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Cost Segregation
ost Segregation: Why are often five to 10 years.
90% of Real Estate
Investors Overpaying Effects of higher depreciation
Federal Income Taxes?
Most real estate investors do not
By ignoring generous IRS understand the benefits of
guidelines when establishing increasing real estate
depreciation schedules, over 90% depreciation. They often ask,
of real estate investors are “doesn’t increasing my
unintentionally overpaying depreciation just mean that I
federal income taxes. In addition will be shifting taxes from now
they are paying federal income until when I sell the property?”
taxes earlier than necessary,
typically years or decades This is a popular misconception
earlier than necessary. Although and the answer is a resounding
these IRS guidelines are “no”. There are two benefits of
relatively new, they provide increasing depreciation:
substantial benefits. Since this
is a relatively new issue, many 1)Converting ordinary income into
accountants have not integrated capital gains income
the new IRS depreciation 2)Deferring income until a gain
guidelines into their practice. on the sale of the property is
Savings for real estate investors realized.
are meaningful- exceeding $50,000
to $1,000,000 in the first year. The conversion of ordinary income
Cost segregation converts income into capital gains income has to
taxes at 35% (ordinary income) to do with the technical nature of
income taxes at 15% (capital the allocation of the gain on the
gains). Cost segregation also sale. Many, if not most,
defers payment of income taxes, accountants initially believe it
is simply a timing issue. already been sold.
However, when the mechanics of
recognizing gain on sale are When told it is possible to
discussed, accountants quickly increase depreciation and reduce
realize increasing depreciation federal taxes, most real estate
leads to paying taxes at the investors ask, “doesn’t my
capital gains rate as opposed to accountant take care of this for
the ordinary income rate. me?”
Correcting a depreciation Our experience, after reviewing
schedule makes a difference if thousands of depreciation
you recently sold a property schedules for real estate, is
since the additional depreciation that less than 5% of depreciation
will be taxed at the capital schedules have been properly
gains rate instead of the established. Most real estate
ordinary income rate. For investors have a good
example, assume an investor sold relationship with their
a property in late 2005, does a accountant and believe, as a
cost segregation study, and matter of faith, that their
increases depreciation by accountant is doing everything
$100,000. The net result is the possible to minimize their taxes.
ordinary income taxes will be Unfortunately, many accountants
reduced by $35,000 ($100,000 x have not focused time or
35%) and the capital gains taxes attention on this issue for
will be increased by $15,000 several reasons. Some accountants
($100,000 x 15%). This nets the are aware of cost segregation as
owner $20,000 in federal tax an option to increase
savings by simply correcting an depreciation and reduce federal
error in the depreciation taxes but believe it is very
schedule after the property has expensive (at least $10,000 per
property) and is financially Property owner involvement
feasible only for large
properties (typically over $10 Many property investors proudly
million). Many of the providers take the stance that, “my federal
started out either as big four tax return is too complicated; my
firms or big four spin-offs who accountant handles it.”
charged between $10,000 and
$50,000 per property. Many of It is almost a rite of passage
these providers were not that a “serious” real estate
interested in properties with a investor is one whose tax return
cost basis under $10 million and must be prepared by a third party
only did cost segregation for because it has become too
newly built properties. Other complicated for the investor to
accountants have not focused on complete. Only about 2-5% of
the topic. depreciation schedule in federal
tax returns have short life
Cost segregation clearly makes property properly separated to
sense for properties with an minimize the owner’s federal
improvement basis of at least taxes. While many parts of the
$500,000. In many cases it makes federal tax return may be too
sense for smaller properties. complicated for an investor to
While accountants are becoming understand and prepare, this area
more and more active in reviewing is simple: if you pay federal
options for depreciating real taxes and can use additional
estate, in many cases the owner depreciation, you benefit from
needs to take the lead role in obtaining cost segregation
proposing cost segregation as a studies. Most investors are not
mechanism to reduce and defer aware of cost segregation and do
federal taxes. not understand the benefits it
provides. Those who are familiar
with cost segregation think it segregation With cost segregation
only makes sense for large Land$50,000 $50,000
properties (over $10 million). 5 year property$0
Regrettably, there is limited and $70,000$14,000$0$70,000
inaccurate information regarding 7 year property$0
a material issue that could $5,000$714$0$5,000
sharply reduce federal taxes for 15 year property$0
many real estate investors. $70,000$4,666$0$46,667
39 year
Practical example property$450,000$11,538$305,000$7
,820$115,384$78,205
The following example is for an $11,538 $27,200$115,385$199,872
office building purchased ten
years ago for $500,000. The value Year 1 Tax Savings
of the land is 10% or $50,000. Without Catch-up
The analysis without cost With Catch-up
segregation assumes all the value
for improvements is placed on the Depreciation with Cost
building. The analysis with cost Segregation$27,200$199,872
segregation estimates a value of Depreciation without Cost
$70,000 for the 5-year property, Segregation$11,538$115,384
$5,000 for the 7-year property, Increase in
$70,000 for the 15-year property, Depreciation$15,662$84,488
and $305,000 for the 39-year
property. Tax Savings at 35%$5,481$29,570
Fee of $3,500$3,500$3,500
Year 1 without catch-up Year 1 Year 1 Payback Ration1.578.45
based on catch-up
Without cost segregation With The year-1 savings without the
cost segregation Without cost benefits of catch-up is $5,481.
