In the past I shared ideas that saved you $10,000 or more per year. I also shared numerous other ways to reduce your tax burden by smaller amounts. And, of course, retirement accounts and the Health Savings Account provide plenty of tax reducing power, too.
That is all small change compared to what I share today. Today the gloves come off. Today you will learn how to peal massive amounts off your tax bill. I am talking about taking six figures and more from the IRS and putting it into your pocket legally.
This program applies to investment properties and businesses with a building. All others can safely skip today’s post. Or you can read it and share it with someone who owns rental properties or a commercial building. You will make a lifelong friend if you do.
What is Cost Segregation?
The risk I take is getting too technical. You don’t need to understand all the deep tax terms to use this strategy so I will avoid technical jargon as much as possible.
The first thing you need to know is that cost segregation only works on buildings with an original cost basis (purchase price, plus improvements) of $250,000 or more. Residential income properties, commercial properties, additions and build-outs all work. This does not include the value of the land!
Example: You buy a property for $450,000. Land value usually comes in at around 20% of the purchase price. Therefore, $360,000 is for the building. Cost segregation works on the building portion of a property only. Also note, the higher the value of the property, the more tax benefits cost segregation provides.
The IRS says you have to depreciate a residential rental property over 27.5 years and commercial property over 39 years. This means you put a lot of money down upfront without a current tax benefit.
The IRS says you can use cost segregation to separate the components of the building for faster depreciation. A typical building under cost segregation may have about half the value reclassified as 5-year and 7-year property (20-25% is a good estimate) and 15-year property (another 20-25% estimated), and the remainder as either 27.5- or 39-year property.
Each building is unique. The exact amount segregated to a shorter class life depends on factors related to the building.
Pictures around this post show some illustrations of tax savings with cost segregation.
Tax Benefits of Cost Segregation
By depreciating a building significantly faster you cut your tax bill by a massive amount. In our example above, a $450,000 property with a building basis of $360,000 could see $180,000 moved from 39-year property to 5-year property. (We will disregard the rest. Review the photos for additional details.) $180,000 depreciated over 39 years allows a $4,615 deduction each year for 39 years. As 5-year property it gets a $36,000 deduction the first year (without considering any bonus depreciation) and the whole $180,000 in depreciated in 6 years. (I know taxes are wacky. It takes 6 years to depreciate a 5-year property due to half-year convention.)
The additional $31,385 is a current deduction at your ordinary tax rate. You will see why this is important later. Assuming a 39.6% tax bracket and ignoring state tax benefits, your tax savings are $12,428. And that is only the 5-year portion. There are still more benefits from the 7-year reclassified property.
Here is where it gets really nice. Let’s say you owned a commercial or residential rental property for 5 years and want to sell the property next year. The IRS says you can go all the way back to the beginning when you bought the property and take all the depreciation you did not claim and deduct it on your current tax return. No amended tax returns required. Just one form: Form 3115.
That means our example above would take the entire 5-year property as a depreciation expense currently; the full $180,000! Why does it matter if you are going to sell the property next year? Simple. Ordinary tax rates are higher than long-term capital gains rates. The top ordinary tax rate for individuals is 37%. (You could receive additional tax benefits from a lower Alternative Minimum Tax and avoiding/reducing Affordable Healthcare Act taxes.) The top LTCG rate is 20%. Get it. You deduct depreciation at 37% and pay tax later at about half that rate.
Who Should Consider Cost Segregation?
There are a few things to keep in mind with cost segregation. First, you need to have a tax liability for it to work properly. The higher your tax bracket, the better it works.
Rental property losses can be limited. Cost segregation increases depreciation deductions and could limit the value due to passive activity rules. The deduction is not lost, only suspended until you have a gain to offset the loss or you dispose of the property.
The best part of cost segregation is you can choose when to do it. All depreciation the cost segregation study reveals is deductible currently. This means you can plan when the deductions take place. If you have a higher income in a certain year you can conduct a cost segregation study that year and catchup all the depreciation on the current year as a change of accounting method. (See the video at the end of this post on how to handle a cost segregation study where back depreciation is claimed.)
Preparing a Tax Return with Cost Segregation
This is the easy part. When you buy a property you enter the building into the tax software for depreciation as either a 27.5-year or 39-year property, depending if it is commercial or residential rental. With a cost segregation study you do exactly the same thing, except you have three or four, instead of one, entry. The 27.5-year/39-year property amount is reduced and an entry is needed for the 5-year, 7-year and 15-year property. The computer does the rest. Simple.
If this is not the first year you owned the property a Form 3115 (Change of Accounting Method) is filed with the tax return claiming all the accumulated depreciation you should have taken. Go back into your software where you have your depreciating assets (usually a 4562 screen) and override the computer’s automatic depreciation calculation with the new higher amount. It is a one-year, one-time adjustment. Depreciation will pick up where you left off. Remember, you need to separate the 27.5/39-year property into 27.5/39-year, 15-year, 7-year and 5-year property. You may need a professional tax preparer for one year if you normally do your own tax work.
The entries are simple for most accountants to do. Form 3115 scares many people. Don’t let it. The form has more bark than bite. Watch the video below for a step-by-step review on how to file Form 3115 and make adjustments on the tax return.
How Do I Start?
You need to hire a firm that specializes in cost segregation studies. How do you do that? Well, there are a lot of firms taking shortcuts with their cost segregation studies and the IRS has noticed. These companies use estimates that should be reasonably close and then wait for the audit to come in to handle actual adjustments. Life is too short for those shortcuts.
I built a relationship with Equity Solutions for cost segregation studies. No shortcuts! We do it right the first time or we walk. Better still, they will handle the Form 3115 if your accountant is unfamiliar with the form. Many are.
Randy Leppla is your contact at Equity Solutions. Mention The Wealthy Accountant blog and receive a $100 or 5% discount, whichever is greater! Randy’s email is: email@example.com. His phone is: 608-852-6772.
Randy is located in Wisconsin, but they have offices over the entire U.S.
If you want, Randy can send me your information for review. There is no cost for an estimate of tax savings. You will be asked for your depreciation schedule and your tax bracket. If I review your account I will definitely need your tax return. I’m picky that way. My involvement is small if I am not preparing your tax return. I only need to verify you will reap the benefits anticipated.
Cost segregation is a powerful tool to reduce taxes. Contact Randy if you own property used for business or as a rental and the building has a cost basis (generally the purchase price) of $250,000 or more. Or comment below. I see comments faster than I see emails at times during tax season.
For more information you can read this post with step-by-step instructions on applying a cost segregation study to a tax return, including a filled-in Form 3115.
This video is partnered with the blog post link above: