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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.
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:
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:
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.
|California Self-Storage Property||Straight-Line Depreciation||Depreciation with Cost Segregation|
|Total Depreciation in First Year||$14,661||$556,822.68*|
*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.
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:
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!
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.
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.
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:
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.