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Have You Paid Thousands, Even Millions in Unnecessary Income Taxes?

Income taxes are a substantial burden and income tax laws are amazingly complicated. However, few are aware of how simple it is to recognize “catch-up depreciation” for prior years. This article discusses how you can generate substantial amounts of depreciation without filing amended income tax returns.

Many income tax preparers initially believe that increasing the level of depreciation simply defers payment of income taxes. Cost segregation increases depreciation by classifying a significant portion (often as much as 30 – 45%) of the original cost basis as short-life property. Short-life property includes items such as carpeting, specialized plumbing & electrical, paving and signage.

For property purchased on or after January 1, 1987, it is possible to “catch-up” depreciation which has been under-reported since the asset was placed in-service (without filing amended income tax returns). Instead of filing amended income tax returns, the taxpayer files a form 3115 (change in accounting method). This form is filed with the first income tax return after the cost segregation study is performed (in the year of change).

This one time “catch-up” of depreciation is available under IRS code section 481(a). Prior to Rev. Proc 2002-19, catch-up depreciation was allowable for the tax payer over a 4 year period. Under the revised procedures, if a change in method results in a taxpayer-favorable adjustment (negative section 481(a) adjustment); the entire amount must be taken into account in the year of change. In other words, this Rev. Proc changed the 4 year recovery period for “catch-up” depreciation to a one time adjustment in the year of change.

For example, assume an office building has been in service by the current tax payer for 15 years, and the current tax payer has not had a cost segregation study completed. All the 5, 7 and 15 year property that a cost segregation study would identify (probably 30 – 45% of the original cost basis) should have already been completely depreciated. However, because those assets were never segregated and depreciated according to the appropriate short-life depreciation recovery periods, nearly 2/3 of the original depreciable basis for these assets are still on the books, even if the asset has long ago been removed and replaced. Cost segregation allows the tax payer to “catch-up” all of this depreciation, minus the 39-yr straight-line deprecation already taken, in the year in which the study is done. In some cases, this has allowed taxpayers to eliminate federal income taxes for several years going forward.

Many questions regarding capital gains and recapture often arise when we discuss cost segregation on a property that has recently been sold or is expected to sell in the near future. For an in-depth look at the affects of cost segregation on capital gains and recapture taxes after a sale, please read the article in this newsletter titled Tax Rate Arbitrage – Cost Segregation After the Sale.

Federal income tax laws are inappropriately complicated. However, a knowledgeable cost segregation practitioner can guide you through the process of obtaining a cost segregation study and taking advantage of this catch-up depreciation, or underreported depreciation in prior years.

Cost segregation produces increased depreciation and reduces federal income taxes in commercial and multi-family properties wherever US federal tax law applies. Cost segregation produces tax deductions for virtually all property types. Typically, as long as the depreciable basis is $500,000 or more, the tax benefits should outweigh the cost of the service. Some examples of ideal property types are discount stores, shopping centers, health clubs, medical office buildings, apartment properties, office buildings, hospitals, restaurants, hotels, self storage, warehouses, office warehouses, and the list goes on and on.

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