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PostHeaderIcon Rental Real Estate Taxation Basics

While I continue to fret over my “about me” page, one of the things people ask me is, “What is your specialty?”  Over the course of my 18+ year career in tax, to a certain extent, I’ve done it all.  I’ve worked on billion dollar bank and insurance companies and large multinational manufacturing companies all the way to the businesses that bring their receipts in a shoe box.  Still, for most of the past ten years I’ve been immersed in real estate.  They’re not the only clients I work on but it’s become a niche I’ve embraced.  This includes big real estate (I spent over five years in the tax department of a publicly traded REIT) to local real estate working with investors mostly in the Detroit-metro area.  You’ll also find that a lot of the content on this site is real estate related.

One of the things I haven’t touched on in a post is the taxation basics of rental real estate.  If done right, rental real estate can be a great investment but when you take into consideration some of the favorable tax rules that surround it, it can definitely be something you want to look at to add to your portfolio of investments.

First off is the disclaimer. I’m going to making a lot of general statements but as always, everyone’s tax situation is unique so be sure to consult with a professional before you put any of this advice in place.

The first question I usually get asked is about entities.  I’m going to focus on just the tax implications and leave the entity protection discussion for your attorney.  If you want to buy and hold real estate, most of the time you’re going to hold it in a non-corporate entity.  If you want to read about why you probably don’t want to hold real estate in a corporation, I discussed that specific issue in a separate post.  Most of the time you’ll be dealing with a limited liability company (LLC).  If it’s a single member LLC, you’ll be reporting your rental real estate activity on Schedule E of your 1040.  If its a multi-member LLC, then the default tax form is the Partnership Return, which is Form 1065 with the specific rental activity being reported on Form 8825.

The next question I’m usually asked is “What can I deduct?”  The IRS’s general rule is an expense has to be ordinary and necessary expense in carrying on the  trade or business.    As usual they like to keep things vague but the first bucket of expenses are what I call the Big Three.  This is your interest, insurance and taxes.  Rental real estate will almost always have insurance and taxes and if there is leverage involved, you will have interest as well.  In dollar terms, those three expenses usually make up the bulk of you cash outflows.  If you hire a property manager, that is also a deductible expense.  Repairs (not to be confused with capital improvements) can also be deducted as can utilities if that’s a cost you incur on behalf of your tenants.  Costs to advertise the property are also deductible and you can also deduct your mileage if you’re making trips out to the property (within reason). You can also deduct legal and other professional fees (accounting and tax as an example) as well.

I mentioned repairs and you have to distinguish between a deductible repair and a capitalized capital improvement.  Lets use a roof as an example.  If you have someone come and patch up your roof, it’s probably something you can deduct. If you’re replacing the entire roof, that would probably fall more into the improvement category and you should capitalize it and depreciate it over its useful life.

Which leads me into depreciation.  When you buy a piece of real estate, you buy several different things.  You get a building, you get land and unless the house is gutted, you also get a lot of fixtures, pipes and wires.  You have a couple of choices when it comes to depreciating your property.  One option, although it’s usually not cost effective for single family homes, is a cost segregation study.  When you do a cost seg. study, you really break down the cost of what you’re buying and the end result is, you usually get property that you can depreciate over a shorter useful life (i.e. more depreciation expense now) versus property you can depreciate over a longer life (less depreciation expense now).  The other option is to just go with an estimate like an 80/20 split between property and land with the 80% being depreciated over 27.5 years.  You don’t get to take advantage of the quicker depreciation tables but you also have to spend less administrative time and money to break everything down.

When you prepare your taxes, the calculation isn’t that challenging but you have to make sure you fill out the form completely and accurately.  You take your rental income and subtract your cash expenses and your depreciation to come up with a net number.  If it’s a positive number, it’s either reported on your 1040 or it will flow through from your Form 1065 via a Schedule K-1.  If it’s a loss, then it gets a little trickier because the passive activity loss rules can get complicated.  I will save how and when you can take these losses for a post of its own.

Hopefully this is enough to get you started or if your already renting property, it validates what you’re doing. There are some other strategies I’d like to talk about, including ways to set things up if you own multiple properties, but this is getting a bit long and I will save those as well for a future piece.  As always, if you have questions, you can find a few different ways to contact me on my contact page or if you have a comment, feel free to leave one here.

PostHeaderIcon August

Typically, August is my single busiest month.  This surprises a lot of people but it mainly has to do with the fact that I have a few big projects that get extended, the don’t come in until the first of August and then it’s a flurry to get it all done before the September 15 deadline.  That means things like writing take a backseat but since it’s been a couple of weeks, I wanted to make sure “something” goes up so here are a few links to some of my popular posts.

