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Houston Tax Reduction and Cost Segregation - Myths and Facts
Houston real estate investors frequently pay excessive federal income taxes. They use a simplistic method to calculate depreciation. However, depreciation is a critical element in reducing income taxes. Houston real estate investors can accurately calculate and increase real estate depreciation with cost segregation. Tax Reduction and Defferal Tax reduction and tax deferral are both generated by cost segregation. Tax reduction occurs because cost segregation changes the character of income from ordinary income to capital gains income. Tax deferral occurs since payment of taxes is deferred from when income is earned until a gain is recognized. Under Utilized However, this tool is not well understood by most real estate investors and by many tax preparers. The root cause of limited understanding regarding cost segregation and how it provides tax reduction is limited dissemination of factual data on the subject. The adoption rate of cost segregation is slowly increasing. As of 2007, the adoption rate for cost segregation is probably in the range of 10% to 20%, but maybe even lower than 10%. Real estate investors and tax return preparers are gradually learning the benefits and modest cost related to cost segregation. The most prevalent myths include:
Tax Reduction Cost segregation provides tax reduction by converting income which would have been taxed at the ordinary income rate (35% maximum) to income taxed at the capital gains rate (15% maximum). The tax reduction benefit can be powerful when real estate is only held for one to two years. The tax reduction benefit from gaining an additional $500,000 of depreciation over a two-year period is $100,000 ($500,000 times (35% -15%). During the ownership period, cost segregation generates additional depreciation real estate investors can use to shelter income from the property or other sources. In many cases, this income would have been taxed at 35%. Tax Reduction Mechanics Upon sale, the property owner and tax preparer will collectively allocate the sales price. The tax preparer typically uses the owner's observations regarding the physical condition of the assets to allocate the sales price. In addition, the client can provide insight into the market value of the site at the time of sale. In most cases, short-life property such as carpet, vinyl tile and paving have depreciated and the market value of these assets (at the time of sale) equals their depreciated cost basis. In this event, the additional depreciation is taxed at the capital gains rate. Hence, the real estate investor gains both tax reduction and tax deferral. Some investors permanently eliminate the payment of federal income taxes by utilizing 1031 exchanges. Upon death, the assets receive a step-up in basis to their current market value. Too Expensive? Cost segregation used to cost $20,000 to $50,000 per property and was only financially feasible for properties with a cost basis of at least $10 million. These fees were typical when big-four accounting firms and highly specialized boutique shops were the only providers of cost segregation services. However, fees for cost segregation studies are now much lower. It generally makes sense to order a cost segregation study if the cost basis of improvements is at least $500,000. In most cases, the first year tax reduction is at least two to four times the fee for the study. It is possible to catch-up previously under-reported depreciation after obtaining a cost segregation study. This option is not well understood by real estate investors and tax return preparers. Many investors have found they can generate year-one federal tax savings of 50 to 100 times the cost of a cost segregation report for real estate owned for five or 10 years. IRS Guided The myth about cost segregation studies being a risky scheme is completely inaccurate. A properly prepared cost segregation study is encouraged by the IRS since it generates more accurate accounting. The Audit Techniques Guide is a 100-plus-page manual regarding the background and proper methodology for a cost segregation report. Both the advisors and appraisers (who perform cost segregation studies) have studied and understand the Audit Techniques Guide. Cost segregation studies are encouraged by the IRS. In private correspondence, IRS staff has indicated a cost segregation study does not increase the change of an audit. If you are a real estate investor or use real estate in your business, ignore the myths and obtain a free preliminary analysis to determine if you could benefit from a cost segregation study and increase your tax reductions and tax deductions. Click here for a FREE preliminary analysis of tax savings resulting from your property. Cost segregation produces tax deductions and reduces federal income taxes across the country and in every size market. Below are just a few examples of where cost segregation generates meaningful tax deductions. City:
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