Income Taxes (Tips for Real Estate Owners to Reduce Income Taxes)
Income taxes often seemed unavoidable. However, real estate investors have multiple opportunities to defer and reduce federal income taxes. Real estate owners receive income tax breaks not available to investors for many other asset classes. These include depreciation, income tax rate reduction, and the like-kind exchange. For example, owners of stocks, bonds and gold are not able to depreciate their cost basis. This article discusses how real estate owners can reduce income taxes by increasing the level of depreciation.
Depreciation is a non-cash expense which can both defer and reduce the level of federal income taxes. In some cases, depreciation actually eliminates federal income taxes. (When an owner claims depreciation, and does not sell the property before it passes into his estate, the income deferred by the depreciation is never taxed.) Depreciation is an accounting mechanism used to address the physical deterioration of assets. Buildings do physically deteriorate over time. However, during most five or 10 year periods, real estate tends to appreciate in value.
Most real estate owners know depreciation defers federal income taxes. Few know real estate depreciation also reduces federal income taxes. The common perception is that depreciation simply shifts payment of income taxes from when income is earned until property is sold. However, depreciation often changes the character of income from ordinary income to capital gains income.
Consider the following example: George purchased an apartment complex in 2005. After obtaining a cost segregation study, approximately 20% of the cost basis of the improvements was allocated to 15 year property, such as landscaping, paving, sidewalks, parking lot striping and exterior signs. If George sells the property in five years, one-third of the cost basis of the 15 year property will have depreciated. Isn't it also reasonable the market value of this property will be one- third less than when the property was purchased?
More often than not, tax preparers believe the market value of short-life property is similar to the remaining basis when property is sold. This means there is no gain upon sale. Hence, additional depreciation was taken for short-life property (which could be used to reduce income taxable as ordinary income rates) while George owned the property. At time of sale, the portion of the gain equal to the short-life depreciation is taxed at the capital gains rate. This is how cost segregation reduces federal income taxes. It generates additional short-life depreciation, which can be utilized to reduce income taxable as ordinary income. Upon sale, the income is recognized (unless a like-kind exchange, or 1031 exchange is utilized). Hence, federal income taxes are both deferred from the time income is earned until a sale occurs and the tax rate is reduced from the ordinary income tax rates to the capital gains rate.
A cost segregation study can typically allocate approximately 20 to 40% of the cost basis of improvements to 5, 7 and 15 year property. This will often increase the level of depreciation by 50% to 100% during the first five to seven years of ownership. Cost segregation is financially feasible for properties with a cost basis of at least $500,000 (for the improvements).
Cost segregation can lead to meaningful deferral of federal income taxes. However, its most significant power is its ability to convert income taxed at the ordinary income rates to income taxed at the capital gains rate.
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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
- Dallas/Ft. Worth, TX
- Memphis, TN
- Washington, DC
- San Francisco, CA
- Bridgeport, CT
- Denver, CO
- Tampa, FL
- Los Angeles, CA
- New York, NY
- Portland, OR
- Syracuse, NY
- Cleveland, OH
- Austin, TX
- Madison, WI
- Santa Rosa, CA
- Rochester, NY
- Oklahoma City, OK
- Manchester, NH
- Tucson, AZ
- Knoxville, TN
- Columbus, OH
- Greenville, SC
- Stockton, CA
- Palm Bay, FL
- Riverside, CA
- Sacramento, CA
- Bakersfield, CA
- St. Louis, MO
- Youngstown, OH
Cost segregation produces tax deductions for virtually all property types.
Property Type:
- Movie theatre
- Neighborhood shopping center
- Tennis club
- Bar
- Health spa
- Subsidized housing
- Retirement home
- Apartments
- Department store
- Greenhouse
Almost every industry, including the following, can generate cost-efficient tax deductions by using cost segregation.
Industry:
- Leather product manufacturing
- Nondurable good wholesalers
- Wood product manufacturing
- Electronic and appliance stores
- Furniture stores
- Paper manufacturing
- Furniture manufacturing
- Chemical manufacturing
- Beverage and tobacco product manufacturing
- Frozen food manufacturing
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