Taxes for People Serving in the Military

Cost Segregation Studies

Real Estate Professional Status Tax Planning

Holding Real Estate in a Corporation

Enjoy and there will be some fresh content coming soon.

 

 

PostHeaderIcon Asset Purchases, Cost Segregation Studies and the Peco Foods Tax Court Case

Doing a cost segregation study could be a beneficial exercise for a company that owns real estate but the Tax Court recently dealt a blow to those looking at a cost segregation study on assets acquired in an asset acquisition.  While usually more beneficial to the purchaser because the goodwill is amortizable for tax purposes, one of the exercises of an asset purchase is Form 8594 which basically makes you pool the assets purchased into buckets based on their character.  The Form is then filed with both the seller’s and purchaser’s tax return.

Putting a little extra time into Form 8594 is even more important now because of the Peco Foods Tax Court Case.  What the tax court determined was that the allocation done on Form 8594 is binding and that you’re not allowed to subsequently do a cost segregation study on the assets that were purchased.  You’re not even allowed to elect a Change in Method of Accounting on Form 3115 to effectuate a change in the allocation so once the Form 8594 is done, you’re stuck.

The moral of the story is, take the extra time to get this allocation done and as much to your benefit as you can.  You can usually work with the seller to get a solid allocation done that helps both of you so put in the extra time either during the negotiations or once the sale is getting close to being finalized because the final allocation could have ramifications for years to come.

PostHeaderIcon Cost Segregation Study Resources

Yesterday I gave the ins and outs of cost segregation studies.  Today, I’m giving you some of the research resources attached to it.  One good place to start, if you don’t mind the investment is CCH’s U.S. Master Depreciation Guide (2011). This guide book will give you the ins and outs of the depreciation rules like nothing else will and it comes with CCH’s top notch explanations.

If you don’t want to spend the money, then I’d recommend Publication 535 which has a section on capitalizing assets in it.  I’d also highly recommend the Audit Technique Guide on Cost Segregation. Between those two things, you should have the tools to at least get started.

PostHeaderIcon Cost Segregation Studies

A while back, I wrote a column for the Oakland County Real Estate Investors Association on cost segregation studies, or the abbreviated cost seg studies.  Here’s that column in its entirety.

Get More Money Out of Your Real Estate Investment by using a Cost Segregation Study

“Accounting and tax rules allow me to depreciate my property, which means I am making money but it looks like I am losing money, I am making money because I am legally allowed to pay less in taxes, So this is money coming in because less money is paid out in taxes. It is also known as phantom cash flow.” Robert Kiyosaki, The Real Book of Real Estate

“In recent years, increasing numbers of taxpayers have submitted either original tax returns or claims for refund with depreciation deductions based on cost segregation studies. The underlying incentive for preparing these studies for federal income tax purposes is the significant tax benefits derived from utilizing shorter recovery periods and accelerated depreciation methods for computing depreciation deductions.” Internal Revenue Service Cost Segregation Audit Technique Guide

There are several tax advantages to rental real estate but near the top of the list is the ability to depreciate the purchase price of your investment and utilize that as a tax deduction each and every year. The current rules allow you to depreciate residential rental real estate over 27 ½ years so if you bought a house for $100,000 and do the standard allocation of 80% going to the house and 20% going to the land, you end up with nearly $3,000 in tax deductions each and every year. In a lot of cases, this can turn an investment with a marginally positive cash flow into a tax loss allowing you to escape paying taxes. Even better, it’s not like a typical expense, such as interest expense, where money is coming out of your pocket. As Robert Kiyosaki described in his quote, it’s like phantom cash flow. With that, it can’t get much better then that, can it?

Actually it can. By utilizing what’s commonly referred to as a cost segregation study, you can significantly narrow the window used to depreciate your investment. While you’re robbing the future to pay for the present, in a lot of cases you’re giving yourself tax deductions in the current year that you might be not be able to normally utilize until over 20 years in the future. We all know that a dollar in our pocket now is worth more then a dollar 20 or 30 years from now so let’s take a look at how this is done.

What Is a Cost Segregation Study?

