Cost segregation: A necessity for every real estate purchase

Business News | 7 Jun |

Most property owners have barely heard of cost segregation and those who have think it is a tax issue. The long-term benefits of a cost segregation study (CSS) are often overlooked. These benefits do not require a tax burden for a CSS to be advantageous, making it a necessity for all property owners.

A CSS is an engineer-based study of all of the individual assets purchased in a real estate transaction. This allows the taxpayer to use an accelerated depreciation schedule resulting in higher tax deductions in the early years of the purchase of a property.

The secondary benefit of a CSS is a full accounting of fixed assets, both personal property and real estate. These assets are given different time schedules, most between five and 20 years. These schedules are not just set to benefit the taxpayer, they are set specifically as guidelines to when the asset is likely to run out, break down or become obsolete. These guidelines provided by a CSS can benefit every property owner.

As homeowners, when do we realize that the A/C unit needs to be replaced? It’s usually the day that it becomes really hot in our house. Most don’t set a planned schedule of repairs and upgrades, so an A/C replacement can be an inconvenience. What happens if you own $600,000 worth of A/C units? That is more than an inconvenience – it’s a real problem.

This problem gets compounded by the cycle of asset depreciation. Assume that a property has five, seven and 15-year assets and they have to be replaced according to their depreciation schedule. Not only is there a required purchase in years five and seven, but also when they come due at the same time. For example, in year 15 both five and 15-year assets need to be replaced. Between years 28 and 30, all three groups need to be replaced. See chart A1 below that represents the planned expenses of a $1,000,000 purchase.

How does this effect the profit of the real estate project? Below are two graphs. Graph B1 represents the gross profit of a rental real estate property. We are assuming a 7% cap rate and have not adjusted for changes in either rents or inflation. Graph C1 represents net profit of the same real estate property. C1 holds the same assumptions but adds a 55% profit margin.

First, we would concede that over a 39-year time horizon it is highly likely that the value of the property would easily cover any net profit losses, though that fact would not necessarily affect cash flow needs. Second, a 55% profit margin is a generous assumption. Many property owners experience much lower profit margins, exacerbating the problem.

These planned expenses can be managed if they are indeed planned expenses. If, however the expenses are not properly documented and planned, we leave far too much to chance.

Let’s talk about the term “chance” in a real-world situation. Chance is a term of probability, as in, what is the probability the property will need a new roof in the next year? Leaving large expenses to chance can work for a single property. If the single roof has a 25% chance of needing replacement, the owner can squeeze a few years out of that roof without an expense.

This changes when you move from one property to 100 properties. The 25% chance of having a roof replacement moves to an almost certain chance that 25 properties will need a roof that year. In this light, planning moves from a good idea to an absolute necessity.

While a CSS is a fantastic tool that offers the property owner amazing tax benefits, it is also a tool that can be the difference between a successful real estate venture and a failed one.

 

Scott Roelofs is the owner of RCG Valuation & Monetization. Based in Scottsdale, Arizona, RCG Valuation & Monetization helps small to medium-sized businesses grow and monetize through advanced financial analysis and specialty tax planning, such as cost segregation, R&D tax credits and more. Learn more at RCGValuation.com.

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