Archive for Depreciation

Increase Your Tax Deductions—Switching from the IRS Mileage Rate to Actual Expenses

Do you feel like you’re not getting as much as you should from your business vehicle mileage deductions? For some business owners, gas and maintenance for a vehicle can be significant business expenses. If you’re not already using the actual expense method to calculate your mileage deduction, that may be your ticket to getting more from your vehicle expenses.

Usually, you’ll make a decision once regarding whether to use the IRS mileage rate for your deductions or to use the actual-expense method. If you choose the IRS mileage rate, you also lose out on MACRS depreciation.[1] However, you’re not locked into your choice forever. You have two different options for switching to claiming actual expenses.

Option 1: Amending Your Tax Return

If you realize fairly quickly that you’ve made the wrong decision in choosing to use the IRS mileage rate, you can act quickly and change your decision. That means you’ll have to file an amendment to your tax return before its original due date (if you filed extensions, the deadline includes the extensions).[2]

This option is fairly easy to enact. You’ll file the amendment, electing actual mileage expenses, Section 179 deductions, and MACRS depreciation. But, you have to act fast. This method essentially replaces the election on your original tax return.

Option 2: Straight-Line Depreciation

If you’ve already missed out on your chance to amend your return, you do have other options. You could still switch to the actual-expense method with MACRS depreciation, but you’ll have to get permission from the IRS commissioner . . . if you enjoy wasting time and money with the possibility of rejection.[3] Let’s be smart here; the commissioner is not a good option.

Instead, you can opt for straight-line depreciation for the remainder of your vehicle’s useful life.[4] This allows you to make the actual expense deductions. For calculating the straight-line depreciation, you’ll need the following information on your vehicle:[5]

  • Its Adjusted BasisThis is typically the original cost of the vehicle minus depreciation. When you use the IRS mileage rate, depreciation is included in it (22 cents per mile in 2014 and 24 cents per mile in 2015).[6] If you pay $30,000 for your car and drive it 5,000 miles for business (with no personal miles), you would calculate your depreciation at 5,000 miles x $0.22, which equals $1,100. Your adjusted basis is $28,900 ($30,000 – $1,100).
  • Its Estimated Remaining Useful LifeYou don’t need to think too hard about this. It’s simply how long you expect to keep the vehicle.[7] We’ll call it 5 years for our example.
  • An Estimate of Its Salvage Value when the Useful Life EndsTo get a salvage value, you should use a respected pricing source, such as Kelly Blue Book. In our example, the value is what you estimate you could sell the vehicle for in 5 years (the remaining useful life). Let’s say this number is $4,000. Don’t forget to document where you get this number from!

Now, when you switch to actual mileage expenses, the IRS gives you a bonus on the salvage value if you plan to keep the vehicle for more than three years. Our example vehicle meets that requirement, which means you can reduce the salvage value by $3,000 (10 percent of the basis). If 10 percent of the basis exceeds the salvage value, that’s no problem. You’ll simply claim a salvage value of zero.

An Additional Consideration

When claiming actual expenses, you’ll have to pay attention to the luxury vehicle depreciation limits. These apply to passenger vehicles, and the limits differ between cars, vans, and trucks. You’ll need to find the amounts for the year you placed your vehicle in service.

For 2014 the limits for cars placed in service that year are:

The limits for vans and trucks are:

Note: These are amounts for used vehicles only. If your leased or purchased a new vehicle, use the tables in Rev. Proc. 2014-21 . Regardless of the type of vehicle or whether it is new or used, you must reduce the limit by your personal use. So, if you use your car for 80 percent business and 20 percent personal purposes, your first year limit is $2,528. If these limits affect your depreciation, you can simply claim the rest of the depreciation in a later year—you do not lose it.

Some vehicles are exempt from the luxury limits. Your truck, van, crossover, or SUV may be exempt if it 1) is classified as a truck by the Department of Transportation, and 2) has a gross vehicle weight rating over 6,000 pounds. Note that some passenger trucks are not classified as a “truck” by this definition.

If you don’t like the choice you made for your mileage deductions, you can fix it. If you catch it early, you’ll still get all the additional benefits that come with the actual-expense method (Section 179 expensing and bonus depreciation). However, if you make the switch later, you can still get some benefit from actual expense deductions with straight-line depreciation. What you need to know is that the choice to switch is available to you.

  1. Rev. Proc. 2010-51; IRC Section 168(f)(1)
  2. Reg. Section 301.9100-2(d)
  3. Rev. Proc. 2011-14, Appendix 6.02
  4. Rev. Proc. 2010-51
  5. IRS Pub. 534, Depreciating Property Placed in Service Before 1987, (Rev. Nov. 1995), p. 7
  6. Notice 2014-79;,-Medical-and-Moving-Announced
  7. IRS Pub. 534, Depreciating Property Placed in Service Before 1987, (Rev. Nov. 1995), p. 7

Why You May Want to Consider Antiques as Business Assets

It’s already well-known that antiques can make a wonderful personal asset for collectors. If you know how to choose the right pieces, you can see a nice return on investment from quality antiques. But, have you ever thought of doing the same with your business? Let’s put it this way, if you could choose between two desks for your office, both for the same price, do you go with the regular desk or the antique?

In many cases, the antique could be a better choice. Thanks to newer tax laws, antiques are now assets under Section 179, just like any other standard business equipment. That means you’ll get the same business tax deductions regardless of which desk you choose. So, why opt for the antique? For the same reason you might buy an antique for a personal collection. A regular desk will likely depreciate over the years, but the antique is a money-maker, likely to increase in value. The final difference could be thousands of extra dollars for your business.

