Tax Deductions (Is Depreciation a Tax Shelter?)
Tax deductions indirectly reduce federal income taxes by reducing taxable income. The vast majority of United States taxpayers want to pay what is lawfully required, but not a dollar more. Most of the top 20% of income earners believes they are paying enough or too much federal income taxes (the top 20% pay 80% of federal income taxes) but are not aware of many legitimate tax deductions.
Despite the intense desire to not pay income taxes beyond what is lawfully required, affluent taxpayers are understandably cautious regarding unknown opportunities to reduce federal income taxes through tax deductions. Typical questions regarding new tax deduction techniques are: “Is this legitimate? Is this a tax shelter? What happens if I get audited? Is this a form of tax evasion? If this makes sense for me, why hasn’t my trusted CPA recommended this tax deduction to me?”
Most real estate investors are paying excess federal income taxes because they are not claiming all legal tax deductions. Most investors do not believe it is possible they are under-reporting a meaningful tax deduction. However, our research indicates only 5-10% of real estate owners are claiming all lawful depreciation.
The rules and regulations regarding calculating real estate depreciation as a tax deduction are based on laws passed by Congress, multiple tax court decisions, and I.R.S. guidance and regulations. Real estate depreciation as a tax deduction is an area of specialized expertise much like art and antiques are specialized area for appraisers. Fortunately, the I.R.S. has prepared a detailed manual (Audit Techniques Guide) regarding the proper procedure for depreciating real estate, thus increasing tax deductions.
Real estate depreciation schedules are commonly calculated in a simple manner. The value of the land is estimated and the balance listed as long-life improvements (27.5 years for residential rental property and 39 years for commercial property). This is analogous to asking a world-class boxer to fight a match for the world championship with 10-pound leg weights on each ankle. You can’t deliver the best results with artificial limitations.
Depreciating real estate by just separating land from long-life improvements is an artificial limitation and reduces tax deductions. There is clearly defined guidance regarding separating up to 130 components which can be depreciated over a shorter period and used as tax deductions. The process of separating these items is termed cost segregation. Cost segregation is typically performed by appraisers or engineers who specialize in this narrow niche. Very few accountants, CPAs, or tax lawyers prepare cost segregation studies. However, they typically work closely with the real estate appraiser preparing the cost segregation study.
Cost segregation sharply increases tax deductions by fine-tuning the real estate depreciation schedule. There are about 130 real estate components that can be depreciated over 5, 7, or 15 years (versus 27.5 or 39 years for long-life property). These short-life items usually comprise 20-40% of the cost basis of the improvements. Accurately establishing the depreciation schedule (by using cost segregation) typically increases depreciation by 50-100%.
The least understood benefit of cost segregation is “catch-up” depreciation. For property owned more than 1 year, owners can claim a lump sum amount of depreciation that was inadvertently understated and use that sum as a tax deduction. This is often referred to as “catch-up” depreciation. It does not require filing any amended tax returns. However, it is possible to generate substantial tax deductions for a modest cost by combining cost segregation and “catch-up” depreciation.
Real estate investors who utilize cost segregation to increase depreciation will increase tax deductions. The adoption of cost segregation will become widespread as real estate owners, accountants, and tax lawyers become more aware of its tax deduction benefits.
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Cost segregation produces tax deductions and reduces federal income taxes across the country and in every size market. Below are just a few examples of cities where cost segregation generates meaningful tax deductions.
City:
- Denver, CO
- Atlanta, GA
- Bridgeport, CT
- Las Vegas, NV
- Phoenix, AZ
- Hartford, CT
- Boston, MA
- Tampa, FL
- Baltimore, MD
- Philadelphia, PA
- Rochester, NY
- Providence, RI
- Nashville, TN
- Cleveland, OH
- Lancaster, PA
- Colorado Springs, CO
- Tulsa, OK
- Knoxville, TN
- San Antonio, TX
- Cincinnati, OH
- Augusta, GA
- Richmond, VA
- Buffalo, NY
- Greensboro, NC
- Charlotte, NC
- Jackson, MS
- Raleigh, NC
- Little Rock, AR
- Wichita, KS
- Louisville, KY
Cost segregation produces tax deductions for virtually all property types, including the following:
Property Type:
- Funeral home
- School
- Amusement park
- Manufacturing/processing
- Fast food restaurant
- Truck stop
- Research and development
- Student housing
- Motel
- Shopping mall
Almost every industry, including the following, can generate cost-efficient tax deductions by using cost segregation.
Industry:
- Metal manufacturing
- Durable good wholesalers
- Warehousing and storage
- Frozen food manufacturing
- Printing activities
- Publishers
- Day care facilities
- Golf courses and country clubs
- Chemical manufacturing
- Transportation equipment manufacturing
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