Cost Segregation
Cost Segregation is an advanced depreciation technique wealthy people use to
leverage existing loopholes in the IRS tax code to maximize profit.
Click here to download a MS Powerpoint
presentation outlining the definition, benefits, and
and a real world example of cost segregation.
Since the 1986 Tax Reform Act, the IRS has defined three different
“buckets” of income, each with different tax consequences:
- Earned Income: You work for the money.
- Portfolio Income: Your money works for you.
- Qualified Dividends and Long-term capital gains currently taxed up to 15%.
- Interest and Short-term capital gains currently taxed up to 35%.
- Passive Income: Your investments work for you.
- With proper tax planning, may be taxed as low as 0% (no payroll/self-employment taxes)!
- The amount of tax benefit one gets in this category depends on how the IRS classifies the individual/property.
- Over time, it should be in your best interest to “convert” as much of your earned income
as possible into portfolio and passive income.
- It is critical to work with a knowledgeable CPA/legal
team in structuring your investment activities to minimize taxes:
- Setting up the correct business entity structure.
- Utilizing cost segregation studies to maximize passive losses.
- Qualifying as a “real estate professional”, so that your real estate
passive losses can offset “earned” income without restriction.
- For more information, please contact Tom Wheelwright, CPA and CEO of ProVision Wealth
Strategies, at (480) 467-4400 or cs@provisionwealth.com.
According to the IRS, there are 3 different real estate
investor/property classifications:
- Real Estate Dealer/Developer
- Dealer: Property held primarily for sale (e.g. Wholesaling, Assignments, etc.)
- Developer: Subdivide or develop property (e.g. Rehabbing, Subdivisions, etc.)
- Tax Consequences:
- Subject to ordinary income tax (i.e. marginal tax bracket) and self-employment tax (if not structured correctly).
- Cannot depreciate or cost segregate to increase passive loss in operating years.
- Cannot delay capital gains through installment sales or 1031 exchanges.
- Real Estate Investor (“Active” Participant)
- Applies to properties held primarily for investment (i.e. long term appreciation).
- Must be able to prove “active” participation to qualify for passive loss rule (i.e. decision making, etc.; not as stringent as “material” participation as there is no time requirement)
- Tax Consequences:
- Can depreciate and cost segregate to increase passive loss in operating years.
- Can use installment sales and 1031 exchanges to defer tax liability.
- “Passive Loss Rule”: Can write off up to $25,000 in passive loss against earned income, provided your AGI is less than $100,000/yr.
- Phases out $0.50 for every $1 earned above $100,000.
- Real Estate Professional
- Must be able to prove “material” participation:
- 750+ hrs/yr spent in real estate related activities (development, redevelopment, construction, reconstruction, acquisition, conversion, renting/leasing, operating, managing, or brokering).
- More time spent in real estate activities than in any other income source.
- Tax Consequences:
- Can depreciate and cost segregate to increase passive loss in operating years.
- Can use installment sales and 1031 exchanges to defer tax liability.
- Can write off unlimited real estate passive losses against earned income!
In order to gain a clear understanding of cost segregation, it is important
to first review how traditional depreciation works for residential properties.
- The IRS allows investors to depreciate the “improved” portion of their long-term
income-producing residential properties over 27.5 years (straight-line; mid-month convention),
which effectively helps the investor to show additional “paper losses”
in the operating years the depreciation is taken.
- Depreciation is “recaptured” up to 25% upon sale (but can be deferred with a 1031 exchange or installment sale).
- Depreciation benefits:
- Time value of money: Free loan from IRS!
- Potential tax savings: May forego taxes at higher rates today to pay taxes at lower rates later.
- A Cost Segregation Study effectively partitions the depreciable portion of the property into:
- 5 year personal property (i.e. carpet, blinds, countertops, cabinets, etc.)
- 15 year land improvements (i.e. lawn, concrete, landscaping, etc.)
- 27.5 year “improved” building/structure
- The 5 year personal property and 15 year land improvement “buckets” are depreciated on IRS-approved accelerated schedules.
- Cost Segregation Benefits (in addition to the previously mentioned depreciation benefits):
- Can show much greater real estate passive loss due to the accelerated 5 and 15 year buckets.
- Can realize benefits from prior years without having to amend a previous return.
- Segregates items that depreciate from those that appreciate.
- The argument could be made that, at the time of sale, these buckets could be sold for book value due to the fact that they are depreciating assets (e.g. carpet, cabinetry, blinds, appliances, etc.)
- The 5 and 15 year buckets are subject to recapture at ordinary income tax rates.
- Please consult with your CPA.