Antiques as Smart Choices

Let’s put together an example so you can see just how the numbers work. Both desks cost $5,000 to purchase. In 10 years, the antique desk would be worth $15,000 and the regular desk would be worth $500. For the sake of this example, we’ll say you’re in the 35% income tax bracket and 15% capital gain bracket when you sell the piece of furniture. Here’s what your federal taxes would be on the antique:

  • 15% of the $10,000 in capital gain equals $1,500
  • 35% of the $5,000 in depreciation recapture equals $1,750

That means you’ll keep $11,750 after taxes from the sale of your antique desk. Compare that to only $325 from the sale of the regular desk ($500 from the sale minus 35% in recapture taxes). You can see how choosing antiques for multiple items in your office can quickly increase your business’s gains!

What kind of items could be purchased as antiques?

  • Conference tables
  • Desks
  • Rugs
  • Business car
  • Cabinets
  • Clocks
  • Paperweights
  • Bookcases
  • Coatracks
  • Umbrella stands
  • Chairs

Think of the possibilities! Any antique that functions just as well as a new purchase is a great investment. It could increase in value, and thus increase your net worth. Just don’t try to buy an antique computer!

Many business owners don’t even consider antiques when purchasing equipment. But, why not? When you choose antiques, you usually get a quality piece of furniture that looks beautiful in your office. They still count as depreciable Section 179 assets. And, they could increase in value. Even if a particular antique choice doesn’t increase its value significantly, you’ve lost nothing (as long as you pay reasonable prices).

Cases Regarding Antiques as Business Assets

Several previous court cases have held up the ability to count antiques as business assets. In particular, Liddle[1] and Simon[2] allowed these two professional musicians to depreciate antique and collector violins as business assets. These musicians used the violins in their role with the Philadelphia Orchestra.

The instruments involved in the case were already 300 years old when purchased. They were bought for $30,000 and had increased in value to $60,000 in less than 10 years when the musicians had depreciated them to zero. Regarding this case, the court noted that the Economic Recovery Tax Act of 1981 (ERTA) had changed the rules for depreciation. Prior to ERTA, antiques could not be depreciated in a business, no matter how often they were used for business purposes.

The cases went through the Tax Court, the Second Circuit Court of Appeals, and the Third Circuit Court of Appeals. Thanks to the decisions made in these courts, the musicians (and you) may now depreciate antiques and count them as a Section 179 expense. ERTA set the path for this by changing the useful-life rules to statutory depreciation periods. So, what does all this mean for you? It means you qualify for tax-favored expensing and depreciation when:

  • During the normal course of business, you actually use the antiques (they are not decorative).
  • The antiques are subject to the same wear and tear that any other business asset would be.

Interestingly, the IRS did not agree with the decisions of the courts in the cases of Liddle and Simon. In 1996, they formally issued a non-acquiescence and stated that in the seven other circuits they would go after taxpayers who tried to depreciated antiques.[3] However, to date they have never done this.

The circuit for the above cases covers the areas of Vermont, Connecticut, New York, New Jersey, Pennsylvania, Delaware, and the Virgin Islands. This means that if you work in one of those areas, the IRS cannot attack your antique depreciation because the courts have already made their decisions regarding that circuit.

Further, it is unlikely that the IRS will actually go after you for business antique depreciation no matter where you live. That’s because courts can order the IRS to pay attorney’s fees for bringing a case that is “not substantially justified.” Per IRS Publication 556, that means:[4]

  • The IRS didn’t follow its own published guidance, such as announcements, private letter rulings, revenue rulings, and regulations.
  • The IRS has taken on substantially similar cases in another circuit’s courts of appeal and lost.

Therefore, even if you live outside the Second and Third Circuits, you are unlikely to be hassled by the IRS about depreciation of antiques. Bringing a similar case in other circuits could obligate the IRS to pay attorney fees, and the IRS has not tried since the time of these cases.

When Preparing Your Taxes

Just remember to follow certain rules established during Liddle and Simon. Artwork does not count as a depreciable business asset, as found in the Noyce case.[5] Any antique furniture or equipment you plan to depreciate on your taxes must be physically used as a part of your business and subjected to the wear and tear of ordinary office equipment.

It turns out you actually get a better deal on taxes than the antique dealer who sells you the piece. A dealer gets to deduct the antique’s cost as a cost of sale, but he pays both self-employment taxes and regular income taxes on the profit. A business owner, on the other hand, deducts the cost at the time of purchase with Section 179 expensing rather than having to wait for the sale. Also, because the item is counted as a business asset, when you do sell it the amount of profit that exceeds the purchase price is a Section 1231 gain, which is a tax-favored capital gain as long as you used the antique in your business for more than one year (assuming you have no offset from Section 1231 losses).

All of this sounds pretty good so far, right? Well, here’s some even better news. If you’re kicking yourself for having antiques that you have not deducted in your business because you weren’t aware of the rules, you can claim those benefits on this year’s tax return. You just claim the depreciation retroactively with a Form 3115.

For business antiques you buy this year, you can expense up to $125,000 of qualifying purchases. You get immediate deductions for this. Down the road, when you sell the items, you’ll get tax-favored capital gains benefits on the amount of appreciation. All in all, you come out way ahead, even with the price of recapture taxes on the depreciation. After all, a regular piece of office equipment is worth much less when you’re ready to sell it. It’s clear that antiques are a good financial choice when you need to select furniture or equipment for practical use in your business.

  1. Brian P. Liddle v Commr., No. 94 7733, 76 AFTR2d &95 5327, 3d Cir, September 8, 1995, aff’g 103 T.C. 285, 94 TNT 165 8 (1994).
  2. Richard L. Simon v Commr., No. 94 4237; 76 AFTR2d &95 5496; 95 2, 2nd Cir., October 13, 1995, aff’g 103 T.C. 247, 94 TNT 165 7(1994).
  3. AOD 1996 009, July 15, 1996.
  4. IRS Pub. 556, Examination of Returns, Appeal Rights, and Claims for Refund (Rev. August 2005), p. 10.
  5. Noyce v Commr, 97 T.C. 689.

