Cost Segregation - Tax Deductions
"Few of us ever test our powers of deduction, except when filling out an income tax form” - Laurence J. Peter, U.S. Educator
By understanding business tax deductions, business owners may enjoy personal benefits from business expenditures – entertaining clients or donating to charitable organizations, - if they follow the myriad tax rules.
Only half of business entertainment expenses can be deducted. Eligible business entertainment consists of taking a client to a ball game, a concert, or dinner at a good restaurant. However, if you are audited, there must some verification that the entertainment expense was related to business. You must therefore file all bills carefully, mentioning the purpose of the bash against each bill.
For a charitable event, only a portion of the ticket value is deductible. The portion that is NOT deductible is the value of the goods or services that you receive (e.g. dinner, entertainment, etc.). The rest is deductible. For example, if you pay $150 for an event, and the benefits received are worth $60, the tax-deductible amount is $90. The charity hosting the event will be able to identify the exact value of the benefits for each event.
Tax deferral strategies are a great way to minimize taxes, and cost segregation and IRC Section 1031 exchanges are two of the most valuable tax deferral strategies available to commercial real estate owners today.
Phrased as the “almighty tax deduction,” a 1031 exchange provides the investor the opportunity to defer 100 percent of realized capital gains. This equates to an interest-free, no-term loan on taxes due until the property is cashed-out. Most often, the capital gain taxes are deferred indefinitely because investors continue to exchange from one property to the next, and increasing the value of their real estate investments with each exchange.
In these exchanges, business or investment property is disposed of through a qualified intermediary, and the proceeds are used to purchase a replacement property of like kind. This results in a deferral of all or most of the gain that otherwise would be subject to income tax on the disposed property. The replacement property has a carryover tax basis that is generally the value of the replacement property less the gain deferred in the exchange. New guidance from the IRS and some of the most taxpayer-friendly legislation since the Tax Act of 1986 also have made a second form of income tax deferral—cost segregation—increasingly popular.
In addition to asking the questions above, business owners should also ask their accountant about taking advantage of cost segregation, a tax mechanism that could generate substantial savings in federal income taxes. Although it is vastly under-utilized, cost segregation is not a wildly speculative accounting tool. In fact, the American Institute of Certified Public Accountants’ National Journal of Accountancy has published numerous articles in support of cost segregation.
Cost segregation identifies applicable components and establishes the value and correct time line for depreciation. Under typical circumstances, depreciation is spread out over as long as 39 years. However, cost segregation applies depreciation to parts of the property in 5-,7- and 15-year increments. This acceleration in depreciation time reduces the income subject to federal taxes. This method does not dictate alternative minimum tax issues.
Historically, most depreciation schedules are split between land and long-life property. Long-life property depreciates over 27.5 years for apartments and 39 years for most commercial properties. A cost segregation study can typically allocate 20% to 40% of the improvement basis to short-life categories, and sometimes more.
High-income owners typically pay a 35% federal tax rate on ordinary income and a 15% rate on capital gains. The mechanics of reporting the gain on a sale usually allocate most of the gain to capital gains, which is taxed at 15%.
A cost segregation study actually reduces the amount of long-life property, which is recaptured at 25% by allocating more of the basis to the 5-,7- and 15-year property. If cost segregation is utilized from inception until a gain on the property is recognized, it can reduce the federal tax rate from 35% to 15% for most investors. The exceptions are C corporations, which pay the same tax rate for either ordinary income or capital gains.
Don’t pay more than your fair share of taxes. Take all legal deductions.
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