a. cost segregation on steroids) allows an immediate first-year deduction on a percentage of eligible business property. Under the 2018 Tax Cuts and Jobs Act, first-year bonus depreciation was increased to 100%. It applies to any long-term assets placed in service after September 27, 2017. The 100% bonus depreciation amount lasts from September 27, 2017 until January 1, 2023. After that, first-year bonus depreciation will decrease as follows:
- 80% for property placed in service after December 31, 2022 and before January 1, 2024.
- 60% for property placed in service after December 31, 2023 and before January 1, 2025.
- 40% for property placed in service after December 31, 2024 and before January1, 2026.
- 20% for property placed in service after December 31, 2025 and before January 1, 2027.1
After 2027, alas, bonus depreciation vanishes completely. What else qualifies for bonus depreciation under the new law? Tangible personal property with a recovery period of 20 years or less and components of purchased buildings.
A cost seg study will examine the qualified property you can deduct at the 100 percent rate. What components qualify for bonus depreciation (i.e., immediate expensing)? Carpeting, appliances, movable buildings, security fencing, landscape, asphalt, and exterior signage. Think of it: you could get more than $300,000 in first-year deductions on a $1 million purchase!
Use the 179D Energy-Efficient Incentive
Don’t overlook the Energy-Efficient Commercial Buildings Tax Deduction (known as 179D), which applies to assets like HVAC, the building envelope, or lighting for climate- controlled units. You can take 179D deductions for new construction and retrofits, but you must be able to reduce total annual energy and power costs by 50 percent compared to a sample building from 2007. And you’re allowed partial deductions.
The maximum deduction is $1.80 per square foot. You’re allowed partial deductions of $0.60 per square foot/per system if you reduce energy consumption through the building envelope, HVAC, or lighting. In addition, you’re permitted a partial deduction for interim lighting.
The Benefits of the CARES Act: Recoup Your Losses
In March 2020, Congress approved a $2 trillion stimulus package in response to the coronavirus pandemic: the Coronavirus Aid, Relief and Economic Security (CARES) Act, which includes several improvements to cost segregation and other tax changes that benefit tax credits and the treatment of business losses.
- Bonus depreciation and net operating loss (NOL): In addition to the 100 percent bonus depreciation described above, CARES includes a new, five-year carryback option. You can now carry back a NOL from 2018, 2019 and 2020 to generate refunds and remove the taxable income limitation. The former NOL limit of 80 percent of taxable income is suspended, allowing NOLs to fully offset income in current taxable years. For this reason, you should definitely consider the cost segregation option. You should also consider 179 and 179D opportunities to generate an NOL and possible refunds.
- Excess business loss carryback: The CARES Act resolves the excess business-loss limitation (the $500,000 cap) applicable to pass-through business owners and sole proprietors for taxable years beginning in 2018, 2019, and 2020. This allows businesses to benefit from the modified NOL carryback rules.
- Alternative minimum tax (AMT) credits: CARES provides temporary relief from TCJA provisions that imposed limitations on using AMT credits. By accelerating the timetable, it allows companies to claim refundable credits to help with cash flow during the pandemic.
But There’s More: Potential New Tax Changes and Options to Defer Taxes
On a macro level, there are potential tax changes that could be coming under President Biden: higher tax rates, a lower estate tax limit, higher capital gains rates, and a potential loss of 1031 exchanges. But as of now, these changes haven’t happened, and considering how the winds of politics can blow, they might never be enacted into law.
That said, let’s focus on options to defer taxes that are currently official parts of U.S. tax law and that you can take advantage of now:
- 1031 property exchange into a Delaware Statutory Trust (DST);
- 1031 exchange (while it lasts);
- 1031 exchange (while it lasts);
- Purchase/build and use bonus depreciation;
- Write off abandoned assets at or after renovation or replacements
Don’t Leave Your Hard-earned Tax Money on the Table
A word of advice: the arcane world of taxes can be bewildering. Even most seasoned CPAs are unfamiliar with the tax strategies I’m outlining here, so it can be best to ally yourself with engineering and tax professionals who are conversant with such specialized solutions as cost segregation, bonus depreciation, 179D energy incentives, and NOL carryforwards. But the financial rewards might surprise you.