Did You Know Your Car Can Accelerate Your Tax Savings?

Would you like thousands, or even tens of thousands, more dollars in tax deductions every year? Of course you would! To boost your deductions, you can count on your vehicle to be a deduction generator if you use it to drive from one business location to another. The only thing you have to do is keep the right records in order to prove your business mileage. Your tax records, like your car, require regular maintenance in order to function properly.

The Documentation You Need

We can look at the court case of salesman, Marcus Crawford, for an example of what a difference minor deviances in documentation can make.[1] Crawford spent much of the work day driving to meet customers. He tried to defend is vehicle deductions in an amount greater than $20,000 by providing 1) destination notes on his daily calendar, and 2) saved gas receipts. Although this sounds like decent record keeping, the IRS rejected this documentation and Crawford got none of the deductions. Zero.

Unfortunately for Mr. Crawford, the IRS is pretty strict about documentation for vehicle deductions. Here’s what you actually need in order to qualify:[2]

  1. A mileage log
  2. Receipts that support your mileage log

Crawford’s proof didn’t work because it failed to document the true number of miles spent driving to each location and how the location was related to his business activities. A proper log divides mileage into the appropriate categories:

  • Personal mileage
  • Commuting mileage
  • Business mileage
  • Investment mileage
  • Rental property business mileage

Here’s a hypothetical example:

Note that rental property mileage should be calculated separately from other business mileage. This is so you can determine Section 179 expensing for your vehicle. Additionally, you see that the miles marked for the trip to the grocery store are zero. Why? It’s because the stop was located on the way between two other stops, so it does not generate any additional mileage.[3] Although the grocery trip is a personal stop, you would have had to drive the same distance from one office to the other whether you stopped for groceries or not.

In some cases, it may be more convenient to group the mileage together for multiple stops. This is perfectly fine as long as you document it that way. For example, a real estate professional may make a note indicating multiple stops to show the same client six different properties. These six stops can go together on one line of your mileage log.

Simplifying Your Record-Keeping by Sampling

Writing down every single stop you make every day for the entire year sounds fun, right? Not so much. If tracking your mileage is starting to sound like too much work to even be worth it, keep reading. Per the IRS, you are allowed to track your mileage for only part of the year, and then use that sample to calculate your total business mileage for the rest of the year. You have two options:[4]

  1. Keep a mileage log one week out of every month, or
  2. Keep a mileage log for three consecutive months.

By using the second option, you can log your mileage for one three-month period and then forget about it for the rest of the year. This is the better way to go because the one week a month method increases your risk of missing a month, and when that happens, the IRS no longer accepts your records. It does not accept “almost” with mileage logs.

There is one little catch. If you use the three consecutive months method, those months must be representative of your driving habits for the entire year. For those of you who work in a business with noticeable seasonal fluctuations in your business mileage, you’d better stick to the one week a month strategy.

Supporting Your Log

Okay, so you’ve logged your mileage and labeled its category for either three consecutive months, or one week out of each month for the year. You’re all set, right? Not so fast. The IRS isn’t so trusting that it will just accept the records you’ve individually recorded. So, you’ll have to back up your mileage sheets with evidence from other sources that match your records.

Some documents the IRS may request during an audit include:[5]

  • Inspection slips, repair receipts, and any other records that record your vehicle’s total mileage
  • A copy of your calendar or appointment book that indicates your business activities for the year
  • A copy of your mileage log

Each of these proofs will be cross-referenced with each other to ensure that everything matches up. That means if your gas receipt shows you were in Henderson, NV on a day your mileage log shows you staying in Riverside, CA, you’ve set off a red flag that may cancel your deductions.

What If You Don’t Keep Paper Records

Certainly many business people are switching over to digital record keeping. If you prefer to track mileage on an app, that’s no problem. However, it may be a good idea to keep paper print-outs as backup until you’re certain the app’s records meet the requirements of the IRS. Always keep some kind of backup of your digital records. You never know when a glitch, virus, or hacker may delete all your records, or render your app inactive.

Tracking your vehicle mileage isn’t too difficult once you set up a system for yourself. Remember, you only have to do it for part of the year. The IRS mileage rate for deductions is $0.56 per mile, so with the right documentation, you can claim thousands in deductions just by going about your normal work routine.

  1. Marcus O. Crawford, TC Memo 2014-156.
  2. IRS Publication 463, Travel, Entertainment, Gift, and Car Expenses (2013), Dated Jan. 14, 2014, p. 25-27.
  3. Reg. Section 1.274-5T(c)(6)(i)(C).
  4. Reg. Section 1.274-5T(c)(3)(ii)(A).
  5. Internal Revenue Manual Exhibit 4.13.7-20 — Examination Documentation Requirements Paragraphs – Cont. 6 [09-01-2006].

Make Your Records Rock Solid to Avoid Audit

This article isn’t about any particular way to save money on your taxes. However, it will make a huge difference in your taxes no matter what strategy you use for your tax return. Even the absolute best tax methods can leave you at the mercy of an auditor when you don’t properly document and keep records. Sure, you may think it’s a hassle, but is putting in a few hours up-front on an organized record-keeping system worth thousands, even tens of thousands, of dollars in tax savings? You bet!

The Rules of Record Keeping

Here’s the fact—the IRS is never just going to take your word for it that you spent X number of dollars on justifiable and legal business expenses that are now tax-deductible on your return. Sorry, no documentation, no deduction.

So, with that in mind, here’s the first rule you need to know.

