Cost Segregation : Real Estate Investors Are Overpaying in Federal Income Taxes

By ignoring generous IRS guidelines when establishing depreciation schedules, over 90% of real estate investors are unintentionally overpaying federal income taxes. Also, they are paying federal income taxes earlier than necessary. Although these IRS guidelines are relatively new, they provide substantial benefits. Many accountants have not integrated the new IRS depreciation guidelines into their practice. Savings for real estate investors are meaningful- exceeding $50,000 to $1,000,000 in the first year. Cost segregation converts income taxed at 35% (ordinary income) to income taxed at 15% (capital gains). Cost segregation also defers payment of income taxes, often for 5 to 10 years. 

Effects of higher depreciation

Most real estate investors do not understand the benefits of increasing real estate depreciation. Many often think that increasing their depreciation just means that they will be shifting taxes from now until whenever they sell the property. 

This is a popular misconception and the answer is a resounding “no.” There are two benefits of increasing depreciation: 

1. Converting ordinary income into capital gains income 

2. Deferring income until a gain on the sale of the property is realized.

The conversion of ordinary income into capital gains income has to do with the technical nature of the allocation of the gain on the sale. Many, if not most, accountants initially believe it is simply a timing issue. However, when the mechanics of recognizing gain on sale are discussed, accountants quickly realize increasing depreciation leads to paying taxes at the capital gains rate as opposed to the ordinary-income rate. 

Correcting a depreciation schedule makes a difference if you recently sold the property since the additional depreciation will be taxed at the capital gains rate instead of the ordinary income rate. 

When told it is possible to increase depreciation and reduce federal taxes, most real estate investors ask, “doesn’t my accountant take care of this for me?” 

Less than 5% of depreciation schedules have been properly established. Most real estate investors have a good relationship with their accountant and believe that their accountant is doing everything possible to minimize their taxes. Unfortunately, many accountants have not focused on time or attention on this issue for several reasons. 

Some accountants are aware of cost segregation as an option to increase depreciation and reduce federal taxes but believe it is very expensive (at least $10,000 per property) and is financially feasible only for large properties (typically over $10 million). Many of these providers were not interested in properties with a cost basis under $10 million and only did cost segregation for newly built properties. 

Cost segregation makes sense for properties with an improvement basis of at least $500,000. While accountants are becoming more active in reviewing options for depreciating real estate, in many cases the owner needs to take the lead role in proposing cost segregation as a mechanism to reduce and defer federal taxes. 

The Proportion of short life property

The proportion of short life property typically ranges from 20% to 50% of the cost basis of the improvements. Items that typically affect whether it is at the low end of the range or the high end of the range include the age, condition, intensity of landscaping, amount of surface parking, and land value.

Property owner involvement

Many property investors proudly take the stance that, “my federal tax return is too complicated; my accountant handles it.” 

It is almost a rite of passage that a “serious” real estate investor is one whose tax return must be prepared by a third party because it has become too complicated for the investor to complete. Only about 2-5% of depreciation schedules in federal tax returns have short life property properly separated to minimize the owner’s federal taxes. While many parts of the federal tax return may be too complicated for an investor to understand and prepare, this area is simple: if you pay federal taxes and can use additional depreciation, you benefit from obtaining cost segregation studies. 

Most investors are not aware of cost segregation and do not understand the benefits it provides. There is limited and inaccurate information regarding a material issue that could sharply reduce federal taxes for many real estate investors. 

Catch-up

What is known in cost segregation jargon as “catch-up,” is reporting depreciation that has been underreported in prior years since the property was purchased or built in the current year. A real estate investor can “catch-up” underreported depreciation by having his accountant file a form 3115 with the current tax return.

The IRS has reported that filing a form 3115 is not a red flag for an audit. Some investors seem concerned this is too good to be true. However, when their accountant reviews the IRS rules and guidelines they quickly find out that you can indeed catch-up underreported depreciation by filling the form 3115.

Getting started

Ask yourself the following questions when deciding whether you can benefit from a cost segregation study: 

1. Do you pay federal income taxes? 

2. Do you own investment real estate? 

3. Can you use additional depreciation? 

Some owners are passive while others are active. If you are a passive real estate investor, you may not be able to use additional depreciation. On the other hand, if you are an active investor or a real estate professional, you are entitled to deduct additional depreciation. 

If you have determined you can use additional depreciation and are paying federal taxes, look into a preliminary analysis. The preliminary analysis will estimate the amount of 5, 7, and 15-year property, which can likely be identified and also see the catch-up depreciation. This analysis will not involve a site inspection and will not be precisely correct. However, it should be accurate enough to help you decide whether a cost segregation study is financially feasible. 

Once you obtain the preliminary analysis, you should consult your accountant, since he/she will be completing and signing your tax return. In many cases, it makes sense for the accountant, the property owner, and the cost segregation advisor to meet and discuss the options and issues. 

Cost Segregation Advantage

Correctly calculating real estate depreciation is important because it substantially reduces federal taxes for real estate investors. The process of fine-tuning the depreciation schedule is called cost segregation. The adoption rate for cost segregation is under 5% because of limited knowledge by many owners and accountants. 

In addition, there are misconceptions regarding the cost of obtaining cost segregation studies and the smallest properties for which cost segregation studies are financially feasible. As awareness of the practice and affordable service providers increase among real estate investors and accountants, the adoption rate will increase dramatically.

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