By Patrick O’Connor, MAI
By ignoring generous IRS guidelines when establishing depreciation schedules, over 90% of real estate investors are unintentionally overpaying federal income taxes. In addition, they are paying federal income taxes earlier than necessary, typically years or decades earlier than necessary. Depreciation, one of the key tax deductions, is understated by not carefully compiling depreciation schedules. Cost segregation is a specialized skill which helps real estate owners increase depreciation. Although cost seg affects meaningful federal income tax reduction, it is not a tax shelter; it is guided by detailed IRS regulations.
Although these IRS guidelines are relatively new, they provide substantial benefits. Since this is a relatively new issue, many accountants have not integrated the new IRS depreciation guidelines into their practice. Savings for real estate investors are meaningful- exceeding $50,000 to $1,000,000 in the first year. Cost segregation converts income taxed at 35% (ordinary income) to income taxed at 15% (capital gains). Cost segregation also defers payment of income taxes, often for 5 to 10 years.
Effects of Higher Depreciation
Most real estate investors do not understand the benefits of increasing real estate depreciation. They often ask, “doesn’t increasing my depreciation just mean that I will be shifting taxes from now until when I sell the property?”
This is a popular misconception and the answer is a resounding “no”. There are two benefits of increasing depreciation:
- Converting ordinary income into capital gains income
- Deferring income until a gain on the sale of the property is realized.
The conversion of ordinary income into capital gains income has to do with the technical nature of the allocation of the gain on the sale. Many, if not most, accountants initially believe it is simply a timing issue. However, when the mechanics of recognizing gain on sale are discussed, accountants quickly realize increasing depreciation leads to paying taxes at the capital gains rate as opposed to the ordinary income rate.
Correcting a depreciation schedule makes a difference if you recently sold a property since the additional depreciation will be taxed at the capital gains rate instead of the ordinary income rate. For example, assume an investor sold a property in late 2005, does a cost seg study, and increases depreciation by $100,000. The net result is the ordinary income taxes will be reduced by $35,000 ($100,000 x 35%) and the capital gains taxes will be increased by $15,000 ($100,000 x 15%). This nets the owner $20,000 in federal tax savings by simply correcting an error in the depreciation schedule after the property has already been sold.
When told it is possible to increase depreciation and affect federal income tax reduction, most real estate investors ask, “doesn’t my accountant take care of this for me?” Since depreciation is a significant source of tax deductions for commercial real estate investors, it seems intuitive that tax preparers would carefully examine all options.
Our experience, after reviewing thousands of depreciation schedules for real estate, is that less than 5% of depreciation schedules have been properly established. Most real estate investors have a good relationship with their accountant and believe, as a matter of faith, that their accountant is doing everything possible to minimize their taxes. Unfortunately, many accountants have not focused time or attention on this issue for several reasons. Some accountants are aware of cost segregation as an option to increase depreciation and reduce federal taxes but believe it is very expensive (at least $10,000 per property) and is financially feasible only for large properties (typically over $10 million). Many of the providers started out either as big four firms or big four spin-offs who charged between $10,000 and $50,000 per property. Many of these providers were not interested in properties with a cost basis under $10 million and only did cost segregation for newly built properties. Other accountants have not focused on the topic.
Cost segregation clearly makes sense for properties with an improvement basis of at least $500,000. In many cases, it makes sense for smaller properties. While accountants are becoming more and more active in reviewing options for depreciating real estate, in many cases the owner needs to take the lead role in proposing cost segregation as a mechanism to reduce and defer federal taxes.
Property Owner Involvement
Many property investors proudly take the stance that, “my federal tax return is too complicated; my accountant handles it.”
It is almost a rite of passage that a “serious” real estate investor is one whose tax return must be prepared by a third party because it has become too complicated for the investor to complete. Only about 2-5% of depreciation schedule in federal tax returns have short life property properly separated to minimize the owner’s federal taxes. Just as preparing a federal income tax return is too complicated for most commercial real estate investors, preparing a cost seg study is too complicated and specialized for 99.9% of tax preparers. While many parts of the federal tax return may be too complicated for an investor to understand and prepare, this area is simple: if you pay federal taxes and can use additional depreciation, you benefit from obtaining cost segregation studies.
Most investors are not aware of cost segregation and do not understand the benefits it provides. Those who are familiar with cost segregation think it only makes sense for large properties (over $10 million). Regrettably, there is limited and inaccurate information regarding a material issue that could sharply reduce federal taxes for many real estate investors. Cost segregation increases depreciation, a non-cash deduction, thus affecting tax reduction. The federal income tax savings resulting from cost segregation are usually much greater than the fees.
Cost Segregation Example
The following example is for an office building purchased ten years ago for $500,000. The value of the land is 10% or $50,000. The analysis without cost segregation assumes all the value for improvements is placed on the building. The analysis with cost segregation estimates a value of $70,000 for the 5-year property, $5,000 for the 7-year property, $70,000 for the 15-year property, and $305,000 for the 39-year property.