Rule #1 Always keep your accounts separate. In fact, you should have separate checking accounts for:

  • Each spouse,
  • Each corporation,
  • Each Schedule C business you report, and
  • Your rental properties (you may even want a few separate accounts for these if they are very different kinds of rentals).

How about an example of why this is so important. Let’s say you own a sole proprietorship, and you cover your spouse under a Section 105 medical reimbursement plan. If you’re using one checking account jointly for your household and your business, you would have to write the reimbursement check to yourself—and that negates your Section 105 plan.

That’s exactly how Darwin Albers lost out on deductions for his 105 plan.[1] Keep your business and personal accounts separate—just do it.

Rule #2 Earnings go to the account belonging to the business that earns the money. Do not take payments in your personal name. If you do, they cannot be assigned to your corporation. The person or entity that earns any given income is taxed for said income.[2] If you follow the rule above, then it’s easy not to mix personal receipts into your business account and vice versa. Although it’s possible to argue with the IRS that some receipts in a given account are not taxable, it’s not worth the frustration and wasted time.

Rule #3 Keep track of your deductible expenses each day. Don’t wait until two weeks from the purchase to write down your expenses (or save them in your file). For one thing, it increases the chance that you may miss something. For another, the IRS requires that deductible expenses are recorded within one week. The idea of doing daily record keeping may make you want to just toss your files over your shoulder (don’t—you’ll hate reorganizing them up later), but it really is good practice. After all, how hard is it to save a receipt and make a note about why you spent the amount?

Rule #4 Keep a log for each set of expenses. For most deductions, you need evidence that proves your business use or business purpose for the expense. Want to deduct vehicle expenses? Keep a log to track daily mileage. Want to deductions on your rental properties? You’d better keep track of how you materially participate in your real estate or how you qualify for status as a real estate professional. Planning to make deductions for your home office? Again, you need a log, this time to keep track of how many hours you spend working in that office. You’ll have to consistently spend more than 10 hours per week working from your home office in order to claim it on your tax return.[3] By keeping track on a daily basis, you can take advantage of the sampling method of calculating your deductions in some cases (such as vehicle mileage); this method allows you to take a sample from a three month period rather than calculating the exact sums.[4]

Rule #5 Keep track of travel and entertainment costs. For travel expenses, you have to prove (with documentation) where you were each day and why. Your business entertainment costs also need proper documentation, including what you spent money on, how much, when, and where the expense occurred. Your receipt will cover all of those, but you’ll additionally need to note who you entertained and why (i.e. the benefit to your business).

In the case that you operate your business as a corporation, you’ll have to turn the expenses in to your company. You can do this by paying with a corporate credit card, or you can have the corporation reimburse you for the expenses. Making sure the company pays is important; otherwise you’ll only get employee-business deductions for those expenses.

What to Remember

No matter what kind of business costs you incur, you need to remember these two primary pieces of information: 1) prove what you bought and 2) prove that you, in fact, paid for it. As mentioned above, a receipt or paid invoice covers the first part of this. In order to prove payment, you can use a credit card receipt or statement, canceled check, or bank statement (for electronic transfers). Note: An item is considered paid for when you charge it to your credit card, regardless of when you pay the amount to your card.[5]

Don’t pay with cash. It makes things more difficult for you. If you pay with cash, an auditor will want to know where the cash came from, how you can show cash trail and tie it to the payment, whether you can prove an ATM withdrawal, and most importantly, did you really pay for something in cash or are you just making up a deduction? Paying with pretty much any other method is much less of a hassle.

A Note on Petty Cash

Petty cash works for some small businesses. If it’s what you’re accustomed to and you haven’t had any problems, then by all means continue using the system. However, many small business owners end up kicking themselves in the pants with a petty cash system. You’ll likely find it easier to use a reimbursement system.

With the reimbursement system, your company simply writes you a check for the expense when you provide documentation for it (a receipt or expense report, for instance). Because you have to present documentation for reimbursement, you’re less likely to get caught without evidence for your spending, as you could with petty cash.

Statutes of Limitations and How Long to Keep Records

The IRS has statutes of limitations on when either you or it can make changes to a tax return (this is not just the period during which they can audit you). Here are the time frames given in IRS publications:[6]

  • No limit if you did not file a return
  • No limit if you filed a fraudulent return
  • Three years after filing if you filed on time (or with extensions), you did not understate your income by 25 percent or greater, and you did not file fraudulently
  • Six years after filing if you filed on time (or with extensions) but you understated your income by greater than 25 percent
  • If you filed an amended return or already made changes to the original return (like a quick refund claim), either three years after filing or two years after paying the tax
  • Seven years from filing for a claim filed for a bad-debt deduction or loss from worthless securities

If you have employees, you need to save your employment tax records for four years after whichever date comes later, the date payroll taxes were paid or the date they were due.

Because these statutes of limitations also indicate how long the IRS can audit your return, you need to ensure that you hang on to all of your records until the risk of audit has passed. This could mean keeping records for a period of multiple years. In the case of assets, like office equipment and office buildings, the records are relevant throughout the asset’s entire depreciable class life. As long as you are still depreciating an asset, it will be in that year’s tax return. When using Section 179 to expense an asset, you also have a potential recapture throughout the depreciable class life.

Here’s an example. You buy a desk for $1,500 and depreciate it over the MACRS life of seven years. This depreciation actually takes eight years, so you need the original purchase receipt in year eight in order to prove your deduction. Additionally, you will need to retain that purchase record for three years after that when the statute of limitations expires (for a total of eleven years). It works the same with Section 179, except that you also have recapture exposure during those eight years of depreciation.

