Step-up in Basis – we’ve all heard this term but I suspect people are missing out on an opportunity when someone who has an ownership stake in a building dies and his/her interests passes to the rightful heir or spouse in many cases.
I’ve mentioned before that if an owner dies and if there is still decent depreciable basis remaining in the buildings he/she owns, the CPA or tax attorney or executor hopefully are aware enough to inquire about getting a cost segregation study done on that buildings or buildings before the estate files the final tax return. This is a sweet deal for the heirs and might put an extra $10k, $50k, $100k in their pockets instead of going to the IRS.
But what about when a married couple owns investment property or commercial property together and one of them dies. Let’s look at an example. (And with all of this, I’m not a CPA nor an attorney… if you find yourself in this situation, you will need to seek your own tax and legal advice. Some states may have different rules as to how this is applied).
Couple purchased a commercial building 20 years ago for $1,000,000. One of the spouses dies. An appraisal is done and it’s worth is now $3,000,000. The surviving spouse gets a step-up in basis. In this case they get 50% of the appreciated value and the initial purchase price. So the step-up is $1,500,000. Because they have owned this property for 20 years, they had depreciated it already by 50% and it’s likely quite profitable at this point. The surviving spouse can do a cost segregation study on that new step-up in basis and likely save a significant amount on their taxes. Just for simple math, let’s say 20% of it can be accelerated…that’s $300,000 depreciation deduction that they could take based upon studying the step-up.
Here’s an example of how a developer who is building a $30,000,000 multi-family property can defer $1,000,000 in income taxes over the first 5 years by utilizing Green Zip Tape rather than standard sheetrock tape. The video below is 3 minutes long. Green Zip Tape works on projects $10 million or more.
Green Zip Tape leverages financial incentives to build sustainably and drive positive environmental change and will revolutionize the way you manage your real estate construction portfolio.
Tax Savings: 5-10% of your construction costs move from 27.5 or 39 year class life to 5 year class life allowing for faster depreciation
Environmental Impact: Eligible for up to 25 LEED Credits (17 direct, 8 indirect)
IRS-Approved Asset Reclassification: The only tape approved by the IRS to convert interior non-load bearing walls into 5-year depreciable assets. Allows for potential wall relocation and drywall reuse.
Improved Remodeling Process: Enables quieter, quicker, and cleaner demolition, remodels, repairs, and retrofits
Explaining Green Zip Tape and how it can help building owners and developers defer more taxes
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.
Tenant Improvements, or TI’s as they are known typically are not studied. If it’s an interior improvement to a building most CPAs will just mark this cost as QIP or Qualified Improvement Property. It has a 15 year class life just like land improvements do. In the world where bonus depreciation was 100%, I could see why they would do this and not study the improvements. I still think there are benefits to studying the improvements even at 100% bonus but I’ll make mention of that in a minute.
But here we are today at 60% bonus depreciation. In 2023, bonus depreciation was 80%. Pretty much all hope has faded at this point that 100% bonus depreciation is coming back in 2024. Speculation is that the new government in 2025 will renew 100% bonus depreciation for 2025 and beyond but no one knows for sure at this point. All we have is 2024 and we sit at 60% bonus depreciation.
When I talk with CRE brokers about TI’s they will often tell me it absolutely makes sense that TI’s have a shorter class life at 15 years because pretty much once those improvements are made for a particular tenant, they are often worthless to the building owner when and if he has to place a new tenant in the space. Usually they have to tear it out or significantly modify the space for the new tenant. So the improvements have zero value essentially. When I talk with GCs who actually build out these TI’s they often say the 5 year class life property often has to be updated anyway in 5 years. It’s often worn out or maybe outdated. If that’s the case, why not identify and reclassify your TI’s so that you can clearly see what is 5 year property?