| Year 1 without catch-up | Year 1 based on catch-up | |||||
| Without cost segregation |
Annual depreciation |
With cost segregation |
Annual depreciation |
Without cost segregation |
With cost segregation |
|
| Land | $50,000 | $50,000 | – | – | ||
| 5 year property | $0 | $70,000 | $14,000 | $0 | $70,000 | |
| 7 year property | $0 | $5,000 | $714 | $0 | $5,000 | |
| 15 year property | $0 | $70,000 | $4,666 | $0 | $46,667 | |
| 39 year property | $450,000 | $11,538 | $305,000 | $7,820 | $115,384 | $78,205 |
| $11,538 | $27,200 | $115,385 | $199,872 | |||
| Year 1 Tax Savings | Without Catch-up | With Catch-up |
| Depreciation with Cost Segregation | $27,200 | $199,872 |
| Depreciation without Cost Segregation | $11,538 | $115,384 |
| Increase in Depreciation | $15,662 | $84,488 |
| Tax Savings at 35% | $5,481 | $29,570 |
| Fee of $3,500 | $3,500 | $3,500 |
| Year 1 Payback Ration | 1.57 | 8.45 |
The year-1 savings without the benefits of catch-up is $5,481. The year-1 tax savings for a building purchased 10 years ago including catch-up depreciation is $29,570. This is based on additional year-1 tax deductions (depreciation) of $84,488 which yields a federal income tax reduction of $29,570 ($84,488 x 35%).
Most owners and accountants consider a $500,000 building much too small for cost segregation. Note that even in the year-1 example without catch-up the tax savings are substantially higher than a typical fee for a building this size. Based on traditional thinking that a building has to be $10 million or larger to justify cost segregation, the tax savings need to be 20 times those in this building or approximately $109,600 to justify a cost segregation study. Both the 1-year and 5-year results merit obtaining a cost seg study. The results for the 10-year catch-up are truly compelling. However only 1% or less of owners of $500,000 properties are correctly setting up depreciation schedules.
Table 1
| 5-year | 7-year | 15-year | |
| Apartments | 3.5-20.74% | .15-1% | 7.5-24.29% |
| Office | 7.37-18.21% | .48-3.79% | 10.18-21.9% |
| Retail | 1.93-14.31% | .32-1.95% | 11.41-36.75% |
| Industrial | 2.92-8.06% | .57-1.38% | 13.46-32.44% |
Proportion of Short Life Property
The proportion of short life property typically ranges from 20% to 50% of the cost basis of the improvements. Items which typically affect whether it is at the low end of the range or the high end of the range include the age, condition, intensity of landscaping, amount of surface parking, and land value.
Catch-Up
What is known in cost segregation jargon as “catch-up” is reporting depreciation that has been underreported in prior years since the property was purchased or built in the current year. A real estate investor can “catch-up” underreported depreciation by having his accountant file a form 3115 with the current tax return. The IRS has reported that filing a form 3115 is not a red flag for an audit. Some investors seem concerned this is too good to be true; however, when their accountant reviews the IRS rules and guidelines they quickly find out that you can indeed catch-up underreported depreciation by filing the form 3115. The combination of cost segregation and catch-up depreciation generate meaningful federal income tax relief.
| 5 years held | 10 years held | 15 years held | |
| 5-year property | $150,000 | $150,000 | $150,000 |
| 7-year property | $14,286 | $20,000 | $20,000 |
| 15-year property | $50,000 | $100,000 | $150,000 |
The above example is based on a $1 million apartment complex. The amounts in the table are the year-1 federal tax savings based on different levels of short life property and different periods of ownership. Many investors have owned property for five to 15 years and have the opportunity to catch-up underreported depreciation. The numbers shown in this table will give you some idea of the amount of depreciation and federal taxes savings achievable by obtaining a cost seg study. The tax savings are based on a 35% tax rate. If you are subject to a state income tax, resulting savings will be higher.
This example and the preceding example clearly illustrates that cost segregation is effective for owners of $500,000 to $1,000,000 buildings.
Getting Started
Ask yourself the following questions when deciding whether you can benefit from a cost seg study:
- Do you pay federal income taxes?
- Do you own investment real estate?
- Can you use additional depreciation (a non-cash tax deduction)?
Some owners are passive while others are active. If you are a passive real estate investor you may not be able to use additional depreciation. On the other hand, if you are an active investor or a real estate professional, which includes people in a wide variety of activities from real estate broker to mortgage broker to leasing agent, you are entitled to deduct additional depreciation.
Tax tip: You can also use the additional depreciation as a tax deduction if your business uses the real estate.
If you have determined you can use additional depreciation and are paying federal income taxes, call a cost segregation expert and request a preliminary analysis. There should be no fee for this initial consultation. The preliminary analysis will estimate the amount of 5, 7, and 15-year property, which can likely be identified and will also identify the catch-up depreciation. This analysis will not involve a site inspection and will not be precisely correct. However, it should be accurate enough to help you decide whether a cost seg study is financially feasible.
Once you obtain the preliminary analysis, you should consult your accountant, since he/she will be completing and signing your tax return. In many cases, it makes sense for the accountant, the property owner, and the cost segregation advisor to meet and discuss the options and issues. Tax advice from a trusted advisor is frequently an essential step in making real estate owners comfortable that the tax deductions resulting from cost segregation will generate credible tax reduction.
Assuming you decide a cost seg study does make sense, you should further review whether the extra depreciation should be used in a prior year, which would involve filing amended tax returns, or whether to use it in the current year. To minimize federal income taxes, make obtaining a cost seg study a routine part of future real estate investments.
Correctly calculating real estate depreciation is important because it substantially increases tax deductions and reduces federal taxes for real estate investors. The process of fine-tuning the depreciation schedule is called cost segregation. The adoption rate for cost segregation is under 5% because of limited knowledge by many owners and accountants. In addition, there are misconceptions regarding the cost of obtaining cost segregation studies and the smallest properties for which cost segregation studies are financially feasible. As awareness of the practice and affordable service providers increase among real estate investors and accountants, the adoption rate will increase dramatically.
Copyright by O’Connor & Associates, 2006
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