Archive for Cost Segregation

You Can Deduct Rental Losses by Qualifying as a Real Estate Professional

Do you manage rental properties on the side? Even if real estate is not your primary profession, you can benefit from tax advantages by qualifying as a real estate professional. Rest assured, your primary employment does not necessarily inhibit your ability to qualify; however, qualification does depend upon how many hours you put into property management versus other employment. You can even gain the same advantages if your spouse qualifies as a real estate professional (if you file taxes jointly).

What Are the Benefits?

Once you are classified as a real estate professional, you are eligible for passive loss tax deductions. These require the government (as your partner) to pay their portion of the taxes. When you have the proper tax advisor helping you to plan accordingly, you have a good chance of getting your IRS partner to provide their portion earlier. This means you’ll have more money free to invest and build your profits with.

As a qualified real estate professional, you can deduct your rental properties’ passive losses immediately, regardless of each property’s income level. If you do not qualify, you may not be able to deduct rental property losses until after the property is sold (unless your joint income is less than $150,000).

How to Qualify as a Real Estate Professional

Qualification depends on your rental property management spending for the course of the year[1]. You or your spouse will qualify if you:

  • Spend greater than 50 percent of your personal service work time participating in real property businesses that you materially take part in or in real property trades; or,
  • Spend greater than 750 hours of your investment analysis and personal service work time participating in real property businesses that you materially take part in or in real property trades.

Here’s an example. Let’s say you work 926 personal service hours throughout the year managing your properties and 920 hours on your W-2 job running your law firm (not including sick days, holidays, or vacations). In this scenario, you would pass both requirements to qualify as a real estate professional. That means you if you materially take part in your rental properties, you may deduct their losses. Just keep in mind that time spent on investment analysis counts toward the hours requirement but not the greater than 50 percent requirement[2]. Also, one spouse must completely meet the requirements. You and your spouse cannot combine your hours together. However, tax law deems that if one spouse qualifies, then both are considered real estate professionals for tax purposes[3].

What Exactly Is “Real Property Businesses or Trades”?

You may have noticed that the requirements hinge on your time spent in real property businesses or real property trades[4]. The terms apply not only to rental properties. In fact, any of the following count toward your service hours:

  • Rental
  • Leasing
  • Conversion
  • Management
  • Operation
  • Brokerage trade or business (including real estate agents)
  • Construction
  • Development
  • Reconstruction
  • Redevelopment
  • Acquisition

Please note: Any work performed as an employee does not count towards the service hours requirement. The exception to this is if you, as an employee, are a five percent owner in the business[5] (i.e., you own more than five percent of your employer’s capital or profits interest, outstanding stock, or outstanding voting stock.

How Do You Prove It?

Now you know what the requirements are, but the IRS obviously requires proof on your part. They will not simply take your word for it that you spent X number of hours working on your business and trades. Fortunately, the IRS has an audit guide for rental properties that lists two proofs an examiner will check for[6]:

  1. You must log the hours spent and services performed during those hours, and provide this documentation when requested. The requirement to track your service hours is discussed in Reg. Section 1.469-5T(f)(4). Acceptable forms of evidence[7] include identification of provided services and approximate hours spent based on narrative summaries, calendars, or appointment books. Just find a way that works for you to track your time and stick to it.
  2. You must provide documentation detailing the amount of time logged in other activities. This allows the examiner to see whether the claimed hours make sense.

To sum things up, you can increase your legal share of government subsidies pertaining to your rental properties. One way is for your total income to be below the threshold. In that case, you can deduct losses up to $25,000. Otherwise, you must qualify as a real estate professional.

  1. IRC Section 469(c)(7)(B).
  2. Reg. Section 1.469-9(b)(4).
  3. IRC Section 469(c)(7)(B)(ii).
  4. IRC Section 469(c)(7)(C).
  5. IRC Section 469(c)(7)(D)(ii).
  6. IRS Passive Activity Loss Audit Technique Guide (ATG), Training 3149-115 (02-2005), pp. 2-5, 2-6.
  7. Ibid., p. 4-7.

Use Cost Segregation to Raise Your Net Worth

Tax planning tips often have two priorities—defer your income and accelerate deductions. Would you like to know an easy way to do the second one? You can make a huge difference in depreciation deductions by using a strategy called cost segregation.

What Cost Segregation Means

Cost segregation allows you to separate a building you own into two components, land improvement and personal property. This lets you to realize deductions on the building more quickly. Cost segregation, essentially, speeds up the depreciation of your deductions. Faster depreciation means more money in your pocket now.

How does it work? Let’s assume you have several buildings depreciating on a 39-year plan. By segregating the costs, perhaps 30% of each of those properties could be depreciated in only 5 years, instead. You can implement a plan like this regardless of when you purchased the building. It could be a place you have already owned for years, a renovation you are undertaking, or even a new property you plan to purchase.

