Taxes are a levy imposed upon people or legal entities by a governmental entity. There are many forms of taxes including income taxes, property taxes, capital gains taxes, consumption taxes, excise taxes, retirement taxes, sales taxes, tariffs, toll taxes, and transfer taxes. This article focuses on reducing income taxes for real estate owners.
Income taxes often seemed unavoidable. However, real estate investors have multiple opportunities to defer and reduce federal income taxes. Real estate owners receive income tax breaks not available to investors for many other asset classes. These include depreciation, income tax rate reduction, and the like-kind exchange. This article discusses how real estate owners can reduce income taxes by increasing the level of depreciation, using tax-deferred changes, casualty losses, maximizing expenses, and planning to minimize estate taxes.
Depreciation is a non-cash expense that can both defer and reduce the level of federal income taxes. In some cases, depreciation actually eliminates federal income taxes. When an owner claims depreciation and does not sell the property before it passes into his estate, the income deferred by the depreciation is never taxed.
Most real estate owners know depreciation defers federal income taxes. Few know real estate depreciation also reduces federal income taxes. The common perception is that depreciation simply shifts the payment of income taxes from when income is earned until the property is sold. However, depreciation often changes the character of income from ordinary income to capital gains income.
Consider the following example: George purchased an apartment complex in 2005. After obtaining a cost segregation study, approximately 20% of the cost basis of the improvements was allocated to 15-year property, such as landscaping, paving, sidewalks, parking lot striping, and exterior signs. If George sells the property in five years, one-third of the cost basis of the 15-year property will have depreciated. Isn’t it also reasonable the market value of this property will be one-third less than when the property was purchased?
More often than not, tax preparers believe the market value of the short-life property is similar to the remaining basis when the property is sold. This means there is no gain upon sale. Hence, additional depreciation was taken for short-life property (which could be used to reduce income taxable as ordinary income rates) while George owned the property. At the time of sale, the portion of the gain equal to the short-life depreciation is taxed at the capital gains rate. This is how cost segregation reduces federal income taxes. Hence, federal income taxes are both deferred from the time income is earned until a sale occurs and the tax rate is reduced from the ordinary income tax rates to the capital gains rate.
Cost segregation can lead to meaningful deferral of federal income taxes. However, its most significant power is its ability to convert income taxed at the ordinary income rates to income taxed at the capital gains rate.