Learn how real estate investors can save on taxes and get tax credits for their investments. This week we interview Bobby Thames on tax credits, tax incentives and cost segregation.

If you own real estate and you have not considered using cost segregation, tax credits or incentives, you need to listen to this episode.

Benefits of a Cost Segregation

The main goal of all cost segregation studies is to accelerate the depreciation expense associated with your property.  If that is the goal, let’s take a moment to discuss the issue.  Spending money to purchase or build an income-producing property does not lower your taxable income.  You do not have an expense; you simply have a new asset.  That asset is then expensed over time lowering your taxable income, this is known as depreciation.  Without a cost segregation on residential real estate, the entire property is placed into one depreciable class life which takes 27.5 years to depreciate.  So, if you spent $1,000,000 on an investment property, you only get a $19,700 depreciation expense in the first year.  That is the issue at hand, spending large amounts of money and not taking the proper expense that should accompany the spend. 

So why are you defaulting to 27.5 years depreciation?  A residential property is made up of 5-year, 7-year, 15-year, and 27.5-year property as described by the IRS.  To properly identify the 5, 7, and 15-year property you need to know very specific rules, court cases, and have engineering experience.  So, when you do not have a specialist to identify these assets, most CPAs will put everything in the 27.5-year asset class to remain compliant. (The IRS does not care if you under-depreciate property, even though it is technically an impermissible method.)   

What we have is a house full of flooring, cabinetry, and long list of other short life assets sitting on a lot full of plants, trees, sidewalks and more… and it is all depreciated extremely slowly as if it were just a building.  So, a cost segregation study does exactly what it sounds like: it segregates all these costs into separate depreciable lives, identifying and moving the appropriate assets into 5-year, 7-year, and 15-year designations.  And it gets better!  Currently (until 12/31/2022) bonus depreciation is 100%.  Bonus depreciation is additional depreciation for short life property you take in the first year.  That means everything that moves into the 5, 7, and 15-year buckets is immediately expensed in the first year.  It varies property-to-property, but a good typical range is 20% - 30% of a property is short life.  Which means that with a $1,000,000 property, you could have $264,000 of depreciation expense in the first year to offset your income, compared to the $19,700 from above.  

Let's look at this from a tax effective standpoint.  If you made $300,000 of taxable income in a given year,  we can see the difference a cost segregation study will make on your tax liability.  Without a cost segregation study, you have $280,300 ($300,000 - $19,700) of taxable income.  Assuming a 32% tax rate, you owe the IRS $89,696 for the year.  If you did the cost segregation study, you will have $36,000 ($300,000 - $264,000) of taxable income and tax liability of only $11,520.  With the study you will pay $78,176 less in tax.  

The two most common responses I receive after laying out these benefits of a cost segregation study to investors are “why have I never heard of this?” and “what’s the catch?”.  

“Why have I never heard of this?”

The answer to the first question is simple: real estate investors are a highly underserved group when it comes to tax incentives.  In my past life at PwC, our cost seg team sat right next to the compliance teams (tax return preparers) and made sure that all their clients were aware of these tax incentives.  Odds are that your CPA does not have a team of engineers and specialists sitting down the hall itching to talk about cost segregation.  Second to that, many of my clients from back in those days were the ones lobbying for these tax incentives.  So that is why many fortune-500 companies cost segregate every single property on their books. 

“What’s the catch?”

It’s a timing play, and what I mean by that is you were always going to get this expense eventually. In my example above, you would get your $1,000,000 of expenses after 27.5 years of owning the property.  We are accelerating deductions, not creating them.  For investors this is not an issue asunderstanding the time value of money is second nature.  We have had people tell us they used the tax savings from a property as the down payment on their next property!  

Summary

If you have properties that are already placed in service, the IRS makes it very easy to go back in time and optimize properties that have already begun depreciating.  We do not have to amend tax returns that have already been filed to fix the depreciation.  Instead, we can fill out a single Form 3115 for the current year’s tax return and gain all the missed benefit right away.  

Tax is an interesting, yet dense area so if you have made it this far I hope you see the value in making sure your tax ledger is optimized for depreciation.  I always tell people that these are the tools used by the largest companies in the U.S., and they are just as available to you – take advantage!  This is also not the only tool for tax incentives out there.  On our website (centiv.tax), you can learn more about Green Energy Tax Credits, Tax Fixed Asset Ledger Review, and Fixed Asset Outsourcing, all of which can help lower your tax liability.