Income Taxes (How to Increase Real Estate Depreciation and Decrease Income Taxes)
Income taxes are a substantial burden for successful real estate investors. Real estate owners can reduce income taxes by increasing depreciation. They can increase depreciation using a specialized service called cost segregation. This article discusses cost segregation and explains the benefits of increasing depreciation. (It both reduces and defers federal income taxes.)
Component depreciation was a powerful tool for reducing federal income taxes in the late 1970s and early 1980s. Component depreciation focused on building systems such as electrical, plumbing, elevators and roofs. Component depreciation ended with the 1986 tax act. From 1986 to 1996, there was no clearly legitimate method to increase the level of real estate depreciation.
Cost segregation became an option to reduce federal income taxes as a result of the Hospital Corporation of America (HCA) in 1996. HCA, a large hospital chain, pursued litigation regarding their ability to depreciate a portion of the cost basis of their buildings as short-life property. HCA prevailed in the case and the IRS did not appeal. The IRS has since developed the Audit Techniques Guide which documents items which may be segregated and methods for conducting a cost segregation study to reduce income taxes.
Cost segregation increases depreciation by allocating about 20 to 40% of the cost basis to short-life items. Increasing depreciation is a key method to reducing income taxes. There are about 130 real estate components which qualify for short-life depreciation. These include items such as carpet, vinyl, tile, signs and sidewalks. Real estate owners can increase depreciation by 50 to 100% during the first five to seven years of ownership by utilizing cost segregation.
Increasing the level of depreciation defers and reduces federal income taxes. Depreciation defers income taxes from the year when income is earned until the property is sold, or when a gain is recognized. Depreciation alters the character of income. It converts ordinary income into capital gains income. Since ordinary income has a maximum tax rate of 35% and capital gains income has a maximum tax rate of 15%, additional depreciation and can reduce taxes by over 50%.
Although a portion of depreciation is recaptured at 25%, depreciation for short-life items is typically recaptured at 15%. This is counterintuitive to many real estate investors and to some accounting professionals. Following is a summary of how the short-life items are depreciated and the gain is recognized upon sale: A portion of the cost basis can be assigned to short-life property. When the property is sold, the depreciated basis is often similar to the market value of short-life property. Therefore, there is no gain on the short-life property. The depreciation is “recaptured” at 15% (long-term capital gains tax rate).
Depreciation is a powerful tool which can reduce the income tax rate by over 50%. Cost segregation amplifies the benefits by increasing the amount of depreciation by 50 to 100%. Cost segregation is financially feasible for properties with a cost basis exceeding $500,000 (for the improvement portion of the property).
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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 where cost segregation generates meaningful tax deductions.
City:
- Hartford, CT
- Memphis, TN
- Houston, TX
- New Orleans, LA
- Orlando, FL
- Boston, MA
- Atlanta, GA
- Los Angeles, CA
- San Francisco, CA
- Baltimore, MD
- Raleigh, NC
- Des Moines, IA
- San Jose, CA
- Omaha, NE
- Stockton, CA
- Buffalo, NY
- Colorado Springs, CO
- Ft. Lauderdale, FL
- Scranton, PA
- Tulsa, OK
- Grand Rapids, MI
- Oxnard, CA
- Nashville, TN
- Detroit, MI
- Portland, OR
- Rochester, NY
- Virginia Beach, VA
- Palm Bay, FL
- Akron, OH
- Birmingham, AL
Cost segregation produces tax deductions for virtually all property types.
Property Type:
- Skating rink
- Truck terminal
- Car wash facility
- Discount store
- Auto dealer
- Bowling alley
- Retirement home
- Motel
- Racket club
- Subsidized housing
Almost every industry, including the following, can generate cost-efficient tax deductions by using cost segregation.
Industry:
- Warehousing and storage
- Wood product manufacturing
- Furniture stores
- Building supply dealers
- Real estate lesser
- Food manufacturing
- Day care facilities
- Transportation equipment manufacturing
- Machinery manufacturing
- Printing activities
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