Real Estate Investment Trusts (REITs) offer investors the chance to earn steady income and add diversity to their portfolios. They also enjoy a unique tax structure compared to traditional corporations. REITs are generally exempt from corporate income tax as long as they meet specific requirements, such as distributing at least 90% of their taxable income to shareholders. However, REITs still need to carefully manage their tax liabilities. This is where cost segregation can provide a significant advantage.
In simple terms, cost segregation is the process of breaking down a residential or commercial building into its various components. These components are then assigned appropriate tax depreciation schedules, which are often shorter than the traditional straight-line depreciation of 27.5 or 39 years. This strategy can unlock significant tax benefits for REITs, ultimately improving their bottom line.
How Cost Segregation Works for REITs
Depreciation Basics
In typical scenarios, real estate property is depreciated over a lengthy period using the straight-line method: 39 years for commercial properties and 27.5 years for residential properties. This approach allows only a small percentage of the property’s cost to be deducted annually from taxable income.
However, many building components such as carpets, specialty lighting systems and certain landscaping elements do not last nearly as long. Cost segregation studies meticulously identify these components, enabling them to be depreciated over much shorter periods of 5, 7, or 15 years under MACRS. This leads to significantly larger tax deductions in the initial years of a property's lifecycle, enhancing cash flow and reducing taxable income early on.
REIT Tax Considerations
While REITs have a favorable tax structure, there are some scenarios where they can still face corporate income tax. Here are a few common situations where cost segregation's benefits become amplified:
Insufficient distributions: The primary way REITs avoid corporate income tax is by distributing most of their taxable income as dividends to investors. If they fail to distribute enough to meet IRS requirements, the undistributed portion becomes taxable at the corporate level.
Income from non-qualified sources: REITs must derive most of their income from specific “qualified” sources, such as rents and mortgage interest. Income from other activities, like selling property or providing certain services, might be considered non-qualified and thus become taxable.
Taxable REIT subsidiaries: These allow REITs to engage in income-producing activities that are not directly related to property rental. Unlike REITs, TRSs are subject to standard corporate income taxes. This structure enables REITs to undertake a broader array of business operations which would otherwise be impermissible.
In the scenarios mentioned above, the increased deductions from accelerated depreciation become extremely valuable for a REIT. For example, let's say a REIT needs to distribute an additional $1 million to avoid corporate tax. A well-performed cost segregation study could generate enough extra deductions to offset this $1 million, effectively shielding it from taxation at the REIT level.
Key Benefits of Cost Segregation for REITs
The accelerated depreciation generated by cost segregation puts money directly back into the REIT's hands. This additional cashflow can then be used for:
Strategic reinvestment: REITs can reinvest these funds into property upgrades, acquisitions or other initiatives that drive growth and enhance their portfolio.
Improved financial stability: Extra cash can be used to pay down debt, improving the REIT's financial position and potentially leading to better credit ratings.
Larger distributions: REITs can choose to increase the dividends paid to shareholders, making the REIT a more attractive investment option.
Investors are drawn to REITs because of their potential for steady income and diversification. Cost segregation can boost a REIT's appeal even further. Larger, more consistent distributions, made possible by increased cashflow, can attract a wider pool of potential shareholders. This is particularly enticing for tax-conscious investors.
Implementing Cost Segregation
A successful cost segregation study requires meticulous attention to detail and specialized expertise. It involves a team of qualified professionals, including:
Engineers: Their in-depth understanding of construction techniques and tax codes allows them to accurately identify and classify building components based on their expected lifespans.
Appraisers: They play a crucial role in establishing accurate values for the reclassified property components, ensuring the deductions taken by the REIT are fully supported.
Tax specialists: Their knowledge of REIT-specific tax regulations is essential. They ensure the study aligns with IRS guidelines and maximizes the tax benefits available to the REIT.
It goes without saying that adhering to IRS rules and guidelines for cost segregation studies is a must. A well-documented and defensible study offers you peace of mind and protection in the event of an audit. Working with a reputable firm specializing in cost segregation provides the expertise necessary to withstand IRS scrutiny.
Get Started Today
Cost segregation isn't just a compliance exercise for REITs; it's a proactive tax strategy. By accelerating depreciation deductions, REITs can boost cashflow, reduce potential tax burdens and achieve greater appeal for investors. The most successful REITs are those who make tax efficiency a core part of their financial management.
Engineered Tax Services (ETS) is committed to helping REITs optimize their tax position and achieve greater financial success using strategic solutions like cost segregation. If you're interested in learning more about whether your REIT's properties could benefit from cost segregation, contact us today for a free assessment.
