So you are excited to take advantage of bonus depreciation, but did you know that most states don’t fully conform with the federal bonus depreciation rules? Many states don’t allow any bonus depreciation to be able to be taken. Some states allow partial bonus depreciation to be taken.
Bloomberg has a comprehensive list of which states allow for bonus depreciation and which ones don’t. As always with anything with tax, please consult your own tax advisor to understand how bonus depreciation can benefit you on both a Federal and possibly state level when it comes to reducing income tax liability.
Car washes and specifically, tunnel car washes, have a favorable status in the tax code. Many who buy these know this already, but if the building truly is a tunnel car wash everything there can be identified as 15 year class life. But even tunnel car wash owners can benefit significantly by doing a cost segregation study. Let’s get into it.
For simple math purposes, let’s use some round numbers. We also are assuming that this was not purchased as part of a 1031 exchange. If that was the case, the basis would be lowered or possibly eliminated. One’s CPA would need to tell us what the remaining basis is in the new building. But let’s move on…
In this example, a tunnel car wash sells for $3,500,000. The land value is estimated at $500,000 for this example. So we are left with a cost basis of $3,000,000. If the property was purchased and placed into service between Sept. 28, 2017 and Dec. 31, 2022, then the full $3,000,000 can be depreciated as 15 year class life property in year one. If you have not done this yet and would like to do it, your tax advisor would need to file an IRS Change of Accounting Form 3115. (We draft these for $750 with cost seg studies). If your car wash went into service in 2023, you could take 80% of the $3,000,000 right away in a depreciation expense – i.e. tax deduction / write off. If it’s in 2024, then bonus depreciation goes to 60% – so 60% of the $3,000,000. You can do this without hiring a firm like ours. Just make sure you truly do have a tunnel car wash and always get the advice of your own CPAs.
Why should owners of tunnel car washes consider paying for a cost segregation study when all the property is already able to be classified on a shorter class life schedule at 15 years? Because, it’s likely that 40-60% of that $3,000,000 could be classified as 5 year property. Why would you leave something as 15 year property when for a cost between $7-8k you can have an engineering-based cost segregation study clearly reclassify all your building components into their proper class lives. When bonus depreciation was 100%, this would not benefit you from an upfront depreciation tax deduction benefit, but it would help you when you go to sell. If bonus depreciation is anything less than 100% as it has been in 2023 and 2024, then you can benefit from doing a study both on the front end with more depreciation in the early years of ownership plus you can benefit when you go to sell.
Depreciation: in 2024, you can take 60% of property with a class life of 20 years or less. So using our example above, you have $3,000,000 and can take 60% or $1,800,000 in year one. The remaining 40% will be taken over the next 15 years as it’s 15 year class life.
But let’s say you study the property and it turns out 50% is 5 year and 50% is 15 year. That’s $1,500,000 for 5 year and $1,500,000 for 15 year. You use the 60% bonus depreciation and take $1,800,000 in depreciation expense. That leaves a total of $1.2MM but it’s actually $600,000 that is 5 year property and $600,000 that is 15 year property. That 5 year property gets depreciated over the next 5 years and then is fully depreciated given you a bigger tax deduction in the early years of ownership. The $600,000 of 15 year gets deducted over the next 15 years. So this is definitely a win. $600,000 depreciation deduction over 5 years at a 35% tax rate is a tax savings of $210,000. Now do you think it was worth spending $7-8k on a cost segregation study?
Now what happens when you go to sell the property years down the road. Let’s say it’s 6 years later. Well, you have fully depreciated your 5 year property. Some of it maybe has even been replaced already which is also nice to have a cost segreagtion study which makes dispositions of property a lot easier for your CPA. It saves him time and you can come up with accurate information. That’s a win for you as the owner as it saves you money from an accounting standpoint and you get another write off. But now you go to sell and it will be between you and your CPA what kind of recapture tax you end up paying. Clearly on the depreciation of the 15 year assets, there is still life on those so you’ll have some recapture. But with the 5 year property, you might be able to pay little to no recapture tax on that $1.5MM in depreciation you’ve taken because those components may not have much value any longer. But let’s say your CPA wants to be more conservative and say that he puts a value of $500,000 on that $1,500,000 you’ve taken in depreciation. You pay recapture tax on the $500,000 and NOT the $1,500,000. Recapture tax is paid at your earned income tax rate. So if it’s 35%, this strategy may have just saved you $350,000 in recapture tax when you go to exit. You’ll still have capital gains tax to pay of course and as with all things dealing with tax, please consult your own tax advisor before proceeding.