Would you like an easy way to keep track of this? Just make a permanent file for any assets with a life greater than one year. This way, you don’t need to keep track of class lives or time frames on the statutes of limitations.

And, here’s another quick tip for keeping those records organized:

Simplify your file system by devoting separate drawers for each tax year. In those drawers, you’ll put any information on assets, income, and other information applicable to your return. This method is for assets other than those you keep in your permanent file. The first drawer will be where you put all documents as you acquire them throughout the year. The next drawer is last year’s tax documents. The drawer after that contains documents from three years ago, and so on until you reach the year at which your statute of limitations expires. Each year, you move the drawers down one level and dump the one at the bottom of the line. You can also use this method for any employee tax files.

You see? It really isn’t all that difficult to keep your records straight. You’ll be thankful you did when it comes time to prepare your return.

  1. Darwin J. Albers v Commr., TC Memo 2007-144.
  2. United States v Basye, 410 U.S. 441, 449, 451 (1973); Lucas v Earl, 281 U.S. 111 (1930).
  3. John W. and Regina R. Z. Green v Commr., 78 TC 428 (1982), reversed on other grounds, 707 F2d 404 (CA9, 1983).
  4. IRS Reg. Section 1.274-5T(c)(3)(ii)(C), Example 1.
  5. E.g., Rev. Rul. 78-38; Rev. Rul. 78-39.
  6. IRS Pub., 583, Starting a Business and Keeping Records (Rev. January 2007), Record Keeping.

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.

Tips to Increase Your Home Office Tax Deductions

Although it may not seem like it, the IRS is not out to make tax preparation as difficult as possible for you. If you make errors, it causes them headaches, too. That’s why they try to accommodate your reasonably documented calculations for home office deductions. According to the IRS in its home office deductions publication, “You can use any reasonable method to determine the business percentage” of your residence[1].

Methods Suggested by the IRS

In that same publication, the IRS then goes on to suggest two methods that may be easy for small business owners to implement:

  • Number of Rooms—This method is just what it sounds like. If all your rooms are approximately the same size, you can divide the number of rooms used for business purposes by the number of rooms in your house. It’s actually fairly simple; however, the calculations will be less precise than with methods in which you measure the size of your office space.
  • Gross Square Footage—For a slightly more in depth calculation (but still relatively simple), you can calculate gross square footage. Multiply the office’s length by its width. Then, divide that number by the total area of your house.

Either of these methods works fine, but it turns out there’s a different calculation that may better benefit your finances.

Net Square Footage

When you calculate net square footage, you only calculate the useable portion of your home. It takes a little more figuring, but you’ll come up with a more accurate number that increases your deductions and save you money. How? Because when you take away from the calculations the parts of your home that cannot be used as office space, you reduce the denominator by which you’re dividing. And, that equals a greater percentage of your residence being considered business space.

Areas that are subtracted to find net square footage include bathrooms, stairways, hallways, outside walls, water heaters, foyers, and heating and cooling equipment. This method is used in cost accounting standards[2] and in commercial real estate[3]. This means you have documented standards for using net square footage to calculate assignable space in your home, since cost accounting standards are used with government grants and contracts.

As long as you keep accurate records, you’ll only have to make this calculation once—unless, of course, you move or change your office space. Tip: Simply measuring the square feet of each assignable room will give you the same number as taking out measurements for bathrooms, hallways, and other spaces that are not available for use.

Form 8829

Despite the fact that the IRS itself states any reasonable calculation method may be used, the IRS Form 8829 only shows an option for the gross square footage calculation[4]. Don’t let that fool you. The instructions for this form clearly specify that you may use other reasonable calculation methods so long as they accurately reflect your business percentage.

Let’s check out an example so you can see the benefit of taking a net square footage measurement. For the example, assume you have a 2,600 square-foot home with eight rooms, excluding bathrooms. When you subtract the common areas that are unassignable space, you have 2,000 useable square feet, of which your office takes up one, 270 square-foot room.

Calculating gross square footage, you divide 270 by 2,600, getting 10.38% business area. Calculating by number of rooms, you take 1 divided by 8 and end up with 12.5% business area. However, the net square footage method takes 270 divided by only 2,000, making your business area 13.5% of the total house.

Using the number of rooms method, you actually allot 20% more space to your office. But, using net square footage, you increase the office portion by 30% more than using gross square footage. As you can see, that can increase your deductions significantly when you consider that accounts for 30% more of your mortgage interest, property taxes, rent, insurance, utilities, pest control, maintenance and repairs that benefit the whole house, or depreciation.

If the IRS allows you multiple options for deducting home office expenses, it makes sense for you to explore them. Under the right circumstances, the number of rooms method can yield greater deductions than gross square footage, and it’s simple to use. But, net square footage will always increase your deductions over the gross square footage method. Make sure you consider your options and get the most tax savings possible!

  1. IRS Pub. 587, Business Use of Your Home (2013), p. 10.
  4. IRS Form 8829, Expenses for Business Use of Your Home (2013).

How to Make Your Proprietorship a Corporation

As a business owner, converting your sole proprietorship to a corporation can have tax advantages. When you’re ready to incorporate your business, the first thing you’ll need to do is prepare and file your corporate documents[1]. You probably already guessed that paperwork needed to be filed, but hold on there—your business is not a corporation yet. Filing the required documents is not the only step in the process.

Transferring Assets

Filing incorporation documents creates an empty corporation. Your business, however, continues operating as it always has, as a sole proprietorship. For your business to fill that empty corporate shell, you have to move your assets over to the corporation in exchange for stock. Basically, when you are incorporating your business, it becomes its own entity rather than an extension of you. Here’s a tip: You don’t have to transfer all of the assets to the corporation. You can keep some under your name. In fact, it would be wise to consult your tax adviser about which assets are better kept in your name.

