How Cost Segregation Can Benefit Property Owners and Managers
by David Crown
Class is in session, and today you’ll learn how cost segregation can lead to accelerated depreciation of an income property. Now, before we begin, I want to clarify that I am neither an attorney nor an accountant, so please don’t take the advice of this article without first consulting your licensed attorney and accountant. But, this article is as much about investment as it is about property management because I believe understanding investment strategies can help managers see the income properties they manage from an owner’s perspective, and offering this benefit to clients can set managers apart in the field.
While some of the terminology may sound complicated, the end result of this combination is simple: it’ll save property owners money.
I can remember a time when I was fully ready to send a check to the IRS for an $80,000 tax payment on a property I owned. I had already stamped the envelope when I received a last-minute call from a colleague advising me to look into cost segregation. With one call to my accountant, I saved all that money. Consider this your last-minute call.
The concept of depreciation is crucial to this strategy. Depreciation shelters income because the IRS allows tax deductions based on the perceived decrease in value of real estate, even if that perception isn’t entirely correct (meaning the real estate isn’t actually decreasing in value).
In a cost segregation analysis, elements of the property fall into two categories: real property (which includes permanent and immobile things like the foundation of a building) and personal property (things like kitchen cabinets, HVAC units, etc.). The real property components depreciate over a period of 27.5 years, but the personal property components depreciate over shorter periods — five, seven or 15 years, depending on the specific element. Cost segregation takes stock of the individual assets of a property and accelerates depreciation, making it possible to deduct more from your taxes.
When someone sells a property for more than the value they’re being taxed on, something called depreciation recapture makes it so that they have to report the gain to be taxed at capital gains rates. Of course, they can transact a 1031 exchange — a trade of one income property for another (or multiple that equal the first in value), letting the owner defer capital gains taxes — to defer the depreciation recapture, but this counts against depreciation opportunities on the new replacement property.
This class of deduction may only be available to those classified as real estate professionals by the IRS. Make sure to work with the right CPA with experience in cost segregation studies, as they can prepare the study and include it as part of your tax preparation.
As I mentioned earlier, I once saved a significant amount on taxes simply because somebody in my circle had the know-how and the wherewithal to recommend looking into cost segregation. The money I kept because of that changed the trajectory of my whole year. If you’re a property manager, gaining a basic knowledge of these principles can immediately make you more valuable to the owners you serve. You can be the person in their circle who changes the trajectory of their whole year.
I’ve always said that truly excellent property management includes more than the tasks typically expected of a property manager: maintenance, rent collection, tenant placement, et cetera. A top-tier property management company shouldn’t see their mission as solely keeping a property in profitable shape, but should instead see themselves as the facilitators of a comprehensively positive ownership experience. Managers should always be looking for new ways to improve their clients’ returns, even if those ways fall outside the realm of traditional management.
So if you’re a property manager, I encourage you to go above and beyond by learning more about tools like cost segregation, and, in general, to keep your mind open to unconventional ways you can benefit your clients. And if you’re a property owner, I recommend working with property management professionals who will constantly seek progressive ways to enhance your ownership experience.
Concepts like these might scare away some in the property management industry, where profits are often made in the day-to-day details of plumbing and roofing. But learning to save property owners money through investment is just as important as learning to save them money on maintenance. Cost segregation analyses can lead to more sheltered income, and that’s a benefit most management companies don’t provide, but should.
David Crown is the C.E.O. of Los Angeles Property Management Group, and has over twenty-five years of experience managing all types of income properties. A hands-on leader who has managed properties in 16 states, Mr. Crown has been asked to serve as an expert witness in property management matters, and currently serves on the Forbes Real Estate Council. He can be reached directly at 323-433-5254.