To sum it up…it we are able to use 100% bonus depreciation, cost segregation doesn’t help very much on the front end of your ownership but it can save you potentially a small fortune on the back end. If we are running at less than 100% bonus depreciation, then cost segregation can help both on the front end with greater depreciation deductions earlier in the ownership life of the building and help with saving on recapture tax on the exit. If you hold long term, having done a cost seg will help when you go to replace parts of the car wash that are no longer working. You’ll be able to take dispositions a lot easier. Those are good and important tax deductions.
I work all over the U.S. If you’d like to discuss or get a quote, please let me know. There is no cost and no obligation.
Many of us thought this was a done deal. In fact, I had thought for some time that Congress would extend 100% bonus depreciation. Part of me thinks they might eventually make it permanent as part of the tax code but there are many in Congress who like to have things like this to negotiate for other deals. If that’s the case, they probably won’t make this permanent.
The House of Representatives passed their bill about 10 weeks ago now. The Senate is still sitting on the Tax Relief for American Families and Workers Act. With all the wrangling going on over Ukraine, Israel and US border funding, things seems to be stuck in the Senate.
I’m so focused on commercial real estate that it hasn’t really dawned on me how this bill impacts other industries. Apparently this is a very big deal for American farmers and they also want this passed.
Most building owners who I know have opted, as they normally do, to extend their tax returns. This year it’s beneficial so they can see if they might end up getting a nice bump from 80% to 100% for their 2023 tax returns.
Anyone paying attention to Washington DC knows that our elected representatives have not put together a real budget. There is still lots to do when they get back to work 🙂 in early January. One of the things that has been floating around DC is the possible extension of the 100% bonus depreciation rule that was originally put into place by the Tax Cut and Jobs Act of 2017.
Many in commercial real estate and particularly the GPs who run the syndications for multi-family investments have become addicted to the 100% bonus depreciation rule. I like to call it the crack of real estate and tax. In 2023 it has moved to 80% bonus and in 2024 it’s scheduled to drop to 60% bonus depreciation.
Bonus depreciation comes in to play or all property with a class life of 20 years or less. When a cost segregation study is completed, the property that is normally all 39 year if commercial and 27.5 year if multi-family / residential investment, gets reclassified to it’s proper class lives which are 5, 7, 15, and/or 27.5 / 39 years. This allows for a much bigger deduction to be taken early in the life of the ownership of the property.
Short-term rental ownership exploded during Covid. The business model has been a good one for many investors throughout the country. These property owners can take advantage of cost segregation just like they would if they owned a commercial building or an apartment complex.
Short-term rentals, VRBOs, Airbnbs are considered 39 year property. It’s commercial property like a hotel is commercial property. It’s not 27.5 year property which is what a long-term rental would be such as a single family rental or an apartment building.
Is it worth is to doing cost segregation on an STR? Yes, of course. Where it might not be beneficial is if you just aren’t netting much profit or if you expect to sell your property within the next year or two. But generally, from what I hear, owners will net $25,000 – $50,000 per year.
In a cost segregation study, the property will be reclassified from all of it being 39 year depreciation to 5, 7, 15 and 39 year property giving you a much bigger deduction earlier on in the life of your ownership. Let’s use simple math to make some calculations. Let’s say you own an Airbnb and you have $600,000 all in. The land is about $100,000. That leaves you with $500,000 cost basis. Normally the FF&E is a separate expense from the real estate. In this case we figure you have this as a separate line item of $35,000 and it is not included in the real estate.
