One of the key elements that is factored into your K1 that helps keep your net rental income low or at a negative value, strictly for income reporting purposes, is cost segregation. Cost segregation expert Brian Bigham from Madison Commercial Real Estate Services gives us a quick and thorough explanation of cost segregation and how it can directly benefit you.
What is cost segregation? Cost Segregation is a commonly used strategic tax planning tool that allows owners who have constructed, purchased, expanded, or remodeled any kind of real estate to increase cash flow by accelerating depreciation deductions and deferring federal and state income taxes.
As the stakeholder(owner) of an apartment complex, the owner can take larger deductions by means of frontloading depreciation in the early years of a property’s life. In 2017 Congress passed a bill called the “Tax Cut and Jobs Act.” that would among other things allow owners of apartment complexes to deduct 100% of the personal property in an apartment the first year of ownership. This will last through 2022, then decrease by 20 points/year until it phases out in 2027.
The maximum allowable cost segregation deduction for 2022 is $1,080,000. Multifamily property that qualifies for a 5-year deduction are carpeting, cabinetry, ceiling fans, and millwork among others. Property that qualifies for a fifteen-year deduction are exterior land improvements such as parking lots, retaining walls, playgrounds, and pools.
So, what does all the above mean to a limited partner (LP) in an apartment syndication?
If the cost of the apartment is $16 million and the cost segregation engineer figures that $4,500,000 of the $16 million can be depreciated the first year, then an LP must use his/her share of ownership in the property to see how much they will get to deduct from their taxes.
Using the formula for figuring your share (amount LP invested divided by the equity raised) multiplied by the equity split is the LP’s share. $100,000/$7,000,000 = .014 x .80 = .0112 is your ownership share. If Cost Seg study states that $4.5 million can be deducted, then multiply that figure by your ownership share. $4,500,000 x .0112 = $50,400 you can wipe off your tax bill. This number can potentially place the owner into a lower tax rate bracket, which could result in paying lower taxes to NO TAXES.