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Apartment Owners Cannot Afford to Ignore Depreciation for their 2006 Taxes

Learn how to save hundreds of thousands on taxes with a $9,800 investment!

By Jerry Kootman, CPA

It is not too late to generate tax savings for 2006. Cost segregation studies can be performed for the 2006 tax return. Many apartment owners have recently discovered the benefits of utilizing cost segregation studies to increase the cash flow and return on investment of their properties. In the process they have discovered that maximizing depreciation deductions reduces income taxes. Most real estate owners spend a fair amount of time managing their expenses and other financial parameters they feel they have control over but neglect to consider how depreciation can factor into the equation. The reason for this is they assume their accountants have maximized their depreciation, when in fact many accountants are not fully aware and have not explored a cost segregation study. This is not uncommon as the cost segregation industry has only recently become more widespread and available to all. Cost segregation is an engineering-based approach to identifying assets within a building that can be reclassified into a much shorter depreciation class than the building itself. This is not simply a matter of classifying furniture or equipment to a 5-year recovery period. Items typically reclassified include certain flooring, finish millwork, cabinetry, specialty electrical and plumbing, and land improvements such as asphalt paving, site lighting and underground utilities. The list is extensive. The following table illustrates the financial benefits of performing a cost segregation study for a sample $5M apartment building and reclassifying 25 percent of the building basis to a shorter life.   Year Depreciation Before Depreciation After Change In Depreciation Tax Savings 2006 $98,500 $231,020 $132,520 $54,824 2007 $181,800 $397,595 $215,795 $89,274 2008 $181,800 $311,595 $129,795 $53,696 2009 $181,800 $257,915 $76,115 $31,489 2010 $181,800 $251,515 $69,715 $28,841 First 5 Years: $825,700 $1,449,640 $623,940 $258,124 Total NPV Tax Savings: $213,692 Typical Fee Range: $6,000 to $8,000

The decision to spend $6,000 to $8,000 and save $213,692 becomes very easy.

Savings are proportionate for lower cost buildings.

Specialized engineering firms that focus on cost segregation, with their blend of knowledge in tax, engineering and construction can typically reclassify between 15 and 40% of a building to shorter recovery periods. The result is a quicker write off of your building and less taxes for you. Think of it this way: If property owners could simply expense the entire construction cost in the year it is incurred instead of capitalizing it, they’d do it in a heartbeat. That’s not feasible, but cost segregation studies provide a good, and absolutely legal, alternative.

Residential rental properties (and everything in them) are generally depreciated using a straight-line method over 27.5 years (39 years for non-residential properties). The cost segregation specialist maximizes the inherent tax benefit by identifying, classifying and segregating the personal property components of the building, resulting in depreciable lives of 5, 7 and 15 years using accelerated depreciation.

The cost segregation specialist uses an engineering-based approach, as specified by the Internal Revenue Service (IRS). The specialist’s job is to examine architectural and engineering drawings, cost data and other project specifications for potential asset reclassification. The cost segregation specialists can use their construction cost estimating expertise to overcome the lack of available information if cost data is not available.

The best time for a study is when a building is constructed or acquired but it is also possible to obtain these benefits for properties that have been in your portfolio for up to 15 years. A retroactive study can be performed without the problems associated with amending prior year tax returns or IRS approval. You can claim the difference between the allowed depreciation and what you actually claimed in prior years all on your current tax return which would mean big tax savings for you.

The government is doing their part to help real estate owners maximize the benefits of investing in real estate. Recent IRS pronouncements have enhanced this tax strategy and made cost segregation studies an even more beneficial method to increase cash flow and profitability of a project.

The IRS recently published a 115-page Cost Segregation Audit Techniques Guide which was developed to provide their agents with a fundamental understanding of cost segregation. Why? Because more and more real estate professionals are using it and the IRS wants their agents to be familiar with it.

The IRS states that “an underlying assumption is that the study is performed by ‘qualified’ individuals or firms, such as those employing personnel competent in design, construction, auditing, and estimating procedures relating to building construction.” For this reason, property owners should align themselves with a cost segregation firm to maximize their tax savings.

To determine if a cost segregation study is appropriate for your portfolio, ask yourself the following questions:
• Is the cost of the building (land excluded) at least $1,000,000?
• Have I purchased, constructed or renovated any property in the past 15 years?
• Do I plan on retaining these properties for at least the next few years?
• Do I have net income that is currently taxed?
Cost segregation will increase your cash flow and return on investment if you can answer “yes” to these questions.

REAL LIFE COST SEGREGATION IN PRACTICE:

A client recently acquired a $5.4 million apartment complex. A cost segregation study was performed which resulted in a Net Present Value tax savings of approximately $247,000.The fee was $7100 with an ROI increase of 2.4%. The client also acquired another complex for $23.3 million which resulted in a Net Present Value tax savings of approximately $1,100,000. The fee was $9800 with an ROI increase of 2.6%. Studies should be done for buildings of $1.0 million and up.

These savings are typical of what can be realized by an IRS permitted allocation of acquisition/construction cost. Cost Recovery Solutions LLC is an engineering valuation firm that specializes in performing these studies for property owners nationwide. We do not replace your CPA but enhance the value of your investment with our combined engineering and tax knowledge. We work with you and your CPA. Why pay unnecessary income taxes? Use the button on the left to contact Jerry for additional information and a free consultation courtesy of Garden StateApartments.com.