What is interesting is that if you actually study tenant improvements, the results will often come back with 30, 40, 50, 60% of the work effort being identified as 5 year property. The result usually is QIP…sometimes there ends up being some structural at 39 years. But lets say the 5 year is 50% of the overall improvement? That is significant in terms of depreciation, tax savings, diminished value and recapture tax. After seeing what I’m seeing on many TI projects, I’m really surprised owners don’t have these efforts cost segregated. The reason they don’t have them studied is their CPAs tell them they will just take 60% bonus and identify it all as 15 year. While that is an accepted practice, the owner is leaving depreciation on the table by not breaking out the 5 year. Some will say it’s not worth the cost of the study. To study most Tis is only a few thousand dollars. It absolutely is worth it for the owner to study it.
Given the space limitations here, I’ll do a follow up post at some point with some further details. But TI’s are not unlike the broader issue with commercial property…why would you buy a commercial property which is made up of 5, 15, and 39 year property but leave it all as 39 year property and depreciate it as such? There are on a few circumstance where that makes sense to do so.
Commercial real estate brokers and General Contractors have a real opportunity here to help their clients maximize their tenant improvements and get all the tax benefits they can out of improving their buildings.
I work all over the U.S. If you’d like to have a conversation, please don’t hesitate to reach out to me. You can also follow me on Twitter @costsegbuilding or visit my blog for more detailed information about cost segregation at www.costsegbuilding.com.
Do you operate a short-term rental such as an Airbnb or VRBO? Is it profitable? I.e. are you having to pay income taxes because you are turning a nice profit on your STR? In this blog post, we’ll explore what cost segregation is, how it works, and the benefits it can offer to Airbnb and VRBO owners.
What is Cost Segregation?
Cost segregation is a tax planning strategy that allows property owners to accelerate depreciation deductions by reclassifying certain property-related expenditures. Instead of depreciating the entire property over the standard 27.5 or 39 years (for residential and commercial properties, respectively), cost segregation identifies and reclassifies specific components of the property into shorter depreciation periods (5, 7, or 15 years). These components can include items like landscaping, fixtures, and certain building improvements. BTW, short-term rentals are considered 39 year property.
How Does Cost Segregation Work?
A cost segregation study is typically conducted by a team of professionals, including engineers, architects, and tax advisors. They analyze the property in detail to identify which parts of the property can be reclassified for accelerated depreciation. The study involves:
Reviewing Architectural Plans and Costs: Examining blueprints, invoices, and other documentation to identify qualifying assets.
Site Visit: Conducting an on-site inspection to verify and document the assets.
Reclassification: Reclassifying the property components into appropriate depreciation categories.
Report Generation: Providing a detailed report that outlines the reclassified assets and their depreciation schedules.
Benefits of Cost Segregation for Airbnb and VRBO Owners
Increased Cash Flow: By accelerating depreciation, property owners can significantly reduce their taxable income in the early years of ownership. This reduction translates to increased cash flow, which can be reinvested into the property or used to expand the rental business.
Tax Deferral: Accelerated depreciation provides a deferral of tax liabilities. By reducing taxable income now, owners can take advantage of the time value of money, allowing them to utilize funds that would otherwise be paid in taxes for other investments or property improvements.
Enhanced Property Value: Reinvesting the tax savings into property improvements can enhance the property’s value, making it more attractive to potential renters. Upgraded properties can command higher rental rates and improve occupancy rates, further boosting income.
Improved Competitive Edge: The savings from cost segregation can be used to offer competitive pricing or to enhance amenities and services, making the property more appealing compared to other listings in the area.
Compliance with Tax Laws: Cost segregation is an IRS-approved method of accelerating depreciation. By conducting a professional cost segregation study, property owners ensure they are in compliance with tax laws while maximizing their deductions.
Flexibility in Planning: The insights gained from a cost segregation study can aid in future tax planning and financial decision-making. Knowing the detailed breakdown of property components and their depreciation schedules allows for better forecasting and budgeting.
Is Cost Segregation Right for You?