Here’s a break-down of how a property’s costs may be segregated:

  • 20% spent on equipment
  • 20% spent on land improvements
  • 60% spent on the building

You could just lump all the costs together and slowly watch 100% of your investment depreciate over a period of up to 39 years. Or, you could separate the costs out and see 20% depreciated in 5 years and another 20% in 15 years. By depreciating the components separately, you raise your net worth! Getting this time advantage makes a huge cash difference for you.

Why Timing is Important

What do all those numbers mean to you? If you have a property that cost you $1 million, tax law allows you to depreciate the equipment, land improvements, and building all the way to zero. So, your property has the potential to produce $1 million in depreciation. That means deductions for you on your tax return. By using cost segregation, you can use those deductions sooner, giving you an edge on tax benefits. Those tax benefits mean more cash available to you now for investing to your advantage.

You may be asking yourself if it can really make that much of a difference. Consider this example: you 1) earn 6% on your investments after taxes, 2) are in the 50% tax bracket, and 3) have $2 million to depreciate. You can use modified accelerated cost recovery system (MACRS) to depreciate it over 5 years, or you can depreciate it on a straight-line schedule of 39 years. Given those circumstances, in today’s dollars you would have:

  • $852,624 investment earnings from using MACRS depreciation
  • $382,427 investment earnings from using the straight-line depreciation

As you can see, that’s a huge difference!

How to Make Cost Segregation Work for You

The cost segregation strategy may not be right for every property owner every year. Here are a few tips for knowing when it will pay off:

  • When passive loss rules aren’t limiting your real-estate deductions, and you are able to benefit from the advantages of a quicker deduction (cost segregation generates a bigger loss on your tax return, which does you no good if your losses are limited);
  • When you are in a position to benefit from the value over time, that is, you intend to keep the building or continue renting it out for the long-term; and
  • When you will pay less for a cost segregation study than what the actual cash benefits will be.

Let’s put it into real numbers for you. You have, for example, a modified adjusted gross income of $200,000 and are subject to passive loss rules. If you have a $35,000 net loss on your rental properties but no passive income, then the $35,000 is a passive loss. It’s not deductible this year, and you will have to carry it forward to next year to see if you can offset it with passive income then.

Qualifying to deduct passive losses is the number one piece to the puzzle of cost segregation. No current deduction available for your losses means no time benefit to the value of your money. Additionally, the longer the amount of time you keep the building, the greater than financial benefit to you when using cost segregation. You may even be able to apply a 1031 exchange both to defer taxes and take your cost segregation benefits from one building to another, giving you some flexibility in the amount of time you hold onto a property. You’ve got plenty to gain, including:

  • Quicker depreciation
  • Section 179 expensing of personal assets that qualify
  • Reduced transfer taxes (because you separated the costs of personal property and real property)
  • Possible reduced property taxes
  • Asset replacement identification (to write off an undepreciated item)
  • A write-off for the cost segregation study fee[1]
  • Look-back depreciation if you use cost segregation on a building you already own and have not segregated before[2] (Make sure you time this right; the IRS allows one automatically approved accounting method change every 5 years, so you would benefit from completing all cost segregations at one time.[3])
  • Owe no user fee to the IRS[4] (most accounting method changes require payment of $2,700)
  • A one-time chance to make a large adjustment by claiming all of the previous years’ depreciation in a lump sum (IRS Form 3115)
  • The opportunity to increase your benefit from a property inheritance

Just be aware that every financial action carries risk. Personal property’s depreciation recapture tax can be higher than that of real property. You could be looking at up to 10 percent higher tax rates when you sell the property (depending upon your income level), so be sure to consider that when making your decision. Hint: As always, watch out for the alternative minimum tax (AMT). For personal property, you can use a 150 percent declining balance depreciation instead of the AMT’s preferred 200 percent declining balance.

As long as you meet these guidelines, cost segregation can be a terrific option for raising your net worth. You will need to hire professionals to perform the study (typically CPA’s and engineers), so check with your tax advisor about whether this option is a good fit before moving forward. If it looks like you will benefit, you can look for a team to perform the study at The American Society of Cost Segregation Professionals . The cost segregation professionals will take care of all the documentation you need for proving your segregation to the IRS.

  1. See “Cost Segregation Applied,” by Jay A Soled, JD, and Charles E. Falk, CPA, JD,Journal of Accountancy, August 2004. You can write off this cost as a 162 expense.
  2. Reg. Section 1.446-1T(e)(5)(iii).
  3. Revenue Procedure 2006-12
  4. Revenue Procedure 2012-39