When we do a study on a building like this, we will generally see about 15-20% will be reclassified as 5 year class life property. The land improvements which are 15 year class life property will often come in somewhere in the 3-10% range depending upon the property. So for simple math, let’s say we identify 20% between the 5 and 15 year property. 20% of $500,000 is $100,000. You would get a $100,000 deduction against your income in year one or whenever you decide to do the study and apply it. Now in 2023, bonus depreciation has dropped to 80%. (If you own an STR that you placed into service between Sept. 27, 2017 and Dec. 31, 2022, you would qualify for 100% bonus depreciation). So that $100,000 in depreciation generated by our study would have 80% of that applied to reduce your taxes in 2023. Let’s say you net $50,000 in 2023. That’s after all your expenses, debt service and regular straight line depreciation. If you’re at the 32% tax rate, you’d owe the IRS $16,000. If you did cost segregation, you would owe ZERO and would have a loss carry forward that would eliminate most, if not all, of next year’s tax liability. The cost for such a study might be $3-4k. If you have owned the property for at least one tax year, you would need to file a 3115. That will end up costing you about another $1-2k to complete.
So if you own a short-term rental property and are making money, be sure to reach out to get a quote and see how it might work for you.
Build it in America Act is making its way through Congress. They are looking to extend 100% bonus depreciation through the end of 2025. Right now the law is that for buildings placed in service in 2023, the owner can take 80% bonus depreciation and then it’s slated to drop by 20 points each year until it’s zeroed out in 2027. This new bill allows for 100% bonus depreciation for ‘23, ‘24 and ‘25. No word what happens in 2026. I kind of figured they might extend this given the slowdown we are seeing in commercial real estate.
American Enterprise Institute has some details on what may be in the Build it in America Act which is dealing with tax reform to try to encourage more growth.
If you’d like a quote for cost segregation, I work all over the U.S. in all 50 states and represent Cost Segregation Services, Inc. We’ve successfully completed more than 40,000 engineering-based cost segregation studies over the past 20 years. We’ve studied all building types and classes in all 50 states. Give me a call at 864-276-1448
Recently I received a call from someone inquiring as to whether or not Starbucks were good for cost segregation. Yes, they are excellent for cost segregation because they typically have large parking lots (15 year land improvements) and excellent interior finishing which a lot of that ends up being identified as 5 year class life property.
Here’s a good example. Let’s say this Starbucks was purchased for $2.5 million and the land was worth $500,000. Since the land cannot be depreciated, that must be deducted so we come up with a basis of $2,000,000 for the building. Every building is different but for the sake of understanding how cost segregation can help an owner of a Starbucks building let’s look at how this breaks down.
A cost segregation study is going to identify and reclassify all the building components as well as segregate the land improvements. So with this property, let’s stay 17% was identified at 5 year class life property. That would be $340,000. And for the land improvements, let’s say those come in at 20% which would be $400,000. So on a $2 million building, this owner could accelerated $740,000 or 37% of the building cost or basis. Depending upon the year in which this went into service, it could be taken as 100% bonus depreciation (Sept. 27, 2017 – Dec. 31, 2022). If the building went into service in 2023 then it would qualify for 80% bonus depreciation. (Bonus depreciation drops 20% each year until 2027 when it goes to zero or just regular accelerated depreciation).
If the owner is paying federal taxes at say a 35% rate, that would be a tax savings of almost $260,000 in income taxes. These studies would typically cost less than $6,000 which is an expense…so it’s a net of $3,900. That’s an ROI of about 66:1.
If you’d like to have us evaluate your property for cost segregation, please feel free to reach out and I’d be happy to discuss.
Recently we completed a cost segregation study for the owner of this retail strip center. I thought it might be helpful for you to see the kinds of results with this kind of asset. (Please note that every building is different and will see a different result…some will perform better than others depending on items like finishings and land improvements like parking lots and landscaping). The owner acquired the building in April 2022. For cost segregation, we deduct the value of the land to come up with the basis or the cost of the building. The basis was $1,125,000. The owner had also spent $125,000 on tenant improvements (TI) which were all interior improvements. Because he had purchased the building in April 2022, he would have had a depreciation expense of $18,750. That is straight line depreciation at 39 years. He also could have taken the $125,000 as a depreciation expense without our help as those tenant improvements are considered Qualified Improvement Property (QIP) which has a 15 year class life. Remember in 2022, we had 100% bonus depreciation for any class life under 20 years so the TI’s could be take at 100% depreciation expense. So he could have potentially had a total depreciation expense in 2022 of $143,750. But he ended up with a significantly larger depreciation expense since he did a cost segregation study. The results were as follows:
Basis: $1,125,000
5 Year: $62,247.71 / 5.5%
15 Year: $124,021.77 / 11.0%
39 Year: $938,730.52 / 83.5%
In 2022, any class life under 20 years can be taken as 100% bonus depreciation meaning you can depreciate the entire asset in year one rather than waiting 5 or 15 years. (Starting in 2023, bonus depreciation goes to 80% and then drops 20% each of the following years until it’s zeroed out in 2027 unless Congress changes the law). In this owner’s case, he was able to accelerate or fully depreciate $186,269.48 in year one because of the cost segregation. That combined with the QIP provides a depreciation expense of $311,555.14 in year one. At a 32% tax rate this would equate to a potential tax savings of $100,000. A study like this generally costs less than $5,500-$6,000. It takes 6-8 weeks to complete and the owner and his/her CPA get a complete breakdown in an easy to use format to apply to the owner’ taxes.
