As our nation begins to emerge from the economic downturn, self-storage owners should consider some of the tax advantages that can be realized using cost segregation, and the recent changes to regulations that allow net operating losses to be carried for up to five years.
Under the new regulations, if you’ve paid taxes over the last few years and are now operating at a net loss, you can apply last year’s losses back five years. You may also want to consider using cost segregation to increase net operating loss and gain the tax benefit.
This, in turn, may free up some capital to take advantage of what every real estate investor sees as the second coming of the Resolution Trust Corp. of the late 1980s and early 1990s.
Traditional, straight-line 39-year depreciation has generally been the norm for self-storage owners. But over the last few years, many owners have considered cost segregation and accounting modification to free up the capital necessary to take advantage of the real estate investment climate.
The following questions will help you determine if your property is a good candidate to benefit from a cost-segregation analysis. If your answer is “yes” to these, you may be able to apply cost segregation to your facility.
- Is your facility worth more than $1 million, excluding the land?
- Do you plan on holding on to the facility for the next few years?
- Have you purchased or built your facility in the last 15 years?
- Do you have taxable income?
What Is Cost Segregation?
Cost segregation is an analysis performed by an engineer to determine if various facets of your buildings can be reclassified into five-, seven- or 15-year depreciation schedules. The goal is to increase the depreciation amount in the initial years of your investment and decrease your tax bill. But remember: Only the improvements can be depreciated, not the land.
Components such as asphalt paving, sidewalks, curbing, fencing, security lighting and underground utilities have specifically been identified by the IRS as improvements with a 15-year depreciation schedule. Other components such as security gates, certain types of flooring and alarm systems can be reclassified into a five- to seven-year deprecation period.
This increase in depreciation essentially defers your taxes due and, therefore, has the same effect as borrowing money from the U.S. government with no interest. Furthermore, if your accountant has been depreciating your facility using straight-line 39-year depreciation, you can file IRS Form 3115, “Change of Accounting,” and catch up this year on all the accelerated depreciation since you purchased or built your facility.
How Do I Begin?
The IRS requires that an engineering-based study be conducted by a qualified professional to reclassify such components of your facility. For self-storage, these studies typically cost between $4,000 and $7,000. Most reputable companies will provide you with a no-cost estimate of your potential tax savings before conducting the study.
A successful and reliable cost-segregation study will require a detailed analysis of direct and indirect construction costs, a review of construction drawings (if available), an inspection and observation of components, expertise in specific mechanical and electrical systems, detailed documentation, and an extensive knowledge of the tax code as it pertains to cost segregation, among other things. It’s important that the study is done correctly and by a reputable firm in case the IRS has questions.
The accompanying chart provides an example of how cost segregation can be applied and the possible tax savings you might anticipate if your situation is similar. Self-storage owners should discuss this with their accountant and legal counsel before applying cost segregation to their depreciation schedules.
Cost Segregation: Potential Tax Savings | |||
Building Cost | $2,374,391 | ||
Date Acquired | January 2005 | ||
Tax Year | 2009 | 2010 | 2013 |
Current Method: Accumulated Depreciation Reported, 39-Year Straight-Line | $301,951 | $362,831 | $545,469 |
Alternative Method: Cost-Segregation Study, Accumulated Depreciation | |||
5-Year | $449,763 | $477,253 | $477,253 |
15-Year | $155,635 | $181,387 | $254,575 |
39-Year | $188,720 | $226,769 | $340,918 |
Total | $794,118 | $885,409 | $1,072,746 |
Results | |||
Increased Accumulated Depreciation Expense | $492,167 | $522,578 | $527,277 |
Tax Rate (Estimated) | 36% | 36% | 36% |
Estimated Accumulated Tax-Savings Benefit | $177,180 | $188,128 | $189,820 |
Source: Cost Segregation Services Inc. | |||
The owner represented in the chart will receive an estimated $492,167 in additional accumulated depreciation expenses in year one. This will lead to an additional $177,180 in deferred tax payments, which the owner can use interest-free until the property is sold and the depreciation is recaptured.
With the new and more stringent underwriting criteria being applied by all financial institutions today, and assuming a 70 percent loan-to-value, this additional capital would allow him to borrow an extra $420,000 to take advantage of buying opportunities in the market.
Moving Forward
To describe the self-storage real estate market as challenging is an understatement. Unless you’ve been in the real estate business for at least 25 years, these are uncharted waters, and even seasoned professionals who’ve been through a few cycles don’t see these times any easier.
The gap between the bid and the ask seems to be getting smaller, but we all need to realize that we’re playing by different rules, and these new rules will most likely be the blueprint for self-storage investing for many years to come.
Cost segregation is one way self-storage owners can benefit from the government, which is doing its part to help maximize the benefit of real estate investing. These changes have made cost-segregation studies more beneficial through increased tax deferment and the ability to carry net operating losses for up to five years.
As many industry professionals over the last year have indicated, self-storage continues to outperform other real estate asset classes. However, the banks and financial institutions are still reluctant to make loans to storage owners because they fall under the general real estate loan umbrella, which has some harsh critics.
Hopefully, this article will give you ideas on alterative ways to borrow money from Uncle Sam, as Goldman Sachs and other financial institutions have done through government bailouts.
Ben Vestal is the executive vice president of the Argus Self Storage Sales Network, a national network of real estate brokers who specialize in self-storage. Argus provides brokerage, consulting and marketing services to self-storage buyers and sellers and operates SelfStorage.com, a marketing medium and information resource for facility owners. For more information, call 800.55.STORE; e-mail bvestal@argus-realestate.com.
Related Articles:
The Basics of Cost Segregation: Tax Benefits for Self-Storage Owners
Cost Segregation Increases Cash Flow for Self-Storage
Extend and Pretend: Finance Regulators Support Self-Storage Borrowers
Self-Storage Talk: Collecting on Delinquent Accounts
