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Multifamily continues to be in high demand. As more people flock to cities for live-work-play lifestyles, developers cannot build apartments fast enough to meet the needs of swelling urban populations. Properties are often fully leased before construction is completed. While this provides immediate rental income, it also results in sooner-than-desired federal and state tax liabilities.
The increased income tax burden could adversely impact the cash flow and retained earnings of property portfolios. There are provisions in the federal tax code to defer income taxes, enabling owners to save the money or apply it to a more strategic use. Proper analysis of assets could result in significant tax deferral.
Cost segregation studies
Cost segregation is an IRS-accepted income tax deferral strategy to increase cash flow, and is ideal for real estate developers and investors. The cost segregation study takes into account an analysis of a building’s components and their costs to properly classify them for tax depreciation purposes. This often results in more personal property identified from the mechanical, electrical and plumbing systems of a building.
The reclassification significantly shortens tax lives to five, seven and 15 years vs. the standard 27.5 years for residential rental properties. Whether building, remodeling or purchasing a multifamily property, cost segregation can defer income taxes and boost cash flow.
“Typically we are able to reclassify 20% to 25% of the construction costs and create some significant tax deferral, which frees up cash when they are completing their first year of operations,” Moss Adams partner Derek Criswell said. “It also frees up capital for new projects, and doesn’t limit the expansion of their portfolios.”
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Repairs and maintenance
The IRS has recently clarified which items can be classified for immediate expensing, creating a new opportunity for more nuanced analysis.
The scope of cost segregation studies related to remodeling has expanded with rules related to improvement of tangible personal property. Rather than just determining which items qualify for accelerated depreciation, studies are now being used to determine if certain costs should be expensed immediately instead of being depreciated over time. It can also be used to determine whether certain assets already being depreciated should be disposed (getting rid of an asset through retirement or other method) or expensed.
“These tax regulations came out and were effective in 2014, but some people are late to the game. The regulations are complicated,” Moss Adams partner Jarret Rea said. "People may not be aware of this opportunity.”
Moss Adams often helps clients understand the newer taxpayer-friendly laws and take a smarter approach to capitalization.
“By virtue of the dollar amount that goes into a renovation, a business might automatically think that they need to capitalize the costs, which could be a missed opportunity to expense certain items under the new IRS regulations,” Moss Adams Senior Manager Duwayne Sibley said.
Retrospective deduction opportunities and timing issues
Enacted as part of the Energy Policy Act in 2005, Section 179D, the Energy Efficient Commercial Buildings Tax deduction has been a popular deduction for those constructing energy-efficient buildings.
Although the deduction has not yet been extended to buildings placed in service after Dec. 31, 2016, there is still opportunity for conducting studies looking back on a prior period. These studies provide taxpayers with a deduction of up to $1.80/SF for buildings of at least four stories tall that meet certain efficiency standards.
The deduction can be applied to current year tax returns without the need for an amended tax return by way of a Change in Accounting Method, Form 3115.
There is currently a plan from the White House and congressional leaders to lower tax rates for businesses. Deductions applied at the current higher rates make them even more valuable in today’s rate structure.
Those who can benefit from a cost segregation study or increases in expensing should take a serious look at performing an analysis sooner rather than later.
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