The IRS gives a tax break called depreciation to commercial property owners. According to the rules, an apartment building will be worthless after 27.5 years of ownership. That means a building depreciates about 1/27, or 3.64% per year. Therefore, each year the owner is allowed to deduct 3.64% of the building’s value from the property’s income before computing the tax liability.
Non-residential commercial property is depreciated over 39 years, so each year 2.56% of its value can be deducted as an expense.
It must be noted that land does not depreciate, at least according to the IRS. Many property owners use an 80/20 rule to value the building versus the land. In the case of an $800,000 purchase, the building(s) would be valued at 80% of that or $640,000. The land would therefore be worth $160,000. Starting at this point, an apartment owner could deduct $640,000 x 3.64%, or $23,296 each year. For an owner in the 28% tax bracket, that’s a real savings of $6,522.88 a year.
However, through a formal procedure known as a Cost Segregation Study (CSS), much greater savings can be realized. The IRS allows you to speed up depreciation on certain elements that make up the property. For instance, many land improvements such as parking lots, fences, sidewalks, sewer lines, etc. can be written off over a 15-year period. Items classified as personal property can be depreciated over a 5- or 7-year period. Examples include carpets, appliances, window coverings, countertops, cabinets and more.
From the perspective of saving on taxes, the savvy commercial property owner will label as much property in the 5-year category as possible. If $100,000 of personal property was so designated, for each of 5 years the owner could take $20,000 as depreciation expense, lowering his taxable income. If that much property had not been segregated out, it would have depreciated over 27.5 years, resulting in only $3,636 saved per year. Over the 5 year period, just this one category would save over $81,000 in taxable income.
Let me give you a real life example. We recently purchased an 18-unit apartment property for $800,000. As noted above, if we just took 80% of this as value of the buildings and depreciated it over 27.5 years, we could expense just over $23,000 a year.
Now let’s see what happens when we do a Cost Segregation Study. To be in compliance, you need to have a third party perform the CSS. We picked a local engineering firm that specializes in this process.
They went into one unit of each type: studio, one bedroom and two bedroom. They measured the carpet, the countertop space, the cabinets, floor molding, window covers, electrical outlet covers, lights, interior doors and shelves, etc. Outside they inventoried the exterior lights, parking lot, fencing, retaining walls, planters, handrails, sidewalks and more. They ended up with almost 100 items put into the 5-, 7- or 15-year categories.
Here are the totals in each category:
Taking the first number, you can take 1/5 of the $86,775 or $17,355 as an expense every year for the first 5 years you own the building. Similarly, you can take 1/7 of the $66,543 or $9,506 each year for 7 years and 1/15 of the $66,369 or $4,425 per year for 15 years. And you also get 1/27 of $522,916 or $18,615 per year for 27.5 years.
So in each of the first 5 years you can deduct $49,901 from the property’s income before figuring your taxes. If you have a loan and are deducting the interest payments, that’s also deductible, along with your usual operating expenses. Thanks to the great power of the CSS, it’s actually possible to have a property throw off great cash flow and still show a loss on your investors’ K-1s. So they can have an income stream as well as a deduction on their personal taxes.
When you sell the property, the total amount you claimed as depreciation will be taxed (currently) at 25%. Still, you’ve saved way more than that upfront, so it’s still a great thing to do. And if you take advantage of a 1031 exchange when you sell, you can push that tax even further into the future.
Be sure to have a good conversation with your accountant before you get into this. It can really save you a lot of money over the long haul, but it’s best to leave the details to the experts.