In the case that you maintain control of your corporation, the exchange of assets for stock is tax-free[2]. How do you know if you control your corporation? For tax law purposes, “control” means that directly following the exchange, you own at least 80 percent of the combined voting power over all the stock and you own at least 80 percent of each of the stock classes without voting rights[3]. This rule of the tax-free exchange always applies, regardless of when you form the corporation.

Be aware: Your family’s stock (including that of your spouse) does not count toward your 80 percent ownership. If, for example, after the exchange you own 70 percent and your spouse owns 30 percent, you do not meet the control criteria. That means you lose the tax-free exchange. Luckily, there are ways around this problem. Your spouse can join you on the transfer, such that both of you are contributing property for the stock. By making the exchange together, you qualify for tax-free status as a group[4].

Considerations When Doing Business with Your Corporation

Since your corporation is a separate entity from you, you have effectively created a new person for tax purposes. This means that you and the corporation do not share assets, and you cannot use each other’s assets without certain consequences. After all, you can’t just use your neighbor’s assets without compensating the person, right?

Here are some scenarios you’ll want to consider:

  • Using Corporate Assets—What if you would like to use your corporation’s assets? You simply have to arrange the use like you would with any other unrelated business acquaintance. You can treat your borrowing of corporate assets like any of the following situations:
  • Compensation,
  • A fringe benefit,
  • A purchase,
  • A lease,
  • A dividend, or
  • Any other economic arrangement business people might enter into.

You should be aware that because you control these arrangements between you and the corporation, the IRS will keep a close eye on the terms you arrange. If the IRS thinks you are mishandling such an arrangement or interchanging your assets with the corporation’s assets, it has the authority to reallocate your deductions, income, and assets in the manner it approves[5].

Usually, these reallocations will not be to your benefit. So, you need to protect yourself when dealing with your new corporation. That means documenting all your transactions and using fair market value terms to the best of your ability.

  • Contributing Debt—When you incorporate your company, it’s not only assets that you can transfer to the corporation. You can also transfer your business debt, such as mortgages and outstanding loans[6]. For tax purposes, this poses no problem; however, your creditors may have a different opinion.

For an asset tied to debt, such as an office building, you will probably need approval from the creditor before transferring the asset to your corporation. It’s not a big deal if you don’t get approval, though. You can always make arrangement with your corporation to compensate you for the use of assets still in your name (e.g., by paying rent to you).

  • Dual-Purpose Assets—Even after careful doling out of assets, you will probably still have some items that you use for both business and personal uses. Your car is an example of these. In such cases, you will have to make your own reasonable decisions based on how the assets are used. The best strategy is to talk to your tax adviser about your options for dual-purpose assets.

When determining how to classify these dual-purpose assets, you may want to consider liability. Incorporating your business does a wonderful job of protecting your personal assets. This is because business creditors are then limited to dealing with the corporation’s assets.

  • Handling Third Parties—When you transfer assets, some of those may have third parties involved. Any permits, licenses, or bank accounts, for instance, will need to be changed and put into the name of the corporation. They cannot remain under your name. It may cost money to make these changes, but by doing so, you avoid the cost of contract penalties and additional taxes. These costs are just part of changing your business over to a corporation.

This article gives you a good overview of how to handle incorporating your sole proprietorship. Now you know what to be thinking about (and documenting!) when it’s time to make the change. Good luck in your endeavors, and be sure to check with your accountant when it comes down to the nitty-gritty!

  1. The necessary documents and process for filing vary between states.
  2. IRC Sections 351(a); 361(a).
  3. IRC Section 368(c).
  4. See Burr Oaks Corp., 43 TC 635, 651 (1965), aff’d, 365 F2d 24 (7th Cir. 1966), cert. denied, 385 US 1007 (1967).
  5. IRC Sections 482; 7701(o).
  6. IRC Section 357(a), (c). However, in some instances, you may recognize gain.

You Totaled Your Vehicle? Tax Benefits You Can Use

Let’s face it; wrecking your vehicle is a bummer. But, don’t let moping about something that’s done and over with keep you from being smart about the situation moving forward. There’s no need for having a totaled vehicle and missing out on tax benefits.

Understanding Tax Law

Your particular business situation will determine exactly how the tax law views your totaled vehicle, also called an involuntary conversion. Both individuals and corporations, however, have to work with the same rules as far as the business part of the vehicle. The difference lies in the personal use part. For an individual, there is a personal casualty loss. For corporations, there is no personal part; it’s all business.

If you’re confused about which situation applies to you, look at the check made out by the insurance company. When you total your vehicle, they will keep the vehicle and give you a check for its pre-accident value. If the check is made out to you (because you are a Schedule C taxpayer and you own the vehicle), you will divide the money between business and personal use based on mileage for each. A check made out to the corporation is not divided. On the books, the vehicle belongs to the business.

For a Proprietorship

Let’s do an example to see how you would divide the insurance money between personal and business use. In this example, you owned the vehicle for three years. During those three years, you drove it 20,000 miles for business and 5,000 miles for other uses. So, you have 80 percent business use from the time of purchase to the totaling of the vehicle.

You can now use that percentage to determine gain or loss on both a business and personal basis. Since a proprietorship is a Schedule C taxpayer, here’s what you need to know. 1) The business part will have either a taxable gain or a deductible loss. 2) For the personal part, you will pay taxes on any gain, but you cannot deduct a loss.

To clarify the personal casualty loss, you probably will not have a personal deduction if you had insurance. You see, by IRS rules you can deduct whichever is lower of your cost or the fair market value, minus the insurance proceeds. Since insurance will likely reimburse at fair market value minus your deductible, there will not be a personal casualty loss deduction.

