How passive real estate investors benefit from accelerated depreciation

Smart money does smart things and there are reasons why real estate frequently forms a key part of wealth preservation and growth.  Through real estate investing, it is entirely possible to have no tax obligation even with strong cash flows and maybe even help generate a refund!  One of the best tools in offsetting cash income with non-cash expenses is rooted in depreciation expense.  In fact, the benefits from cost segregation studies can be both material and timely to partnership and the investor cash flows – sometimes in unexpected ways…

Fundamentally, a cost segregation study allows for more depreciation expense providing the benefit of lowering taxable income and even generating a taxable loss.  Depreciation expense is great.  The tax authorities recognize that assets lose value over time primarily through wear-and-tear all the while you still own the asset.  Accelerated can be even greater.  The same taxing authorities recognize that some assets lose value at different rates.  So, a building might take 39 years to write down the full value but an air conditioning unit might have a useful life of 15 years.  Through the combination of accounting and engineering expertise, a cost segregation study will identify and separately categorize the full range of assets included in the cost of the building –concrete and masonry from the walls/flooring/ceiling and further from the finishes and even still from the plumbing and electrical systems – each with a different assigned useful life.

For the property and partnership, the primary metric reflecting property performance is net operating income.  However, the ultimate consideration for the real estate investor is total net income where higher depreciation expenses can help a healthy net cash producing property generate a net tax loss.  With the higher cash flows and a lower tax burden, you will want to ensure that the acceleration of depreciation doesn’t get out of hand.  The best defense in any inquiry is a cost segregation study produced by a reputable firm who produce detailed support and credibly stand by their analysis based on their training and experience.  The audit trail will allow the owners to feel comfortable with great combination of higher cash and lower taxes.  

In an effort to share best practices, we have utilized cost segregation to better approximate a projected total net income.  Capital gains can come in jolts.  A transaction can settle at the end of a tax year or a passive interest in a Limited Partnership can inform you of a gain that was realized in a prior year.  A cost segregation has the powerful benefit of having an impact even after the close of the tax year. 

For example, months after the close of the tax year, we found out that an LP investment produced a significant taxable gain from a sale in the underlying partnership.  At such a late stage in preparing the tax return, we could no longer look to the stock portfolio to offset the gain with any losses.  With projecting a taxable gain, a cost segregation is one of the few tools that can be pursued to mitigate the taxable gains. 

Importantly, a cost segregation can work on assets you have owned for a while.  Although an existing asset has likely had the benefit of regular depreciation expense, the missed accelerated depreciation over the years can be caught up in one year.  So, a single significant tax event in one year can be offset by the cumulative impact of missed accelerated depreciation from previous years.  By utilizing cost segregations properly and strategically, the benefits to the property owners can be significant!

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HLC has prepared this article based on information from various sources that are believed to be reliable (including clients and other third parties), but no guarantee is made as to its accuracy or completeness and HLC accepts no liability related to information provided.