The year-1 tax savings for a Table 1
building purchased 10 years ago Typical Percentage of Short-Life
including catch-up depreciation Property
is $29, 570.
5-year7-year15-year
Most owners and accountants Apartments3.5-20.74%.15-1%7.5-24.
consider a $500,000 building much 29%
too small for cost segregation. Office7.37-18.21%.48-3.79%10.18-2
Note that even in the year-1 1.9%
example without catch-up the tax Retail1.93-14.31%.32-1.95%11.41-3
savings are substantially higher 6.75%
than a typical fee for a building Industrial2.92-8.06%.57-1.38%13.4
this size. Based on traditional 6-32.44%
thinking that a building has to
be $10 million or larger to Proportion of short life property
justify cost segregation, the tax
savings need to be 20 times those The proportion of short life
in this building or approximately property typically ranges from
$109,600 to justify a cost 20% to 50% of the cost basis of
segregation study. Both the the improvements. Items which
1-year and 5-year results merit typically effect whether it is at
obtaining a cost segregation the low end of the range or the
study. The results for the high end of the range include the
10-year catch-up are truly age, condition, intensity of
compelling. However only 1% or landscaping, amount of surface
less of owners of $500,000 parking, and land value.
properties are correctly setting
up depreciation Catch-up
schedules.
What is known in cost segregation
jargon as “catch-up” is reporting The above example is based on a
depreciation that has been $1 million apartment complex. The
underreported in prior years amounts in the table are the
since the property was purchased year-1 federal tax savings based
or built in the current year. A on different levels of short life
real estate investor can property and different periods of
“catch-up” underreported ownership. Many investors have
depreciation by having his owned property for five to 15
accountant file a form 3115 with years and have the opportunity to
the current tax return. The IRS catch-up underreported
has reported that filing a form depreciation. The numbers shown
3115 is not a red flag for an in this table will give you some
audit. Some investors seem idea of the amount of
concerned this is too good to be depreciation and federal taxes
true; however, when their savings achievable by obtaining a
accountant reviews the IRS rules cost segregation study. The tax
and guidelines they quickly find savings are based on a 35% tax
out that you can indeed catch-up rate. If you are subject to a
underreported depreciation by state income tax, resulting
filing the form 3115. savings will be higher.
5 years held10 years held15 years This example and the preceding
held example clearly illustrates that
5-year cost segregation is effective for
property$150,000$150,000$150,000 owners of $500,000 to $1,000,000
7-year buildings.
property$14,286$20,000$20,000
15-year Getting started
property$50,000$100,000$150,000
Ask yourself the following
questions when deciding whether There should be no fee for this
you can benefit from a cost initial consultation. The
segregation study: preliminary analysis will
estimate the amount of 5, 7, and
1.)Do you pay federal income 15-year property, which can
taxes? likely be identified and will
2.)Do you own investment real also identify the catch-up
estate? depreciation. This analysis will
3.)Can you use additional not involve a site inspection and
depreciation? will not be precisely correct.
However, it should be accurate
Some owners are passive while enough to help you decide whether
others are active. If you are a a cost segregation study is
passive real estate investor you financially feasible.
may not be able to use additional
depreciation. On the other hand, Once you obtain the preliminary
if you are an active investor or analysis, you should consult your
a real estate professional, which accountant, since he/she will be
includes people in a wide variety completing and signing your tax
of activities from real estate return. In many cases, it makes
broker to mortgage broker to sense for the accountant, the
leasing agent, you are entitled property owner, and the cost
to deduct additional segregation advisor to meet and
depreciation. discuss the options and issues.
If you have determined you can Assuming you decide a cost
use additional depreciation and segregation study does make
are paying federal taxes, call a sense, you should further review
cost segregation expert and whether the extra depreciation
request a preliminary analysis. should be used in a prior year,
which would involve filing accountants. In addition, there
amended tax returns, or whether are misconceptions regarding the
to use it in the current year. To cost of obtaining cost
minimize federal income taxes, segregation studies and the
make obtaining a cost segregation smallest properties for which
study a routine part of future cost segregation studies are
real estate investments. financially feasible. As
awareness of the practice and
Correctly calculating real estate affordable service providers
depreciation is important because increase among real estate
it substantially reduces federal investors and accountants, the
taxes for real estate investors. adoption rate will increase
The process of fine-tuning the dramatically.
depreciation schedule is called
cost segregation. The adoption Copyright by O’Connor &
rate for cost segregation is Associates, 2006
under 5% because of limited
knowledge by many owners and
About the Author:
Patrick O’Connor, a designated member of the Appraisal Institute, is president of O’Connor & Associates. The firm, in business since 1974, specializes in real estate appraisals, research, and state and federal tax reduction services nationwide. Visit http://www.cutmytaxes.com
Read more articles by: Patrick O'Connor
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