Even if you have an insurance deductible, it is unlikely you will come out with a personal loss deduction. That’s because tax law includes these two additional rules regarding personal loss:

  1. The amount of each casualty loss is reduced by $100[1], and then
  2. Casualty losses are only allowed to the extent that they exceed ten percent of adjusted gross income[2].

If you think you might still have a personal loss to claim after these calculations, check with your tax advisor to be sure.

For a Corporation

Your corporation may own a vehicle that you use for both business and personal reasons. In that case, the corporation will assign a value to your personal use. That amount then goes on your W-2, or you will be responsible for reimbursing the corporation. Since you are a more than 5 percent shareholder, you are obligated by specific legal requirements regarding how your corporation determines this value.

Here’s how the example above plays out when the vehicle belongs to your corporation. As far as depreciation, gain, and loss purposes, the corporation owns 100 percent of the vehicle. So, all gains will be taxable, and any loss will be deductible.

Deferring Taxes

In either scenario, you can end up with some taxable gains. Usually, these gains come about because of depreciating the vehicle or expensing deductions claimed on it. When your gain comes from deductions, it’s called “recapture income”, which is taxed at the usual income tax rates. But, here’s a little secret: you can avoid those taxes!

Instead of claiming your totaled vehicle as a gain, you can replace it with other like-kind property. Tax law even allows for two years from the time of the wreck for you to make the replacement[3]. The details are covered under IRS Section 1031 on exchanges of business vehicles, which states that like-kind property for vehicles includes cars, light general-purpose trucks, and vehicles that share characteristics of the two former types (such as crossovers, SUV’s, vans, etc.).

All you have to do to defer the taxes is reinvest all of your insurance money into a new vehicle and properly document this on your tax return. That means if you wreck your SUV, you can take the $20,000 insurance money and replace your SUV with a car. If you don’t reinvest the full amount, you will have taxable income for the amount leftover[4]. So, if that new car only costs $16,000, you’ll have a taxable gain of $4,000. It works this way for both a proprietorship and a corporation.

Don’t Forget the Documentation

In order for your vehicle replacement to be accepted by the IRS (and to avoid taxes), be sure you attach a statement to your tax return (either the Form 1040 or the corporate return) that includes[5]:

  • Details of the wreck, including the date,
  • Amount of insurance reimbursement,
  • How you calculated the gain,
  • The replacement property purchased,
  • The amount of gain that is postponed,
  • The adjusted basis on the replacement vehicle (which is reduced by the deferral of gain), and
  • How much of the gain is taxable (again, if you invest the full reimbursement amount, there is no taxable gain).

So, in order to avoid those gain taxes, replace your vehicle with one of like-kind (which basically means for the same use) and document everything about your wreck, insurance reimbursement, and purchase of the new vehicle. For any business losses, deduct those immediately! Business loss deductions work the same way for a proprietorship or a corporation. You may not like knowing that you totaled your vehicle, but you can rest easy with the knowledge to set your finances straight in the aftermath.

  1. IRC Section 165(h)(1).
  2. IRC Section 165(h)(2).
  3. IRC Section 1033(a)(2).
  4. IRC Section 1033(a)(2)(A).
  5. IRS Pub. 547, Casualties, Disasters, and Thefts (2012), posted Nov. 29, 2012, p. 12.

Are You a “Dealer” or “Investor” for Tax Purposes?

Tax law is forever classifying people and making structures that either create benefits or disadvantages on your tax return. Part of getting the most from your return is about understanding the definitions of the IRS. Two that seem very similar, but have distinctly different consequences on your taxes, are real estate dealer and real estate investor.

What’s the Downside of Each?

We’ll start by discussing the disadvantages. That’s right—there is no golden choice when trying to figure out if you classify as a dealer or an investor. In either case, there will be some disadvantages.

As a real estate dealer:

  • Your profits are taxed at both the ordinary income rates (up to 35 percent) AND the self-employment rates (up to 14.13 percent).[1]
  • You may not depreciate property that you are holding with the intention of selling.
  • You may not use the tax-favored installment method to report dispositions of your property.
  • And, you may not use the Section 1031 exchange to defer taxes on properties you hold as a dealer.

As a real estate investor:

  • You are subject to the net capital losses limit of $3,000 (applied after gains are offset against losses).
  • You must treat selling expenses as a reduction in sales proceeds, which means those expenses produce benefits at the capital-gains tax rates only.

Admittedly, the dealer gets the lesser deal when it comes to disadvantages. The investor does get to depreciate property, is allowed to sell using the tax-favored installment method, and may choose to use a Section 1031 exchange, thereby deferring taxes on a disposition.

What about the Up Side?

Every coin has a heads and a tails. And, it’s the same with tax designations. Both dealers and investors gain some advantages from their respective positions.

Advantages for real estate dealers include:

  • You are treated as a business and may treat most expenses as ordinary business deductions (advertising, commissions, legal fees, real estate sales, etc.).
  • Your property sale losses are not limited capital loss cap of $3,000 that limits investor properties.
  • Your losses are deducted as ordinary losses.
  • You get to deduct the entire loss (either immediately or using the net operating loss rules to deduct it over time—these rules allow you to carry back your losses up to five years and forward up to twenty years).

Advantages for real estate investors include:

  • Your sales profits are taxed at 15 percent or less, a tax-favored capital gains rate.
  • You are not subject to the self-employment tax.

Practical Application

So, what does all this mean for you and your business? Let’s run through some example numbers. For the example, we’ll say you have a $90,000 profit from a property sale. Based on the tax rates mentioned above, your taxes as a dealer could be as high as $36,370.[2] Your taxes as an investor might be as high as $13, 500.

You can clearly see that having your properties qualify as investment sales generates a considerable tax savings—potentially $22,870!

