Do you own an investment property valued at $1,000,000 or more?
Do you pay federal income taxes?
Do you operate a corporation or entity that is for-profit?
Are you planning to the hold the property for more than one year?
If you answered yes to all of these questions, you are eligible to enter a raffle that will be held at the end of this article.
Just kidding. But you are eligible for major tax benefits, so keep reading.
You already know that real estate is the best industry to be in, but you’re about to learn that it’s even better than you thought. Why? Because of all the tax perks that come along with it.
What is Depreciation?
It’s one of the best gifts Uncle Sam gave to property owners and real estate investors. Depreciation is a special tax deduction based on the concept that the more something is used, the lower its value goes. When you drive a new car off the lot, it immediately goes down in value. It’s the same with real estate. Every year, the IRS allows you to take a deduction of the property value against that loss in value. (This does not include the value of the land, which doesn’t depreciate each year). But here’s the best part — this applies even if your property value is appreciating each year!
Simply put, depreciation is a paper write off for real estate.
OK, so I understand what depreciation is. And I know that a residential property is depreciated over 27.5 years—and a commercial over 39. But what does it mean to accelerate that depreciation?
These are very long periods of time. To make the benefits of depreciation more tangible, the IRS established shorter “lives,” as follows:
- Five years for personal property within the building (flooring, boilers, etc.)
- Fifteen years for ‘land improvements” outside the building.
- The standard 27.5/39 year rate for the structure of the actual building.
What does this mean for you? You can depreciate the value of the first two categories of assets at a faster rate and start saving on taxes during those first few years after purchase. These savings you can reinvest in other ventures.
How Much of a Property Can Generally be Re-classified Through Cost Segregation?
Usually between 10 percent and 30 percent of the property value.
OK, so let’s make sure I understand this completely. What are some examples of five-year personal property?
Flooring, carpeting, wall coverings, appliances, furnishings, special purpose lighting, special purpose plumbing, special purpose electric, and much more.
What are examples of 15 year property land improvements?
Asphalt, fencing, landscaping, signage, etc.
Wait. So, all these years I’ve been willingly lending the IRS my money when I could have possibly lowered my tax liability to ZERO?
Umm…yes. But you can stop today!
Now comes my most important question:
Why Didn’t my Accountant Tell me About This?
A CPA isn’t qualified to perform cost segregation. Tax knowledge is not enough. You also need to understand engineering to calculate how each structure depreciates. That’s why there are cost segregation firms – which employ engineers that are trained in the tax code and tax experts who work together to conduct the cost segregation study.
Your CPA can certainly apply the results once the cost segregation study is complete. But the IRS recommends (not requires) that those “competent in construction methodology or techniques” perform the actual study determining how much you can save.
Who Works at These Firms, if Not Accountants?
The firms hire engineers that are trained in the tax code and tax experts, and they work together to conduct the cost segregation study according the Cost Segregation Audit Techniques Guide from the IRS.
But you can’t just make claims. Everything has to be documented: what you built, when it was built, and how much you paid for it. The construction budget or the AIA (American Institute of Architects) documents will be used during the study.
Does This Mean That Certain Materials and Building Methods Can Save me More Money?
Yes. The materials used and how they are affixed make a difference in whether the property is considered a five-year property. As we said above, if something is part of the main structure, it is not personal property and can’t be accelerated.
What Are Some Common Examples of Things That Could be Eligible if Done Properly?
Floor coverings — if it’s affixed with permanent adhesive, nailed, or screwed, then it’s considered part of the structure.
Not eligible: ceramic tile, marble, paving brick, or permanent wood floors.
Eligible: strippable adhesives such as vinyl-composition tile, sheet vinyl, carpeting, and floating hardwood floors.
Should I Have Cost Segregation in Mind Already as Soon as I Start Building or Renovating?
You should. A savvy real estate professional will keep this in mind.
What are Other Examples of Things That Could be Eligible?
- Mirrors clipped to the wall instead of glued on.
- Portable air conditioner units that plug in instead of being hard wired.
- Demountable walls. These have become a very common trend in corporations, educational institutions, health care, and government organizations. Such walls, in addition to making customizable work space easy, can bring in major tax savings as they are not considered a structural component.
Are There Other Benefits to Bringing in a Cost Segregation Expert in the Planning Stages?
Yes. Cost segregation engineers can review the construction contract and identify the line items that need to be priced out separately. Knowing the actual costs will allow for a much more accurate report than having the engineers estimate the cost down the line.
When Does the Property Begin to Depreciate?
Depreciation begins when the property is “placed in service.” For a new construction, this is generally when the property is advertised as “ready to move in,” or when monies have been transferred to a permanent account.
When Doing Renovations, What Needs to be Capitalized and Depreciated — And What Can Just be Deducted as an Immediate Write Off?
If the property is rehabbed before being put into service, the rehab expenses should be added to the basis. If rehab work is done while in service (tenants are still there), you can fully expense an item that would normally be capitalized if it’s less than $2,500.
You can only fully expense those items (it’s called de minimis safe harbor rules if you want to get technical) after the property is placed into service. Where the expenses were incurred before the property is placed into service, then they almost always have to be capitalized.
That’s the technical answer.
Does This Put me at Risk of an Audit?
If the engineering report is well-documented, the cost segregation is not only a permissible depreciation method, but it is actually the preferred technique under the internal revenue code. However, if a CPA uses ad hoc calculation, or relies on a contractor’s guesstimations of cost, it is a surefire way to fail in the event of an audit.
Are There Any Other Advantages of Doing a Cost Segregation Study?
If a building component subsequently needs replacement and a cost segregation study was done on it, taxpayers can write off that component’s remaining tax basis.
Example: A cost segregation study showed the carpeting to be initially valued at $100,000. Two years later, when the carpeting has an adjusted tax basis of $80,000, it needs to be replaced. The taxpayer could deduct an $80,000 loss. Without a cost segregation study, though, no loss could be taken because the carpeting and building tax basis would remain intertwined.
What is 100 Percent Bonus Depreciation?
A new law that took effect on September 28, 2017, determined that any five- or 15-year asset placed in service (by you) for the first time — whether it was just constructed or newly acquired — is now eligible to depreciate the entire value of an item in the first year. With this law, it is more important than ever for real estate companies to use qualified cost segregation experts to maximize their savings and be eligible for 100% bonus depreciation.
What is the Biggest Fear When Discussing Accelerated Depreciation?
Depreciation recapture. When you sell a property, you must pay tax (capped at 25 percent) on the amount that you took depreciation deductions. So if you took $100,000 of depreciation deductions, you will have to pay $25,000 in tax upon sale of the property. This is only if you sell for a profit. However, the amount of personal property depreciation that was taken is taxed at your ordinary income rate.
Can This be Avoided?
With a 1031 like-kind exchange (details in another article) you can defer these taxes even further.
If I Accelerate the Depreciation on my Five-year Personal Property, Will I Have to Pay Taxes on All of That When I Sell?
It depends. Consult your CPA or tax adviser to learn about different strategies.
“You were right — I really did win a lottery. I’m going to cash in on it now!”
Do you have questions about cost segregation?
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