For most real estate investors, depreciation is a fundamental aspect of any property and are key in facilitating financial strategies to better optimize results based on certain goals. Depreciation enables property owners to gradually recover the cost of assets over their useful life, thereby helping to reduce taxable income and potentially improve bottom line cash flow. In multifamily property and industrial real estate sectors, getting a deeper understanding of depreciation schedules, asset categories, and accelerated depreciation methodologies helps investors reach for maximum profitability.
Let’s explore depreciation within these categories, addressing variations in asset types, depreciation durations, and the possible advantages of employing accelerated depreciation techniques. Keep in mind, we’re not tax advisors, so please consult your tax professional when considering any of these topics discussed.
Depreciation for Multifamily Apartment Owners
Multifamily real estate properties feature multiple residential units, such as apartment complexes, assisted living/senior care homes and condominiums. An emerging sub category of multifamily real estate is Build for Rent (BFR) housing, which essentially is an apartment community that spreads over multiple acres in the form of town homes or detached dwelling units vs. multi-level apartments. Ultimately, multifamily is housing.
Depreciation in multifamily apartment ownership follows the guidelines set by the Modified Accelerated Cost Recovery System (MACRS) specifically tailored for residential rental properties. Where my CPAs at!? Under MACRS, multifamily properties are depreciated over a period of 27.5 years.
Why so long?
The rationale behind the 27.5-year depreciation period lies in the recognition of the enduring nature of multifamily residential buildings. Unlike certain commercial properties that may require frequent renovations or face technological obsolescence, apartment complexes and condominiums are designed to provide stable and long-term housing solutions for tenants. As such, the depreciation schedule aligns with the extended economic lifespan of these residential structures, allowing owners to gradually recover the initial investment cost over a period of time.
Moreover, multifamily apartment owners benefit from the versatility of depreciation deductions in offsetting taxable income generated from rental operations. By spreading the depreciation expense over several decades, owners can work with their tax professionals to try and reduce their annual tax liabilities, thereby aiming to bolster any cash flow and enhance overall profitability. This tax advantage serves as a vital component of the investment strategy for multifamily property owners, enabling them to optimize potential returns and maintain financial stability in the competitive real estate market.
In essence, depreciation for multifamily apartment owners reflects not only the physical wear and tear of the property over time but also the enduring value and stability historically inherent in residential real estate investments. By adhering to the prescribed depreciation schedule and leveraging tax benefits effectively, owners can navigate the complexities of property ownership with confidence, ultimately striving to realize the full potential of their multifamily investments.
Varied Depreciation Periods for Asset Types
Assets within multifamily properties exhibit different depreciation periods contingent upon their anticipated lifespan. For instance, items like appliances and carpeting may undergo depreciation over a 5 to 7 year period relative to structural elements like the building itself which could be 20 years or more.
– Structural Components: The building’s structure undergoes depreciation over the 27.5-year period.
– Appliances and Fixtures: Assets such as refrigerators, ovens, and light fixtures commonly feature shorter depreciation periods, typically spanning 5 to 15 years.
– Carpets and Flooring: These components generally sustain a lifespan of 5 to 7 years, warranting briefer depreciation periods.
Significance of Cost Segregation Studies
How do you leverage any potential tax savings on shorter lifespan property like carpets and flooring?
It’s called a “cost segregation study”.
Cost segregation studies emerge as a valuable strategy for expediting depreciation benefits within multifamily properties. These analyses entail identifying and reclassifying specific assets to shorter depreciation periods, thereby front-loading depreciation deductions and augmenting any cash flow. This kind of approach proves particularly advantageous for property owners seeking to mitigate current taxable income it may be offset by the deductions from the depreciation.
We find that in order to continue the sheltering of any income through depreciation, apartment owners who exhaust their depreciation typically utilize a 1031 exchange in an effort to maintain cash flows and defer any capital gains. This usually involves working with the apartment owner’s accountant, their attorney and various other professionals who are intimately familiar with the property owner’s situation.