However, depending upon your business structure and activities, it may not be possible to define all of your property sales as investment sales. No problem. The IRS has no qualms with an individual taxpayer acting as part dealer and part investor. You read that right; you can balance the pros and cons of each situation. It’s simply a matter of taking each property on a case-by-case basis.[3]

Not so fast. You may think the IRS is giving you some kind of free gift by allowing this pick and choose method, but it’s not quite as unstructured as all that. You will be required to make a clear distinction in your record books. You didn’t think the IRS was going to let you off without documentation, did you? And, this means you must decide before-hand which route you’re going with each property sale. You cannot simply go back over your sales at tax time and assign designations. You will have to establish what your intent was with the sale—dealer sale or investment sale.

Tips on Documentation

Good documentation of your purpose and activities helps you to establish your case with the IRS. You should determine, and make note of, your intent for the property throughout the process:

  • When you purchase the property;
  • During your ownership; and
  • At the time you sell it.

If you keep records throughout the process (not just at the time of sale) it gives your case credibility. It’s important to keep in mind, however, that if your return is challenged in court, they will likely examine the sale when they rule on whether you acted as a real estate dealer or real estate investor on a particular property.[4] None of this means that your purpose may not change between the time you buy a property and sell it, but at least you will be prepared to understand and plan for such a scenario.

The All Important Point-of-Sale

Important: The point-of-sale is the most critical part of the process in determining your investor or dealer status. It’s often the deciding factor in IRS decisions. Although a single piece of real estate can have features of both dealer and investor property, it can only be treated as one or the other. Take a look at the characteristics of each from a tax standpoint.

  • Real Estate Dealer—First off, dealer property is held with the intention of being to customers in the ordinary fashion of business or trade.[5] If you buy and sell many properties throughout the year, you are likely a dealer regarding those properties.[6] Unfortunately, the IRS has not established any set number for determining dealer status, so it’s all about making your case. In fact, number is only one factor, and in previous rulings:
  1. A company earned dealer status with only one sale because it had already agreed on sale to a third party prior to purchasing the property itself;[7]
  2. A taxpayer, Mr. Goldberg, did not earn dealer status even with 90 home sales in a year.[8] In his case, the homes were built for rentals and used as such prior to the time of sale.

However, in the majority of cases, more sales equal dealer properties. In addition to the influence of the number of properties sold, real estate that you subdivide also has an increased chance of achieving dealer status,[9] except under Section 1237.[10] Removing a lien can also make a property more salable under the ordinary processes of business[11] (recall that dealer property is sold in the ordinary course of business).

Several other traits indicate a dealer business transaction over investment actions. They include active marketing and sales activities,[12] property held for a short period of time (indicating the intention to turn over the property for profit),[13] generally making your living as a dealer,[14] regularly buying and selling real estate for your own account,[15] and buying property with the proceeds from another property.[16]

  • Real Estate Investor—In contrast to dealer property, investor property is held with the intention of producing rental income[17] or appreciating in value. This means that investor properties are typically held for longer periods of time[18] and are not often sold, unlike the quick turnover of a dealer property.[19] Other situations in which a court may rule your property is an investor property include acquiring the real estate by inheritance,[20] dissolution of a trust,[21] or a mortgage foreclosure.[22] It’s even possible for you to make improvements to such property prior to selling it and still retain investor status.[23] [24] Just don’t put the proceeds into more real estate or subdivide the property[25] if you want to maintain that status.

If you don’t make clear in your documentation which type of property sale you are making, the IRS will make the decision based on their interpretation, and that is not the best situation for you! So, look at those characteristics above again. Since you’re going to know at the outset what your purpose is with each property, you can make sure to include as many of the appropriate features as possible well before the sale.

  1. The usual self-employment tax rate times the Schedule SE adjustment.
  2. Assuming the real estate profits were your only income.
  3. Tollis v Commr., T.C. Memo 1993-63.
  4. Sanders v U.S., 740 F2d 886.
  5. IRC Section 1221(a)(1).
  6. Sanders v U.S., 740 F2d 886; Suburban Realty Co. v U.S., 615 F2d 171.
  7. S & H, Inc., v Commr., 78 T.C. 234.
  8. S & H, Inc., v Commr., 78 T.C. 234.
  9. Revenue Ruling 57-565
  10. IRC Section 1237.
  11. Miller v Commr., T.C. Memo 1962-198.
  12. Hancock v Commr., T.C. Memo 1999-336.
  13. Stanley, Inc. v Schuster, aff’d per curiam 421 F2d 1360, 70-1 USTC paragraph 9276 (6th Cir.), cert den 400 US 822 (1970); 295 F. Supp. 812 (S.D. Ohio 1969).
  14. Suburban Realty Co. v U.S., 615 F2d 171.
  15. Armstrong v Commr., 41 T.C.M. 524, T.C. Memo 1980-548.
  16. Mathews v Commr., 315 F2d 101.
  17. Planned Communities, Inc., v Commr., 41 T.C.M. 552.
  18. Nash v Commr., 60 T.C. 503, acq. 1974-2 CB 3.
  19. Rymer v Commr., T.C. Memo 1986-534.
  20. Estate of Mundy v Commr., 36 T.C. 703.
  21. U.S. v Rosbrook, 318 F2d 316, 63-2 USTC paragraph 9500 (9th Cir. 1963).
  22. Cebrian v U.S., 181 F Supp 412, 420 (Ct Cl 1960).
  23. Yunker v Commr., 256 F2d 130, 1 AFTR2d 1559 (6th Cir. 1958).
  24. Metz v Commr., 14 T.C.M. 1166.
  25. U.S. v Winthrop, 417 F2d 905, 69-2 USTC paragraph 9686 (5th Cir. 1969).

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