Cost Segregation - Tax Deductions (Taxes are your enemy, but tax deductions are your friends)

Taxes are your enemy, but tax deductions are your friends. Taxes are the great bane of most businesses. Alas, business deductions act as a salve to cool the burning and itching of your bank account.

Business taxes can be summarized simply as calculating your total revenue, reducing this amount by as many tax deductions as you can and then paying tax on the remaining amount.

Owners of investment real estate can take advantage of a depreciation technique called cost segregation that could save them hundreds of thousands of dollars in federal income tax this year. It does so by increasing their depreciation and reducing their income tax rate from 35 percent to as little as 15 percent. It can also help defer payment of much of the tax until a building is sold.

Typically, the increased depreciation in early years of ownership can offset much of the income derived from the property. When depreciation advantages expire, the property can be sold, and taxes are paid at the capital gains rate of 15 percent. In such cases, this defers income taxes by five, 10 or even 15-plus years.

In addition to asking the questions above, business owners should also ask their accountant about taking advantage of cost segregation, a tax mechanism that could generate substantial savings in federal income taxes. Although it is vastly under-utilized, cost segregation is not a wildly speculative accounting tool. In fact, the American Institute of Certified Public Accountants' National Journal of Accountancy has published numerous articles in support of cost segregation.

Cost segregation identifies applicable components and establishes the value and correct time line for depreciation. Under typical circumstances, depreciation is spread out over as long as 39 years. However, cost segregation applies depreciation to parts of the property in 5-,7- and 15-year increments. This acceleration in depreciation time reduces the income subject to federal taxes. This method does not dictate alternative minimum tax issues.

Historically, most depreciation schedules are split between land and long-life property. Long-life property depreciates over 27.5 years for apartments and 39 years for most commercial properties. A cost segregation study can typically allocate 20% to 40% of the improvement basis to short-life categories, and sometimes more.

High-income owners typically pay a 35% federal tax rate on ordinary income and a 15% rate on capital gains. The mechanics of reporting the gain on a sale usually allocate most of the gain to capital gains, which is taxed at 15%.

A cost segregation study actually reduces the amount of long-life property, which is recaptured at 25% by allocating more of the basis to the 5-,7- and 15-year property. If cost segregation is utilized from inception until a gain on the property is recognized, it can reduce the federal tax rate from 35% to 15% for most investors. The exceptions are C corporations, which pay the same tax rate for either ordinary income or capital gains.

Don't pay more than your fair share of taxes. Take all legal deductions.

O'Connor & Associates is a national provider of commercial real estate consulting services including federal tax reduction, cost segregation, due diligence, renovation upgrading cost analyses, tax return review and apartment inspections.