Below is the cost detail on this retail strip center.
We all know that mobile home parks and RV parks kick off tremendous cash flow for the owners. It’s a phenomenal real estate investment. There are many different groups of investors who have been trying to buy as many of these parks as they can get funds to do so. In part what they do is they buy these and then immediately cost seg them for massive income tax savings.
If you’re reading this blog post you probably already have a pretty good idea about cost segregation, but in case you don’t, cost segregation is a tax planning strategy where the owner segregates or reclassifies real property into shorter class lives. This allows the owner to take a bigger tax deduction earlier in the ownership of the property.
Mobile home parks and RV parks are some of the best assets for cost segregation. I will often get asked…”how might a specific property do with cost segregation?” I can usually give them a ballpark figure and then have our team run an estimate but other than C-stores and tunnel car washes, there isn’t another asset class that performs as well with cost segregation as does a mobile home park or RV park.
It’s very common for us to see 50-70% of the overall cost be able to be accelerated – i.e. depreciated in the first year of ownership. Let’s say you buy a mobile home park for $2.5 million. The land is worth $750,000. That leaves $1.75 million in cost basis. We would run an estimate for you and note that you could expect $800,000 – $900,000 in increase accumulated depreciation expense. But the actual results might reach as high at $1.5 or $1.6 million potentially. Of course we would not know that until we completed the study. So what happens in these situations is many times these owners have other parks that kick off massive cash. They have big tax liabilities because of that. But now they buy this new park, cost seg it and get maybe a $1 million tax deduction in that first year of buying the new mobile home park. They don’t need that $1 million to offset the income from this newly acquired park but they do need it to offset the other income from their other parks and properties. A cost segregation study like this might cost somewhere in the neighborhood of $5,000 – $7,000 depending upon the complexity of the property.
What kinds of property can be accelerated? Below is an example of what you might see in a cost segregation study for a mobile home park. In this particular study, the owner would be able to accelerate $2,141,369.70. At a 37% federal income tax rate, that would be an income tax savings of $792,306. I don’t know what this study cost but let’s say it was $6,500 which is a business write off. That $6,500 after tax is $4,095 making the ROI 193:1….that’s 19000% return on investment. Crazy but it’s legit.
If you’d like to learn more about cost segregation or would like us to run an estimate for you, please reach out. We are happy to run numbers for anyone no matter where you are. There is no charge and no obligation. I can study properties anywhere in the United States and am happy to help.
Certainly rich people use 1031 Exchanges to defer taxes but it is also used by many others who would not consider themselves rich. It’s a highly popular tax strategy as you can imagine among real estate investors. I am not privy to their negotiations nor do I have an insider who might be representing the real estate industry onn this deal but it sure seems to me that Biden is throwing this out there to use as a negotiating tactic or bargaining chip for something else.
It seems difficult to believe they would just eliminate the 1031 Exchange. However, I could see they doing a phase out or a cap depending upon the amount of taxes deferred either per deal or cumulatively. If this ends up being the road this goes down, I’d like to see a counter balance be to extend 100% depreciation indefinitely instead of having bonus depreciation drop by 20% each year until it is zeroed out by 2027. Eliminating 1031s or putting some kind of cap in place would slow down some transaction activity I believe. A counter to that might be extending the 100% bonus depreciation ability. The bonus depreciation helps drive transactions as well. Transactions are good for the enconomy. We want to see more of them rather than fewer of them.
In the event someone reads this who has any influence on this, please remove the sunset provision in the current tax law and immediately bump bonus depreciation back to 100% and make it permanent with no sunset provision.
