Increasing Tax Deductions from Real Estate
by Christopher Levarek
“Knowledge is power. Information is liberating. Education is the premise of progress, in every society, in every family.”
- Kofi Annan
There are multiple reasons why investors turn to real estate however today we will take a look at the most common reason, tax deductions. Hopefully this didn’t just make you cringe at the very thought of discussing taxes. You see for many, taxes come once a year and are painfully completed by gathering up all the expenses to provide to a tax attorney at H&R Block in the hopes something good happens.
However, for those looking to build and protect wealth, tax season has been meticulously planned for and anticipated.
Why? Well, simply because for the knowledgeable real estate investor, tax season means writing off all those well-planned deductions and paper losses against income and optimally receiving a refund from Uncle Sam. The well-versed real estate investor understands, or their CPA understands, the tax credits and incentives given by the government for those investing into real estate and puts them to use.
With tax season right around the corner, today’s topic is covering one of the most powerful methods of realizing tax deductions in a given year for a real estate investor. Today we cover cost-segregation.
What is Cost Segregation?
Real estate assets have what is called depreciation, meaning a method of “reducing the value of an asset with the passage of time” or what’s known as a paper loss. It is a way of calculating a “loss” in wear and tear on the property on paper. Now, the IRS has determined that this depreciation or deductible life of property is 27.5 years for residential and 39 years for commercial real estate. So the depreciation or losses are divided up over those time spans for a given property.
Example :
So if you owned a 6-unit apartment complex (commercial building) at $1,000,000 and 80% of the property was depreciable, (ie 20% is land being non-depreciable),
This means, 80% * $1,000,000 / 39 years = $20,512
So in this example, the property owner would be able to deduct $20,512 per year for 39 years in tax deductions from this property.
Enter side-stage cost segregation.
Cost segregation is a method, provided by the IRS, by which the depreciation can be accelerated. Thus instead of depreciating over 27.5 years or 39 years, a property owner could take the entire 80% depreciation in the example above in the first year or even over 5-7 years instead.
Imagine being able to sustain a paper loss of $800,000 in a single year. For those looking to grow wealth, such tax deductions could be game-changing.
How does it Work?
Alright, so if a real estate investor is looking to take advantage of cost-segregation how does it work? Typically it starts by investing into real estate whether passively or actively. Ok, maybe too obvious there. In all seriousness, once a piece of real estate property is under ownership, the owner would then request a cost-segregation study from a firm specialized in this work.
These cost-segregation firms employ engineers trained in the tax code and work with tax experts to complete the study. They will visit the property and gather measurements, take pictures/video and compile all the depreciable pieces of the asset or property.
Without going to deep into the details of the study, the categories often used in depreciation are broken into different assets in the property :
5 years for personal property within the building (i.e.. fixtures, carpet, appliances, special purpose lighting, furnishings, etc)
15 years for land improvements outside the building (i.e. signage, fencing, asphalt, landscaping, etc)
27.5/39 years for the structure of the building
The cost-segregation study accounts for the value of such assets and then depreciates them over a 1 year span or 5-7 years span. This study is a multiple page document showcasing the paper loss and evidence is then presented to a CPA, tax attorney, at tax time and applied to the tax return for the investor/owner.
When does it make Sense?
Cost-segregation studies can be a significant cost to have completed. Typically, depending on the property, they can range anywhere from $3000-$15000 for the one-time study. Thus it makes sense to perform these studies on higher-worth properties that are around the $1,000,000 property value and above.
When a passive investor invests into a syndication or apartment building projection, the benefits of a cost-segregation are passed down to the investor. The cost of the study is incorporated into the cost of the project and the investor simply receives the K-1 at tax time with the benefits passed down without any additional cost or overhead. This is one of the benefits of investing as a group or with other investors into large syndications.
In Final
The benefits of tax deductions and cost segregation have been used by those growing their wealth for years. One example of someone using these methods is of course Donald Trump. The now famous, “That Makes Me Smart” Donald Trump video from the 2016 elections declared to the world that Mr. Trump pays 0 in taxes, thus causing the video to go viral and cause an uproar.
However, this is a strategy that has been used for years and is an incentive from the IRS or government to invest into real estate. Mr. Trump and the countless others growing/protecting their wealth are simply using the tools available to achieve a desired outcome. The smart investor or taxpayer would be wise to not be upset by Mr. Trump’s actions but seek to understand, how can I do the same?
With the tax season near upon us, we hope this article provided some information on how to best be prepared and take full advantage of the benefits of cost segregation in your wealth creation strategy. Hopefully, you have already invested into some projects for the 2020 year and aren’t scrambling for tax deductions in December.
Although our projects have all been closed and cost segregation studies performed for 2020, we invite you to reach out to join our Valkere Investor Club and get access to any upcoming 2021 projects. The early bird…plans tax deductions? As always, Invest Smart!