After a hot streak at the roulette table, a gambler strolls away, leaving behind his pile of $1 million in chips. Shocking to think of, isn’t it? None of us would be so foolish as to walk away from so much money — or would we?
Actually, leaving large sums of money on the table is exactly what many commercial real estate owners do once they acquire a building. This is because they have not been taking advantage of tax deductions related to depreciation. And now time is running out. Mortgage brokers need to advise their clients that if they don’t take action by the end of this year, they may be walking away from hundreds of thousands — if not millions — of dollars in accelerated depreciation deductions.
The tax deductions at hand were outlined in the Tax Cuts and Jobs Act of 2017. The act made major changes to the rules on bonus depreciation. Most significantly, it doubled the bonus depreciation deduction from 50% to 100% for qualified property acquired and placed in service after Sept. 27, 2017, and before Jan. 1, 2023.
Bonus depreciation is a tax incentive that allows a business to immediately deduct a large portion of the purchase price of an eligible asset, including real estate, rather than write it off over the useful life of the asset. Qualified properties are defined by the IRS and involve virtually any asset class, including multifamily housing. The purchased or improved properties must have a useful life of 20 years or less, and they must be purchased from an individual or entity not related to the taxpayer.
Bonus depreciation must be taken in the first year that the asset is placed in service. Taxpayers can deduct any amount of bonus depreciation. If the deduction creates a net operating loss, they can carry this amount forward and deduct it from future income.
Notably, it’s critical for real estate owners to take the depreciation this year to get full use of the program. Bonus depreciation of 100% comes to an end on Dec. 31, 2022. Starting in 2023, the rate will drop to 80%, and it will continue to drop by 20% annually until the provision sunsets in 2027.
Not all commercial real estate assets are eligible for bonus depreciation, so real estate owners will have to use a cost segregation study to determine how much of their property can be included. A cost segregation study is a way to maximize depreciation deductions and minimize tax bills.
Assets with a life span of 20 years or less are eligible for bonus depreciation. The study looks at each element of the property and identifies the items that are eligible for an accelerated depreciation timeline, based on IRS criteria.
Traditionally, a commercial property must be depreciated over 39 years (or 27.5 years for multifamily properties). The IRS, however, recognizes that certain components of real estate can be depreciated on a faster timeline. These items include specialty lighting, flooring, decorative millwork and even landscaping.
Such items are eligible for bonus depreciation. And if the building was acquired after Sept. 27, 2017, the property owner can still take advantage of accelerated depreciation without having to worry about amendments to their previous tax returns. These bonus depreciation rules also have been extended to purchases of previously used assets. In other words, a commercial real estate owner can fully depreciate all qualifying assets acquired this year.
Here’s an example of how accelerated depreciation can work. In November 2021, a client closed on an 80-unit apartment acquisition in Orlando for about $8 million, which would usually take 27.5 years to depreciate. After completing a cost-segregation study, the owners were able to legally take more than $1.8 million in deductions on their 2021 taxes. Without cost segregation, they would have only qualified for about $29,000 in deductions, since the building was acquired in November with just one month of the year left to count toward the annual depreciation of the building.
Although a certified public accountant, a real estate attorney or an experienced commercial mortgage broker should know about these rules, many do not. A lack of knowledge about this unique strategy is the biggest hindrance in leveraging bonus depreciation for property owners. And as previously stated, time is running out. Property owners need to act fast to get the full impact of this program before it begins to be phased out in 2023.
These tax breaks may be crucial for many property owners during the current economic environment. The COVID-19 pandemic hit many sectors of the commercial real estate industry hard. Although new construction of multifamily and industrial assets has continued to show strength, other sectors have suffered. Lockdowns, quarantines, social distancing, remote work and job losses have all changed the face of commercial real estate.
Now rising interest rates and a slowing economy are beginning to adversely impact the real estate segments that were thriving in 2021. Refinances are coming to a grinding halt and new acquisitions are starting to show signs of slowing down.
Cost segregation has been a financial strategy available to investors since 1997. Today these studies can be more of a help than ever for property owners. But the process isn’t well known. So, let’s clarify some commonly held beliefs about cost segregation.
First, cost-segregation studies are not expensive. Since the IRS issued the audit technique guide in 2004, the cost of the studies has gradually come down. Today the prices can range anywhere from $5,000 to $30,000 or more, depending on the size of the property and its complexities.
Because of the lower cost, studies can even be conducted on buildings valued at $1 million or less. Second, cost segregation can be done on newly constructed buildings or newly acquired older buildings, and the IRS recognizes all purchases or renovations as eligible for cost segregation.
Lastly, cost segregation can be done on buildings that were acquired three, five or even 10 years ago. The process also does not require amending tax returns. And contrary to popular perception, cost-segregation studies do not automatically trigger IRS audits.
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For those who decide a study is right for them, they should be sure to choose a cost-segregation study provider carefully. According to the IRS audit technique guidelines, a qualified engineer with a background in the construction process, experience in cost estimation and allocation, and knowledge of applicable tax law should be taken into consideration. Although there are no prescribed qualifications, the overall accuracy and quality of cost-segregation studies are reflective of the skills of the firm hired to do the work.
Not all cost-segregation studies are the same. Your clients must do their due diligence before hiring a company to perform the study. If done correctly, the results can be lucrative for property owners. But time is of the essence and the clock is ticking for 100% bonus depreciation. ●
Rohit Malik is the founder and principal of consulting firm Business Anatomy. He has been a business consultant for 25 years, specializing in strategic-execution, cost-reduction and tax-deferral strategies for a variety of industries. His work includes cost-segregation and research-and-development tax credits. Malik earned an MBA in operations and general management from the Tepper School of Business at Carnegie Mellon University.
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