Archive for Tax Topics
Tax Savings: Cost Segregation – Why isn’t my CPA already doing this?
Most commercial property owners, even those who use professional accountants, fail to take advantage of cost segregation, a tax mechanism that could generate substantial savings in federal income taxes.
While most accountants are familiar with the approach, many are hesitant to recommend it without a documented analysis of correct depreciation amounts. The numerous intricacies of IRS designated building components make it difficult for some accounting professionals to be cognizant of all applicable items on a specific property. CPAs recognize that in order for the client to fully benefit, it is usually necessary to seek a real estate specialist to provide an independent report supporting the owner’s depreciation schedule.
Although it is vastly under-utilized, cost segregation is no 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.
Professionals Prepare Detailed Reports
To perform a cost segregation analysis, initially the building’s cost basis for construction, renovation and repairs is reviewed. A technician goes on site to take detailed measurements and observe the quality and condition of the property. After the site visit, he or she calculates the value of the property using widely accepted pricing resources and local economic conditions.
A cost segregation study produces a professional document that is backed by careful research. The results are summarized in a detailed report, documenting the amount of 5-,7- and 15-year property that qualifies for short-life depreciation.
Real estate appraisers or engineering firms typically have the knowledge to perform the detailed cost segregation studies, frequently at the recommendation of the owner’s tax preparer. Preparing the study requires expertise in evaluating real estate and complete command of the regulations that detail these depreciation options. Internal Revenue Code regulations outline approximately 130 categories of property, which qualify for shorter lives.
Cost segregation regulations contain a lot of variables that are not necessarily intuitive. The 5-year property includes items such as carpet and vinyl flooring. Seven-year property may reflect signs and parking lot striping. Fifteen-year property encompasses paving and landscaping.
Many CPAs Do Recommend Cost Segregation
Most property owners instinctively believe their CPAs are performing cost segregation for them, but research has suggested that this tool is used only 5 to 10 percent of the time. CPAs and other tax preparers may not routinely perform the study because it involves real estate appraisal methodology and specialized knowledge outside the scope of a typical tax practice. Even though cost segregation may be unfamiliar territory to some accounting professionals, it is highly praised by many accountants. Recent changes in tax regulations make cost segregation more attractive and allow it to be implemented years after the completion of a real estate purchase.
How Does It Work?
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 percent to 40 percent of the improvement basis to short-life categories, and sometimes more.
High-income owners typically pay a 35 percent federal tax rate on ordinary income and a 15 percent 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 percent.
A cost segregation study actually reduces the amount of long-life property, which is recaptured at 25 percent 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 percent to 15 percent for most investors. The exceptions are C corporations, which pay the same tax rate for either ordinary income or capital gains.
How Much Can It Save?
A recent client of the firm realized a payback ratio for the first year savings at 4:1 and the payback ratio for the first five years at 20:1.
Who Prepares Cost Segregation Studies Today?
Appraisal and engineering firms, Big Four firms and spin-offs of Big Four firms are the primary providers of cost segregation studies. Some accounting firms offer the service but frequently outsource the actual report preparation to an appraisal or engineering firm. With the introduction of new providers, the price gap has widened between very low cost analytical studies and much higher large firm rates.
Do All Properties Benefit From Cost Segregation?
Cost segregation is typically effective and financially feasible for properties that have an improvement basis of $500,000 or higher.
Properties with a great deal of site-improvement, including landscaping and parking, generate great results.
Cost segregation can be performed for properties anywhere in the United States. It is effective for apartments, office, retail, industrial, self-storage and many special use properties.
When Should You Obtain A Cost Segregation Report?
It typically makes sense to obtain a cost segregation report the year a property is purchased or built. Property owners who purchased or constructed property after 1986 can often benefit substantially by re-couping previously under-reported depreciation without filing amended tax returns.
Appraisers lower costs for federal tax savings on small property depreciation
Tax savings through cost segregation is no longer out of reach for investors in small and medium size properties. With appraiser expertise, fees for analysis are often one-third to one-half lower than those charged by traditional preparers.
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 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 lower 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.
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 properties, especially those holding less-than-new assets. 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 very significant 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 benefit from cost segregation. This compares to the limited properties worth $5 to $10 million and above that previously benefited.
2. Existing properties built or purchased after 1986 offer significant savings in year-one of cost segregation, even without producing original cost documents. Capturing non-segregated depreciation from prior years is perfectly allowable by the IRS. This compares to firms previously applying the methodology only to new construction.
3. Fees are no longer prohibitive. 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.
It is wise to keep the owner’s CPA or tax preparer abreast 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.
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.
Asset Protection for Real Estate Investors
Many real estate investors started out running their investing business as a sole proprietor because they really didn’t know any better. Most survived with only minimal damages, but quickly realized they needed to take the time to assess the best legal structure to use for real estate investing.
If you ask 10 experts you are likely to get 10 different opinions. With that in mind, here’s our opinion. Please don’t let our advice interfere with common sense and sensible business practice — ie, consult with your attorney or accountant (or the website of your state’s secretary of state) when choosing a business structure.
Many say that if you are a beginning investor, it’s probably best to not worry about asset protection until you actually have a few assets to protect. On this point we disagree. Our opinion is that you carefully consider the method(s) you will be acquiring and disposing of your real estate assets. Then huddle with your team/advisors and set up a business structure that will provide the best asset protection for the way you plan to run YOUR business. Why do we suggest getting the asset protection part done up front? Because you can turn around an investment deal faster than you can set up a business. Better to have your asset protection plan in place when you do the deal, than to try to go back and get everything re-done in the name of the business. Our recommendation is to never take title to investment property in your own name.
So, now that you’re going to structure that business, what structure should you take?
Assuming you want to set up an entity for handling your investment properties, the most popular are an LLC (Limited Liability Corporation) or a C Corporation. There is a lot of debate about which one is better. Many investors prefer the C Corporation because a certain amount off the top is taxed at 15percent and you can have a kick-butt employee (you) benefit plan to write off expenses. Others prefer the LLC, even though the income is passed through like a sole proprietor. The LLC is easy and inexpensive to establish, and just as easy to dissolve. In fact, we know investors who set up an LLC for each property they hold.
There are other ways to structure your business and shield your assets, but don’t even get us started on S Corps, or on the more complicated structures whereby you establish one entity which owns the others. Just trust us that you’ll want to talk it all over with a trained professional or a mentor.
Why is the tax issue such a big deal?
Here’s a simplified example using the C Corp. If you make $100K as a sole proprietor you are taxed on the full amount (35 percent) and have $65,000 left. Anything you buy for yourself comes from after-tax dollars. However, with a C Corporation if you could make the same $100K on paper, but have $50K in allowable expenses that you can write off. So you get taxed on that $50K at 15 percent and only have to pay $7,500 in taxes compared to $35,000 if it was your personal income being taxed. You still can buy the same stuff, but you are taxed less if you structure things correctly.
A very wealthy man once said It’s very hard for a C Corporation to make any money! What he meant was that C Corporations can expense almost everything until there is little or no profit.
Think about it… and then call a professional.