Income Taxes (Real Estate Investors can Obtain a Refund for Income Taxes Paid on Real Estate Sold Several Years Ago!)
Income taxes are high and tax laws are overly complicated. Most real estate investors know depreciation defers federal income taxes. Fewer know depreciation both defers and reduces federal income taxes. Even fewer know real estate depreciation can be increased through a specialized service known as cost segregation. Very few are aware it is possible to use cost segregation to increase depreciation and obtain a refund of income taxes for a property that sold three or four years ago. This article discusses how some investors may obtain a substantial income tax refund by revising depreciation calculations to reduce federal income taxes paid several years ago.
Income tax returns may be amended up to three years after the time they are filed. For example, if a 2002 income tax return was filed in August 2003, it can be amended until August 2006. This provides real estate owners a generous amount of time to correct federal income taxes overpayments.
Cost segregation is a specialized service typically performed by appraisers and engineers. Cost segregation precisely calculates and allocates depreciation among various classes of property. This increases the amount of depreciation, particularly in the early years of ownership. It also defers and reduces federal income taxes. Most real estate depreciation schedules are established by allocating a portion of the cost basis to land and the balance to long-life improvements. Long-life improvements, or the building, are depreciated over 27.5 years for rental residential property and 39 years for commercial property. Experienced cost segregation specialists can typically allocate 20% to 40% of the improvement cost basis of real estate to 5, 7 and 15 year property. This typically increases depreciation by 50% to 100% during the first five to seven years of ownership.
Increasing the level of depreciation typically reduces federal income taxes. This is because depreciation generally alters the character of income from ordinary income (maximum tax rate of 35%) to capital gains income (maximum tax rate of 15%). A portion of the cost basis of property will be allocated to short-life property (5, 7 and 15 year property) as a result of a cost segregation analysis. This will include items such as carpet, vinyl tile, paving and sidewalks. Short-life items physically deteriorate over time. In most cases, the market value of the short-life property is similar to the basis at the time of sale. And there is no gain or loss. Instead, depreciation is used to shield ordinary income during the ownership period and (at time of sale) the resulting gain is taxed at the capital gains rate.
Real estate investors can "catch-up" underreported depreciation after completing the cost segregation study. It is not necessary to file amended income tax returns. Instead, the additional depreciation for the period since the property was purchased is claimed in the first income tax return filed after obtaining the cost segregation study. The income tax preparer utilizes form 3115 (change in accounting method) to report the additional depreciation.
Consider the following example: Bob sold an apartment complex in 2003. He had claimed depreciation totaling $400,000 while he owned the property. By obtaining a cost segregation study, Bob increased the cumulative depreciation to $800,000. The net effect is to reduce income taxes by $80,000. Since Bob had a substantial ordinary income in 2003, the additional depreciation claimed will reduce his taxable income (taxed at 35%). The $400,000 of additional depreciation reduces income taxes on ordinary income by $140,000 ($400,000 X 35%). However, capital gains income will increase by $400,000, resulting in additional taxes of $60,000 ($400,000 X 15%). The net savings of $80,000 can be obtained in a refund up to three years after the 2003 income tax return was filed.
Cost segregation is a powerful tool to help real estate investors reduce federal income taxes. Investors are amazed when they learned it is possible to obtain an income tax refund for property sold several years ago.
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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
- Miami, FL
- Las Vegas, NV
- San Francisco, CA
- Denver, CO
- New York, NY
- Hartford, CT
- Phoenix, AZ
- Los Angeles, CA
- New Orleans, LA
- Little Rock, AR
- Rochester, NY
- Augusta, GA
- Sarasota, FL
- Bakersfield, CA
- Ft. Lauderdale, FL
- Columbia, SC
- Greenville, SC
- Boise, ID
- New Haven, CT
- Columbus, OH
- Raleigh, NC
- Stockton, CA
- Milwaukee, WI
- Oklahoma City, OK
- Providence, RI
- Palm Bay, FL
- Indianapolis, IN
- Lancaster, PA
- Des Moines, IA
Cost segregation produces tax deductions for virtually all property types.
Property Type:
- Land
- Bar
- Skating rink
- Truck stop
- Shopping mall
- Greenhouse
- Single-tenant retail
- Bowling alley
- Multifamily
- Retail
Almost every industry, including the following, can generate cost-efficient tax deductions by using cost segregation.
Industry:
- Metal manufacturing
- Day care facilities
- Automotive repair facilities
- Truck transportation
- Computer and electronic manufacturing
- Frozen food manufacturing
- Furniture manufacturing
- Apparel manufacturing
- Beverage and tobacco product manufacturing
- Health care facilities
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