Income Taxes (A New Option to Reduce Income Taxes for Real Estate Investors)
Income taxes are a substantial burden and artificially dampen the accumulation of wealth. Successful real estate investors can reduce their income tax burden by utilizing a variety of income tax benefits. Income tax benefits which favor real estate include depreciation, cost segregation, and like kind exchanges. This article reviews how real estate investors can reduce and defer federal income taxes by utilizing cost segregation.
Depreciation is a well known concept to account for deterioration in both personal property and real estate. The accounting concept is the decline in value of assets is recognized with depreciation. Real estate improvements often appreciate in value even though they are depreciated for accounting and tax purposes. Theories and practice regarding depreciating real estate vary periodically. During the late 1970s and early 1980s, component depreciation was used to increase the level of depreciation. There was concern this concept was being abused. Component depreciation was phased out with the 1986 tax act.
Cost segregation became an option after the 1996 Hospital Corporation of America case. Cost segregation focuses on discrete components of real estate and land improvements. These include items such as signs, sidewalks, paving, landscaping and flooring. There are up to 130 items which can be segregated. (Component depreciation focused on building systems such as elevators, plumbing, electrical and roofs.) A cost segregation study identifies and quantifies real estate components which can be depreciated as short-life property. Most short-life components can be depreciated over 5, 7 or 15 years. Identifying the short-life components typically increases depreciation by 50% to 100% during the first 5 to 7 years of ownership.
The benefits of increasing depreciation are often unclear. The initial reaction to increasing depreciation from many investors is: "but won't I have to pay the income taxes when I sell the property? Doesn’t this just defer income taxes and create a huge liability when I sell?" The answer is NO. Depreciation both reduces and defers federal income taxes. Increasing depreciation reduces federal income taxes since it alters the character of the income. Instead of being taxed as ordinary income (maximum tax rate 35%) it is taxed as capital gains income (maximum tax rate 15%). This is because of the method of allocating the basis upon sale. A portion of the cost basis is ascribed to the 5, 7 and 15 year short-life property when the building is purchase. Most of these assets have depreciated during the ownership period. In most cases, the market value of these assets is similar to their book basis. Therefore, no gain on sale for the short-life assets is necessary. Instead, income that would have been taxed as ordinary income is now taxed as capital gains income. Depreciation defers income taxes from the time when income is earned until the property is sold, or a gain on the sale is recognized.
Cost segregation often increases depreciation by 50% to 100% during the first five to seven years of ownership. Although this concept has been available for over a decade, some investors are not utilizing its benefits. Cost segregation is financially feasible for properties with a cost basis of least $500,000 (for the improvements).
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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:
- Washington, DC
- Las Vegas, NV
- New Orleans, LA
- Orlando, FL
- Boston, MA
- Phoenix, AZ
- Atlanta, GA
- Baltimore, MD
- Miami, FL
- Dallas/Ft. Worth, TX
- Augusta, GA
- Charlotte, NC
- Tucson, AZ
- Bakersfield, CA
- Sarasota, FL
- Albany, NY
- Milwaukee, WI
- Charleston, SC
- Cleveland, OH
- Santa Rosa, CA
- Grand Rapids, MI
- Kansas City, MO
- Sacramento, CA
- San Jose, CA
- New Haven, CT
- Poughkeepsie, NY
- Fresno, CA
- Riverside, CA
- Omaha, NE
- Detroit, MI
Cost segregation produces tax deductions for virtually all property types.
Property Type:
- Mini-warehouse
- Restaurant
- Neighborhood shopping center
- Truck stop
- Motel
- Drugstore
- Auto service garage
- Bar
- Land
- Amusement park
Almost every industry, including the following, can generate cost-efficient tax deductions by using cost segregation.
Industry:
- Metal manufacturing
- Electrical component manufacturing
- Leather product manufacturing
- Machinery manufacturing
- Warehousing and storage
- Durable good wholesalers
- Day care facilities
- Air transportation
- Automotive repair facilities
- Textile mills
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