Income Taxes (Reduce Income Taxes by Claiming and Using More Real Estate Depreciation)
Income tax laws are often designed to motivate desired behaviors. Many income tax laws encourage investment in real estate. These rules include allowances for depreciation, cost segregation, 1031/“like-kind” exchanges and real estate professional status. Being a "real state professional" allows investors to steer clear of passive rules. This article discusses the benefits of cost segregation and how real estate professionals can utilize higher levels of depreciation to reduce income taxes.
Cost segregation is a specialized process which identifies the portion of real estate which can be depreciated as short-life property. Buildings are depreciated over 27.5 years (rental residential real estate) or 39 years (commercial real estate). Short-life property can be depreciated over 5, 7 or 15 years. Short-life property in real estate includes carpeting, vinyl tile, some signs and paving. Real estate includes up to 130 types of short-life property. A cost segregation specialist can identify and quantify this property.
A cost segregation expert can typically identify about 20% to 40% of the improvement cost basis as short-life property (which can be depreciated over 5, 7 or 15 years). The benefit of identifying the short-life property is to increase depreciation by 50% to 100% during the first five to seven years of ownership. Increasing depreciation both reduces and defers federal income taxes. Depreciation reduces the income tax rate by changing the character of income from ordinary income to capital gains income. It defers recognizing income from when it is earned until the property is sold, or when the gain is recognized.
Real estate investment was a hot vehicle to avoid and defer income taxes during the early 1980s. Income tax laws passed in the early 1980s provided very liberal provisions for depreciation. However, the 1986 tax act effectively reneged on prior income tax laws by disallowing deductions for "passive losses". (A loss is passive if the person is not active in operating the real estate.) Congress later allowed a simpler option for "real estate professionals" to utilize losses from passive activities to offset ordinary income.
Investors can qualify as a "real a state professional" by meeting the following criteria:
1) more than 50% of his professional services are provided in the real estate fields; and
2) he spends more than 750 hours per year in the real estate fields; and
3) he is not an employee (unless he owns at least 5% of the business).
Income tax laws are complex. Identifying and valuing the 130 components which qualify for short-lived appreciation is not intuitive. Very few tax professionals have the knowledge and experience to perform a cost segregation study. Even fewer who are not tax professionals could perform a cost segregation study. Knowing and understanding the real estate professional rules are also somewhat complex. Minimizing federal income taxes will likely require a team of knowledgeable tax advisers. While one tax professional may lead the team, you will be best served if he utilizes these services of specialists.
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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:
- Dallas/Ft. Worth, TX
- Los Angeles, CA
- Tampa, FL
- Atlanta, GA
- Baltimore, MD
- New York, NY
- Boston, MA
- Miami, FL
- Memphis, TN
- San Francisco, CA
- New Haven, CT
- Lancaster, PA
- Birmingham, AL
- Jacksonville, TN
- San Jose, CA
- San Diego, CA
- Durham, NC
- Bakersfield, CA
- Cincinnati, OH
- Minneapolis-St. Paul, MN
- Rochester, NY
- Columbus, OH
- Raleigh, NC
- San Antonio, TX
- Oklahoma City, OK
- Allentown, PA
- Colorado Springs, CO
- Sacramento, CA
- Greenville, SC
- Detroit, MI
Cost segregation produces tax deductions for virtually all property types.
Property Type:
- Shopping mall
- Bowling alley
- Convenience store
- Commercial building
- Neighborhood shopping center
- Single-tenant retail
- Retail
- Tennis club
- Auto salvage yard
- Office building
Almost every industry, including the following, can generate cost-efficient tax deductions by using cost segregation.
Industry:
- Textile mills
- Wood product manufacturing
- Leather product manufacturing
- Paper manufacturing
- Frozen food manufacturing
- Arts, Entertainment, and Recreation
- Truck transportation
- Food manufacturing
- Amusement parks
- Health care facilities
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