While cost segregation offers significant benefits, it may not be suitable for every property owner. One of the things we often will say is that if the owner is planning to hold the property for at least 3 more years, cost segregation will often make sense. If you’re going to hold shorter than that, then it probably doesn’t make sense. We always recommend you consult with your own tax advisor when it comes to cost segregation. The initial cost of the study and the complexity of the property are important considerations. Typically, properties with a cost basis of $200,000 or more are candidates for cost segregation. The more expensive the property, the better the results will be with cost segregation. Depending upon the size, cost and complexity of the property, these studies can often range from about $2,500 to $5,500.
Conclusion
Cost segregation is a powerful tool that can unlock substantial tax savings and enhance the profitability of short-term rental properties on platforms like Airbnb and VRBO. By accelerating depreciation, property owners can increase cash flow, defer taxes, and reinvest in their properties to gain a competitive edge. If you own a short-term rental property, it’s worth exploring whether cost segregation can help you maximize your investment and take your rental business to the next level.
I get asked this question quite a bit….is “this – insert building type or address” particular building a good candidate for cost segregation? And so I also hear this with Dollar General Stores. They are pretty basic. Generally if they are stand-alone buildings they are metal buildings with not a lot of finishing. That said, almost every commercial building that is profitable and has enough basis is usually worth studying. Dollar General Stores are no different.
I recently studied a couple of them for an owner recently and the studies turned out great for the owner. Every building is different of course but in general we might see about 5-6% of the cost be identified as 5 year class life and 10-20% identified as 15 year depending upon the size of the parking lot. The two I completed recently had the 15 year land improvements come back at 16 and 18%. That is significant especially given that 15 year can be taken as bonus depreciation. Remember, property eligible for bonus depreciation is those with class lives of 20 years or less. When we do our studies, we identify 5, 7 and 15 year property. For the tax year of 2023, if a building went intok service in this particular year bonus is 80%. (Note: Congress is currently considering revising this to take bonus back up to 100% at least through 2025 is what I’ve read).
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.
If you’re looking for cost segregation services or studies in the Upstate of South Carolina, I can help. I’m based in Greenville and work with many building owners in Greenville, Spartanburg and Anderson to help them with their properties. We have saved owners a small fortune on their income taxes.
Our firm conducts an engineering-based cost segregation study that allows you as the owner to maximize the deductions you might have with your building(s) when it comes to depreciation. Reach out if you’d like a free, no-obligation estimate on what your income tax savings might be if you utilize cost segregation. We can do this on properties if they have been newly acquired as well as those that perhaps you’ve held for a number of years. Call me at 864-276-1448. John Murphy, CSSI.
Cost Segregation Explained for Mobile Home and RV Park owners in 2 minutes. These are great assets for cash flow and the depreciation these parks generates is second only to C-stores and tunnel car washes. It’s not uncommon to see 50-90% of the property get reclassified so it can be accelerated.
What does this mean? Let’s say you purchased an RV Park for $2.5MM and the land is worth $500,000. That leaves you with a cost of $2MM which as it sits is 27.5 year property. But what if you could reclassify 75% of it by doing cost segregation? That’s $1.5MM in property that has been reclassified as either 5 or 15 year property. In 2023 you can take 80% bonus depreciation. So the owner could get a depreciation expense of $1.2MM in year one of owning the property. If he/she took straightline 27.5 year deprecation without cost segregation, the depreciation expense would be a maximum of about $72,000 that first year depending upon when they put it into service.
Remember that cost segregation is based upon cost and not appraised value. If you have a property that you paid $200,000 for 20 years ago and now it’s worth $1.5MM, a study isn’t going to help you much unless you’ve done a ton of improvements along the way. What we are seeing is a number of these parks are either being developed or they are trading hands. Once that happens, the new owners should definitely look at doing cost segregation.
I work all over the U.S. in all 50 states and get calls from all over the place to help with cost segregation not only on these assets but all types of commercial property. I’d be happy to talk with you at no charge and if you’d like our team to run the numbers for you, just let me know. Connect with me on LinkedIn or Twitter.
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.