When depreciating both real and personal property, it’s necessary to classify each asset so a useful life has been determined. Computers are depreciated over five years while non-residential real estate is depreciated over 39 years. The shorter the useful life, the better the depreciation deduction is in the early years of the asset. Sometimes, you can’t break down each and every asset (like for a house), so the Internal Revenue Service let’s you use estimates to segregate or allocate costs to various buckets of assets. A house or apartment building consists of a structure, but there’s also wiring, personal property (cabinets and lighting fixtures as an example) and even furniture. This allocation estimate is what a cost segregation study provides for you.

Who Performs Cost Segregation Studies?
There are no requirements to do cost segregation studies but in my experience, the best combination is to have a certified public accountant (CPA) and an engineer work together. This way, you have both the tax side (CPA) and the structural/construction side covered. A CPA could do a cost segregation study by himself but without the proper experience that an engineer could bring to the table, things usually get missed. Of course an engineer could do it by himself, but they usually lack the necessary tax knowledge to fully take advantage of the study. In addition, a cost segregation study that doesn’t utilize an engineer is usually going to be more closely scrutinized by the IRS if there’s an audit because a CPA isn’t a construction expert.

When’s the Best Time to do a Cost Segregation Study?

The best time to do a cost segregation study is when you buy the property. It’s a lot easier to do it on day one when all of the paperwork is fresh and the CPA and engineer can get in there before any work is done on the house. It also establishes all of the useful lives associated with property on day one and doesn’t require any additional paperwork.

What if I bought my a rental property five years ago? Can I still do a cost segregation study?

You can still do a cost segregation study if you have a house that you bought several years ago although the benefit could diminish over time. There is additional paperwork because you have to provide the Internal Revenue Service documentation to show them you’re changing your method of account. This involves filing Form 3115 (Application for Change in Method of Accounting). The good news is, for cost segregation studies, the change in method of accounting is automatic (some changes need IRS approval) and you also get to take advantage of the depreciation benefits entirely in the year that you apply for the accounting method change.

How Much Money Can I Save by Doing a Cost Segregation Study?

The short answer is there will be no savings, at least over the useful life of the asset. If you have a $100,000 depreciable asset, the total depreciation expense will be $100,000 over its useful life. What a cost segregation study can do is give you more of your depreciation deductions now so you have more money to put to use here in years one through five rather in year 20 or year 28.

Here are a few simple examples of what a cost segregation study can accomplish (note: I have spreadsheets that provide more detail on the numbers I’ve provided. These are available upon request by emailing brian@briancpa.com).

Example 1 – Assume you buy a rental property for $100,000. A quick and easy calculation has 80% going to the building ($80,000) and 20% going to the land ($20,000). Say you bring in a cost segregation study expert and he’s able to determine that 15% ($15,000) should actually go to the land, 50% ($50,000) should go to the building, 15% ($15,000) should go towards land improvements and then 20% ($20,000) should go towards what’s called distributive trade or service property (these are items like wiring, lighting fixtures and personal property). In the first five years, this would result in an increase of $19,545 in depreciation expense when you use the cost segregation study versus a traditional allocation.

Example 2 – Assume you buy an apartment building for $500,000. A traditional allocation would have 20% ($100,000) going towards land and 80% ($400,000) going towards the buildings. With a cost segregation study, you might get 17% ($85,000) going to land, 56% ($280,000) going towards the building, 10% going towards land improvements ($50,000) and 17% ($85,000) going towards distributive trade or service property. This would give you an increase of $79,128 in depreciation expense when you utilize the cost segregation study.

This sounds great, but how much money am I going to save?

This is where I get to hedge with my favorite answer, “it depends.” If you can use all of the extra depreciation deductions and you’re in a high tax brackets, example 2 could save you in excess of $30,000 in the first five years. On the other hand, if the extra deductions put you in a loss situation and you can’t take advantage of those losses because you fall under the passive activity rules, it might not benefit you at all. As always, you should consult with your personal tax advisor as to whether a cost segregation study is good for you.

This sounds fishy. What is the IRS going to do if you do a cost segregation study?

The IRS not only acknowledges that cost segregation studies are valid, but they also told everyone how they’re going to audit them. If your cost segregation expert knows what he’s doing, he’s read the IRS’ cost segregation study audit technique guide to know exactly what the hot spots are and how to protect the client as much as they possibly can.

In Conclusion

Cost segregation studies aren’t for everyone, but if you buy and hold real estate, whenever you buy a property you should at be thinking about doing a cost segregation study. I know some cost segregation study experts will analyze the property to see whether you’ll benefit or not before they even do the work so finding someone who will give you a quick review would limit your risk. Cost segregation studies are just one of the many tools that a real estate investor can keep in their tax planning toolbox.