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Appraisers Lower Costs for Federal Tax Savings on Small Property Depreciation

January 23, 2006

Appraisers Lower Costs for Federal Tax Savings on Small Property Depreciation

By Patrick O’Connor, MAI
Click here for a PDF version of this article.

Tax savings through cost segregation is no longer out of reach for investors in small and medium size properties. With appraisal expertise, fees for analysis are often one-third to one-half lower than those charged by traditional preparers.

Cost segregation allows commercial real estate owners to increase depreciation (a key non-cash deduction) and affect federal income tax reduction. During preparation of their federal income tax return, the additional depreciation reduces taxable income and cuts income taxes. Owners of commercial property are often astounded at the increase in tax deductions and size of the tax cut resulting from cost segregation.

Cost segregation is not tax evasion or a tax shelter. It is an accurate way to allocate the cost basis for investment property. It also increases tax deductions by increasing depreciation. Those involved in tax preparation, including tax lawyers, CPAs and accountants, agree cost segregation is a legitimate IRS-guided method of depreciating real estate.

Several years ago a definitive court case ruled that tangible personal property included in an acquisition or in overall costs should be depreciated as personal property for asset recovery, using the old Investment Tax Credit principles to classify personal property.

This meant that owners of improved properties (i.e. commercial or residential real estate) could distinguish between real property and personal property to depreciate component costs over varying useful lives. Basically, instead of depreciating an entire commercial property over 39 years, or residential property (single-family rentals or multifamily) over 27.5 years, certain components are correctly identified as depreciating in much less time. For about 135 items, useful life periods can be 5, 7 or 15 years. This is known as cost segregation.

The result of increasing depreciation is a higher level of tax deductions and a lower level taxable income (which would have been taxed at 35%) and more income taxed at the capital gains rate (15%) when the property is sold. Furthermore, it works for any type of improved property. The tax cut is substantial since tax reduction exceeds 50%, to the extent depreciation is increased.

Until recently, primarily large accounting firms or engineering firms implemented cost segregation studies, addressing large and newly built properties and sometimes outsourcing the analysis.

Prices for those analytical reports, usually in the $10,000 to $40,000 range, were out of reach for owners of small to mid-sized real estate investments. Unfortunately, those owners representing the largest segment of real estate investors in the country were mostly overlooked by previous providers of cost segregation services.

Now a revolutionary paradigm shift is opening the door to significant federal income savings for owners of small properties. Much of the change is based upon introducing the efficiencies of highly knowledgeable real estate appraisers who often apply industry-accepted cost estimation techniques before determining remaining asset life. By not “over-engineering” the staffing or production process, professional fees are lower. Yet, results can usually meet or exceed those of far more expensive reports. This approach has been successfully field-tested by IRS auditors.

Changes that appraisers are introducing to cost segregation analysis and reporting are addressing: 1) the size of the property being analyzed, 2) the age of the property, and 3) an affordable price point. O’Connor & Associates, a nationwide real estate service firm, is taking advantage of such techniques to effect these beneficial changes:

  1. Owners of property with an improvement basis as low as $500,000 can increase tax deductions by using cost segregation. This compares to the small number of properties worth $5 to $10 million and above that previously benefited.

  2. Owners of investment property built or purchased after 1986 can affect a large tax cut in year-one, even without producing original cost documents. Capturing non-segregated depreciation from prior years is acceptable to the IRS. This compares to firms previously applying the methodology only to new construction.

  3. Fees are no longer prohibitive. The ratio of higher tax deduction/tax reduction to fees is attractive to owners of small and mid-sized investment property. To prepare an analysis and report for many small properties, prices are low enough to generate at least 3 times the report cost in the first year. This compares to the traditional fees ranging from $10,000 to $20,000 and up for comparable size properties.

We suggest including your tax attorney, CPA, accountant or tax preparation specialist involved throughout the process. For older properties, the CPA may need to complete a Form 3115 to submit with the tax return so the owner can realize savings on items not previously depreciated - without filing an amended return. The tax preparation cost is modest compared to typical additional tax deductions.

Income producing properties worth as little as $500,000 can achieve a 3:1 payback ratio of tax savings over the modest price of a cost segregation report. If owned for 3 or more years, the typical payback ratio is 10:1. Commercial real estate owners seeking additional tax deductions can obtain a free preliminary analysis upon request. We will work with your tax preparation expert.

Owners of commercial property worth $1 million or more can achieve a 4:1 payback ratio of tax savings over the cost of a report. The typical payback ratio jumps to 12:1 if owned for 3 or more years. The table below summarizes actual results generated through cost segregation reports prepared by O’Connor & Associates for properties located throughout the country:

Range on Year 1 Tax Savings
(100,000-500,000 sq. ft. property size)

$35,500 - $160,000
$19,240 - $96,200
$36,500 - $182,600
$10,800 - $54,000

In late 2005, O’Connor & Associate's pipeline of cost segregation work was up more than 100%. As owners are preparing for 2006 federal income tax filings, many are tapping into this opportunity to lower their federal income taxes. Even general partners who are not paying federal income taxes should use this depreciation method since K-1s will reflect lower taxable income to benefit their limited partners.

Maximizing legitimate tax deductions is difficult. The IRS tax code is too complicated for any tax preparation specialist to understand all aspects of federal income taxes. Even tax lawyers, CPAs and experienced accountants can't have a high depth of knowledge for every industry. Our 20-person team of cost segregation specialists has the depth of knowledge to help you maximize depreciation tax deductions.

About the Author
Patrick O’Connor, MAI, is president of O’Connor & Associates. The firm, in business since 1974, specializes in state and federal tax reduction services, real estate appraisals and research and consulting nationwide. With offices in Houston, Dallas, Los Angeles and Newport Beach, the firm employs more than 130 people. Patrick O’Connor is frequently acknowledged by national publications as a respected source of information on real estate trends. Visit www.cutmyfederaltaxes.com.

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