Tax deferral is a key benefit of cost segregation; however, a popular misconception about cost segregation is it is just used for tax deferral, it does not reduce taxes. The tax deferral and tax reduction issue is misunderstood both by sophisticated real estate investors and tax professionals. The consequences of this incorrect information is unfortunate since numerous real estate investors forgo tax deductions, which would lead to material income tax deductions and tax deferral.
Cost segregation generates both income tax deferral and income tax reduction. Income tax deferral is effective since more depreciation is taken in the early years of real estate ownership. Income tax reduction is obtained since more income is taxed at the capital gains rate (15% maximum versus the ordinary income tax rate at 35%). The tax deferral delays the payment of taxes until a future date.
The mechanics of the tax deferral and tax reduction calculations are straight-forward but are not intuitive. Many accounting professionals believe the only benefit is tax deferral until they consider the mechanics or recognizing gain on sale. Tax deferral is not the only benfit to be realized.
The following example illustrates the mechanics of the recognition of gain on sale and the tax deferral and tax deduction benefits accruing from a cost segregation study.
John purchased apartment building five years ago. Cumulative depreciation during ownership was $600,000 based upon the results of a cost segregation study. Cumulative depreciation would have been $400,000 without the cost segregation study.
The cost segregation study identifies five, seven, and 15-year property in addition to 39-year property and land. John’s tax preparer discusses the condition of the five, seven, and 15-year property at the time of the sales. They agree the value of the short life property (five, seven, and 15-year) is the same as its depreciated cost basis. Hence, the tax rate for the additional $200,000 of depreciation is the capital gains rate.
During each year of ownership, John received an additional $40,000 of depreciation as a result of the cost segregation study. This additional depreciation reduced his federal income taxes by $14,000 per year ($40,000 X 35%) and by $70,000 over five years. Upon selling the property, the capital gains tax is increased by $30,000 ($200,000 X 15%). The net tax saving are $40,000 ($70,000 – $30,000).
Cost segregation provides both tax reduction and tax deferral.
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.
New York, NY
San Francisco, CA
Los Angeles, CA
New Orleans, LA
Santa Rosa, CA
Little Rock, AR
Palm Bay, FL
Baton Rouge, LA
San Jose, CA
Cost segregation produces tax deductions for virtually all property types.
Strip shopping center
Used car lot
Almost every industry, including the following, can generate cost-efficient tax deductions by using cost segregation.
Warehousing and storage
Nondurable good wholesalers
Electronic and appliance stores
Fabricated metal products
Electrical component manufacturing
Textile product mills
Automotive parts distributors
O’Connor & Associates is a national provider of commercial real estate consulting services including cost segregation, due diligence, renovation upgrading cost analyses,income taxes, tax return review and apartment inspections.