Example: Employing Cost Segregation
Consider a hypothetical scenario where a client acquired an apartment complex two decades ago for $1,000,000. Over the years, they’ve utilized depreciation and have participated in rental income. The property is now valued at $10 million.
By reallocating these assets by way of a 1031 exchange into newer, better property, the owner is now able to expedite their new depreciation and experience an upsurge in annual depreciation deductions, culminating in amplified tax savings and enhanced cash flow. This exemplifies the tangible benefits of integrating cost segregation to optimize depreciation in multifamily commercial real estate.
Depreciation in Industrial Real Estate
Industrial real estate encompasses properties employed for manufacturing, warehousing, distribution, and related industrial pursuits. Unlike multifamily properties, industrial assets frequently entail longer depreciation periods due to the nature of the equipment and machinery involved. Though some parts of the property like machinery and equipment may utilize a shorter lifespan, typical Industrial properties are on a 39 year depreciation schedule.
Diverse Depreciation Periods for Industrial Assets
Industrial properties encompass a myriad of assets, each subject to distinct depreciation schedules contingent upon their anticipated lifespan and usage. Common industrial assets and their corresponding depreciation periods may include:
– Machinery and Equipment: Industrial machinery typically undergoes depreciation over 7 to 10 years, reflective of technological advancements and abbreviated asset lifecycles.
– Specialized Infrastructure: Assets such as HVAC systems, conveyor belts, and storage racks may feature depreciation periods ranging from 5 to 15 years, contingent upon their robustness and maintenance requisites.
Leveraging Bonus Depreciation
Bonus depreciation enables property owners to deduct a substantial portion of eligible asset costs in the year they are commissioned, furnishing an immediate escalation in depreciation deductions and mitigating taxable income. This proves particularly advantageous for industrial real estate investors aiming to offset income and funnel capital into property enhancements or expansion initiatives.
The Clawback (Depreciation Recapture)
Depreciation recapture refers to the potential tax implications when the property is sold if one were to forego a 1031 exchange. When a property owner claims depreciation deductions on their commercial real estate over its useful life, they’re essentially reducing its value on their tax returns each year. That’s a benefit while owning the property, right?
Well, when the property is eventually sold, any gain realized from the sale must account for the depreciation previously claimed. This “recaptured” depreciation is taxed at a higher rate than the standard capital gains tax rate which is currently 25% of whatever you depreciated.
The rationale behind depreciation recapture is to ensure that taxpayers don’t receive an unwarranted tax advantage by deducting more than the actual decline in the property’s value over time. It’s a critical consideration for investors in commercial real estate, as it affects the overall tax liability associated with selling the property.
1031 Exchanges
This is a big reason why investors use a 1031 exchange when they sell their property. Any depreciation recapture, along with capital gains tax and net investment income tax, is deferred until a later date. 1031 exchanges are a great tool for the current property owner, but it is also generally utilized as an estate planning technique for the owner’s family or heirs. Once an owner passes away, their beneficiaries get a step-up in basis – meaning all of that deferred tax gets wiped clean. But estate planning is a topic for another day.
All in all, proper planning and understanding of depreciation recapture can help investors mitigate its impact on their tax obligations.
Conclusion
Depreciation stands as a fundamental financial component in multifamily commercial and industrial real estate investments. Mastery of depreciation schedules, asset categorizations, and accelerated depreciation strategies is super important for aiming to maximize returns and fortify any cash flows. Using accelerated depreciation techniques and identifying opportunities for asset reclassification, property owners can work with their tax professionals to curtail tax liabilities, which may amplify investment yields, and unlock the full potential of their real estate portfolios.
Whether via front-loading depreciation deductions in multifamily properties or harnessing bonus depreciation in industrial assets, proactive tax planning and strategic asset management stand as linchpins driving sustained success in the ever-evolving landscape of commercial real estate investment.