Cost Segregation Why Are 90 Of Real Estate Investors Overpaying Federal
Income Tax

Cost Segregation Why Are 90 Of Real Estate Investors Overpaying Federal Income Tax



Cost Segregation : Why are 90% of​ real estate investors overpaying federal income tax?
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 .​
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:
1. Converting ordinary income into capital gains income
2. 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 2018,​ does a​ cost segregation 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 reduce federal taxes,​ most real estate investors ask,​ doesn't my accountant take care of​ this for me?
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 .​
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 .​
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 effect 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.
Getting started
Ask yourself the​ following questions when deciding whether you​ can benefit from a​ cost segregation study:
1. Do you​ pay federal income taxes?
2. Do you​ own investment real estate?
3. Can you​ use additional depreciation?
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 .​
If you​ have determined you​ can use additional depreciation and are paying federal 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 segregation 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 .​
Assuming you​ decide a​ cost segregation 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 segregation study a​ routine part of​ future real estate investments .​
Correctly calculating real estate depreciation is​ important because it​ substantially 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.




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