Income taxes are a regrettable fact of life. Equally regrettable is that few real estate investors utilize the multitude of generous income tax benefits available to them. These benefits include cost segregation, depreciation, casualty loss, section 179 depreciation, and 1031 exchange. Income taxes can be sharply reduced with modest planning. This article reviews how to reduce federal income taxes by increasing depreciation and making the best of a bad situation when a casualty loss occurs.

federal income tax reduction strategiesReal estate investors benefit from income tax laws not available to investors for most other asset classes. The U.S. Congress has provided generous income tax benefits for both commercial and single-family owners. Purchasers of stocks, bonds and gold cannot depreciate their cost basis. However, real estate investors are able to depreciate a substantial portion of the cost basis of properties they purchase to reduce their income taxes. Depreciation is important because it: 1) is a non-cash expense, 2) converts ordinary income into capital gains income and 3) defers the payment of income taxes. Depreciation alters the character of income from ordinary income to capital gains income for most investors. Since the maximum income tax rate for ordinary income is 35% and the maximum income tax rate for capital gains income is 15%, this reduces the total amount of income taxes by over 50%. Depreciation defers payment of income taxes from the year in which it is earned until the year when the property is sold. Investors may further defer the recognition of gain/income by utilizing a 1031 exchange.

Cost segregation is a specialized service used by many real estate investors to enhance the benefits of depreciation. Cost segregation allows owners to increase the amount of depreciation by 50% to 100% during the first five to seven years of ownership. Cost segregation increases the level of depreciation by identifying up to 130 portions of the building which qualify for short-life depreciation. Short-life items can be depreciated over 5, 7 or 15 years. Buildings are depreciated over 27.5 years (rental residential real estate) or 39 years (commercial property). Cost segregation is financially feasible for real estate with a cost basis of at least $500,000 (for the improvements).

A casualty loss for real estate investment property could include fire, flood, hurricane, tornado, or mudslide. Real estate owners incur both financial and emotional distress following this type of casualty. There’s also a significant amount of work involved to coordinate with the insurance adjuster, tenants, contractors, vendors and lender. Even if the owner has complete insurance for building repairs and business interruption, a casualty loss deduction can legitimately be taken.

Casualty losses provide the opportunity to depreciate a large portion of the cost basis of real estate. The basis for calculating a casualty loss is the value of the property immediately before the casualty versus the value of the property immediately after the casualty plus insurance proceeds.

Consider the following example: a 200-unit apartment complex in Beaumont Texas was flooded with 3 feet of water on the first of two stories. The owner has casualty insurance expected to cover 100% of the cost to recover repair the property. He also has business interruption insurance to cover lost income while construction occurs and the property is leased. The initial reaction in reviewing this situation may be there is no casualty loss since the physical repairs and lost rents are covered. However, the market value of the property immediately after the casualty is substantially less than the market value of the property before the casualty. It is highly unlikely someone would purchase the property and agree to undertake the work required to negotiate with the insurance company, contractors, tenants, vendors and the lender without expecting a profit for their work. The magnitude of the casualty loss would have been much larger if the owner did not have business interruption insurance. In either case, a real estate investment group seeking to purchase the property immediately after the casualty would likely require an appropriate return for their capital and an entrepreneurial profit for the effort to renovate and lease the property.

Real estate investors use depreciation to reduce federal income taxes. They can further reduce federal income taxes by using cost segregation to increase the level of depreciation by 50 to 100% during the early years of ownership. Those suffering a casualty loss can often take a large deduction as a legitimate casualty loss.

Cost segregation produces tax deductions and reduces federal income taxes across the country and in every size market. Below are just a few examples of where cost segregation generates meaningful tax deductions.

City:

  • Houston, TX
  • Dallas/Ft. Worth, TX
  • Boston, MA
  • Baltimore, MD
  • Las Vegas, NV
  • Bridgeport, CT
  • Hartford, CT
  • Phoenix, AZ
  • Washington, DC
  • Los Angeles, CA
  • Santa Rosa, CA
  • Little Rock, AR
  • Springfield, MA
  • Minneapolis-St. Paul, MN
  • Akron, OH
  • Stockton, CA
  • Bakersfield, CA
  • Portland, OR
  • Durham, NC
  • Columbus, OH
  • Colorado Springs, CO
  • Charleston, SC
  • Oklahoma City, OK
  • Albuquerque, NM
  • Oxnard, CA
  • El Paso, TX
  • St. Louis, MO
  • Rochester, NY
  • Providence, RI
  • Milwaukee, WI

Cost segregation produces tax deductions for virtually all property types.

Property Type:

  • Self-storage
  • Amusement park
  • Truck terminal
  • Student housing
  • Truck stop
  • Racket club
  • Multifamily
  • Regional mall
  • Discount store
  • Single-tenant retail

Almost every industry, including the following, can generate cost-efficient tax deductions by using cost segregation.

Industry:

  • Furniture manufacturing
  • Beverage and tobacco product manufacturing
  • Machinery manufacturing
  • Food manufacturing
  • Fabricated metal products
  • Transportation equipment manufacturing
  • Leather product manufacturing
  • Day care facilities
  • Arts, Entertainment, and Recreation
  • Paper manufacturing