Income Taxes (Income Tax Reduction Tips for Real Estate Owners)
Income taxes are too high. Real estate investors benefit from tax laws which can markedly reduce their federal income taxes. These tax rules include depreciation, cost segregation, tax-free exchanges, and casualty losses. Surprisingly, some of these tax benefits are not widely used. This article briefly reviews how real estate investors can reduce federal income taxes by utilizing cost segregation to increase depreciation and tax-free exchanges to defer taxes.
Depreciation is a powerful tool in reducing federal income taxes. Depreciation is a non-cash expense which both reduces and defers the amount of income taxes. Depreciation reduces the level of income taxes by converting the character of income. Depreciation converts income which would have been taxed as ordinary income (maximum tax rate 35%) to capital gains income (maximum tax rate 15%). In some cases, depreciation converts ordinary income to income that is taxed 25%. However, in many cases, the allocation of gain on sale shifts most of the gain to capital gains rate income versus income taxed at 25% or 35%. Depreciation defers payment of income taxes from the time when income is earned until the property is sold, or the gain for the sale is recognized.
Most investors recognize the benefits of depreciation on their income taxes. Few investors recognize the power of using cost segregation to increase the amount of depreciation and reduce federal income taxes. Cost segregation is a specialized service typically performed by real estate appraisers or engineers. Buildings are depreciated over 27.5 years (rental residential real estate) or 39 years (commercial real estate). However, there are up to 130 short-life components which can be depreciated over 5, 7 or 15 years. Cost segregation specialists can identify up to 130 different 5, 7 or 15 year components which qualify for short-life depreciation.
A cost segregation analysis can typically identify between 20% and 40% of the total cost basis which can be depreciated as short-life property. This typically increases the amount of depreciation by 50% to 100% during the first five to seven years of ownership, decreasing income taxes owed. Cost segregation is typically financially feasible for properties with a cost basis of at least $500,000 (for the improvements).
Depreciation offers an opportunity to defer recognition of income while you own a property, therefore deferring income taxes. The like-kind exchange offers the option of further deferring income and income taxes or perhaps never recognizing the income and paying no income taxes. (When a replacement property is purchased, the gain may never be recognized if this property becomes part of an estate. There is a step up in basis as the property goes into the estate. Of course, the estate is taxable, and there may be the tax on the estate. However, the gain on the property would not be taxed directly.)
A like-kind exchange allows you to defer recognizing gain after selling of property if you purchase a "like-kind" property. Most exchanges of real estate for real estate qualify as a like-kind exchange. For example, it is possible to trade agricultural land for an apartment building, to trade an apartment building for an office building, to trade an office building for a house, and to trade a house for a ranch. It is not possible to exchange real property for personal property and receive the benefits of a like-kind exchange. There may also be some limited interests in real estate, other than a fee simple interest, which do not qualify as real estate for purposes of a like-kind exchange. This might include exchanging the interest in leased land with five years remaining on the lease for fee simple title to another parcel.
The basics of executing a tax-free exchange are fairly simple. You must identify the replacement property within 45 days of the time you sell your property. You can identify up to three replacement properties or an unlimited number of replacement properties whose market value does not exceed twice the value of the property you sold. The replacement property must be purchased within 180 days of selling your property. A qualified intermediary must handle the exchange. To defer all of the gain, the market value, debt and equity of the replacement property must be equal to or greater than the market value, debt and equity of the property which was sold. Rules for like-kind exchanges are rigid, but there are experts who can guide you and allow you to legally defer substantial amounts of income.
Real estate investors benefit from more generous income tax breaks than investors in most other asset classes. By using cost segregation to increase depreciation and like-kind exchanges to further defer recognizing income, they can enhance the income tax benefits of real estate investment even further.
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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:
- Bridgeport, CT
- Los Angeles, CA
- Washington, DC
- Tampa, FL
- Philadelphia, PA
- Miami, FL
- Baltimore, MD
- Dallas/Ft. Worth, TX
- Orlando, FL
- Hartford, CT
- Cincinnati, OH
- Greenville, SC
- Durham, NC
- Fresno, CA
- Milwaukee, WI
- Charlotte, NC
- Baton Rouge, LA
- Pittsburgh, PA
- Little Rock, AR
- Lancaster, PA
- Charleston, SC
- Wichita, KS
- Rochester, NY
- Jackson, MS
- St. Louis, MO
- Boise, ID
- Palm Bay, FL
- Lakeland, FL
- Dayton, OH
- Poughkeepsie, NY
Cost segregation produces tax deductions for virtually all property types.
Property Type:
- Skating rink
- Self-storage
- Service center warehouse
- Fast food restaurant
- Car wash facility
- Movie theatre
- Medical facility
- Service station
- Motel
- Mobile home park
Almost every industry, including the following, can generate cost-efficient tax deductions by using cost segregation.
Industry:
- Building supply dealers
- Leather product manufacturing
- Furniture stores
- Textile mills
- Durable good wholesalers
- Fabricated metal products
- Textile product mills
- Food and beverage stores
- Printing activities
- Nondurable good wholesalers
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