Get a $100,000 Gift from the IRS Using Cost Segregation

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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. No jail required.

This program applies to investment properties and businesses with a building. All other 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 additions) 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 but a property for $450,000. Land value usually comes in 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 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 property, 20-25% as 7-year property, and the remainder as either 27.5- or 39-year property.

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.)

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. No amended tax returns required. Just one form.

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 39.6%. (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 39.6% 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 in some cases. 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.

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, instead of one, entry. The 27.5-year/39-year property amount is reduced and an entry is needed for the 5-year and 7-year property. The computer does the rest. Simple.

If this is not the first year for the property a Form 3115 (Change of Accounting Method) is filed with the tax return and with the Washington D.C IRS office 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 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, 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. I have a solution if you want the whole thing done for you for the one year the adjustments are made. A small investment can pay large dividends. Then you can go back to what you always did preparing your 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 that BS.

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: randy@rjl-equitysolutions.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 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.



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Keith Schroeder

10 Comments

  1. John McCarthy on March 3, 2017 at 2:09 pm

    Timely article. I have a new client this season with a bunch of real estate (commercial and residential). He has had some cost seg done but has one property where he wanted to evaluate.

    • Keith Schroeder on March 3, 2017 at 3:01 pm

      Your client should be happy, John, with the cost seg study as long as he has a tax liability. I kept plenty out of the post so people would not get confused. No talk of components and such. For accountants it is generally straight forward. The 3115 throws some of them. Seems like Google is sending people here searching for a sample filled-in Form 3115. If I find the energy during tax season I may put one together and add it to the post.

      • John McCarthy on March 3, 2017 at 8:11 pm

        I found a pretty good sample at the Tax Book website for a 3115. I had another client that missed $40,000 in tax depreciation over the years. Fun times!

        • Keith Schroeder on March 4, 2017 at 8:31 am

          Great point, John. For readers, you MUST take depreciation on your property or assets. Tax law reads “allowed or allowable” which means if you did not take depreciation you act like you did when you sell and are double taxed. Form 3115 allows you to fix this problem all on the current year even if years involved are out of stat. Form 3115 is filled out in a similar way to cost seg studies when the property has been owned before the current year filed. The point is, if you have a cost seg study done or missed past depreciation, you need a tax pro. In my office I am pretty much to extensions for new clients. Are you taking new clients, John? If so, readers around here might want to give you a try.

          • John McCarthy on March 4, 2017 at 9:41 am

            Keith, I think I am nearing my max for the year. I had much more growth than I expected, about 100 new clients in all. March is going to be BUSY! But in a good way. 🙂



          • mary on April 29, 2017 at 3:42 am

            The “allowed or allowable” bugaboo was resolved many moons ago. This is from Diane Kennedy:

            “Allowed or Allowable Depreciation

            “Before we move on to the rest of the depreciation strategies, I want to address a lingering myth about depreciation.

            “The IRS code actually says that when you sell your property, you must recapture depreciation that is allowed or allowable. That one phrase “allowed or allowable” created all kinds of heartburn for CPAs for years. The reading of the code made it seem that if you didn’t take a depreciation deduction, then the IRS was going to force you to recapture depreciation you could have taken, even if you didn’t.

            “The IRS set that all straight in 2004, over 10 years ago.

            “The IRS issued Rev. Proc. 2004-11 which permits a taxpayer to make this change even after the disposition of the depreciable property.

            “Revenue Procedure 2004-11 allows a taxpayer to change the taxpayer’s method of determining depreciation for a depreciable or amortizable asset after its disposition if the taxpayer did not take into account any depreciation allowance, or did take into account some depreciation but less than the depreciation allowable, for the asset in computing taxable income in the year of disposition or in prior taxable years. Because the taxpayer is permitted to claim the allowable depreciation not taken into account for this asset, the taxpayer’s lifetime income is not permanently affected by the “allowed or allowable” rule.

            “In other words, Rev. Proc. 2004-11 allows the taxpayer to deduct the unclaimed depreciation even after disposition. With this, the IRS effectively did away with the “allowable” depreciation rule. As a result, a taxpayer who has claimed less than the depreciation allowable for its property will no longer risk permanently losing an allowable depreciation deduction.

            “Bottom line, if anyone tells you that you must take a depreciation deduction because of an allowed or allowable depreciation rule, just tell them they are over 10 years late to the party.”



  2. Andy on May 17, 2017 at 8:42 pm

    I have two office buildings that are both above the 250k threshold. One was purchased for 498k and one for 350k. I’ve owned since 2014. If we completed the cost segregation studies would I then need to amend my previous couple years tax returns to maximize the benefit? Would the benefit be treated at the tax bracket for the year being amended (39%) or for the year that the study was done (who knows what the rate will be in 2017). Just curious what kind of benefit I would realize right away from the studies. Thanks for any insight you can give .

    • Keith Schroeder on May 17, 2017 at 9:23 pm

      Andy, you file Form 3115, Change of Accounting Method, to claim all the past depreciation currently. Form 3115 is a long discussion so I recommend a qualified accountant for the one year you have to file the form.

      In your case it might be easier to amend the prior tax returns. The deduction value is determined by your tax bracket (and other facts and circumstances) the year it is on. Form 3115 is on the current year and the amends are on the respective returns amended.

  3. Trey on October 2, 2017 at 9:45 am

    I have a question regarding the tax rate benefit on sale. I understand that depreciation is deducted at ordinary rates and there will be cap gain on the sale but won’t some of that gain be classified as depreciation recapture (which is recognized at ordinary rates)? I know you can play with the purchase price allocation (allocate more of the value to land, etc) to hopefully avoid recapture but is there something I’m missing?

    • Keith Schroeder on October 2, 2017 at 10:25 am

      I think you are referring to non-recaptured Section 1231 losses. A non-recaptured Section 1231 loss carryover can offset some (but not all) of the current year 1231 gains. The carryover first offsets the 1231 gain subject to the 25% rate and then is taxed at LTCG rates.

      Section 1231 gains are recaptured and treated as ordinary income to the extent you have unrecaptured losses. Non-recaptured losses are net 1231 losses deducted in the last five years before the current year. You then subtract 1231 losses from the same period to determine your amount to recapture.

      A simpler way (if not always the most accurate) is to say depreciation above straight line is recaptured in the first five years and taxed at 25%. (Remember, I said this isn’t 100% accurate, but it illustrates the point nicely to laymen who read this blog.)

      Then there is Section 179 and 280F recapture which I will not even start to discuss in a comment (even though my shortened version includes a bit of 280F and Section 1250 in it).

      A deeper discussion on depreciation recapture in longer than a single post can handle when said post already is dealing with another issue. There is an arbitrage opportunity many times with cost seg studies. However, the nasty five year rule lifts its head more than once. Improvements within five years of purchase are generally considered improvements rather than repairs.This means a new roof is depreciated versus deducted.

      At some point in the future I will write a series of posts on the multiple issues surrounding recapture and the difference between improvements and repairs as they relate to the tangible property rules. These types of posts are only appreciated by tax professionals so I tend to skirt the issue knowing tax pros know I what I mean (there is more to the tax story). My goal is to introduce something most people are unaware of that has massive tax benefits. Hope it isn’t too distracting, Trey.

      A short post will have plenty of holes when dealing with a complex tax issue. It’s the risks of the trade.

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