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Alternative Asset Series - Advanced Real Estate Tax Part 1

Discover advanced real estate tax strategies to optimize alternative asset investments in Part 1 of our comprehensive series.

Welcome to the first of our 2-part series on alternative assets. Part 1 focuses on core concepts, big wins, and also small things that you can do as you get started in real estate. This article will cover the following topics:

1. Advanced depreciation techniques & cost segregation
2. Tax Cuts & Jobs Act of 2017 (TCJA) and using it to your advantage + hidden deductions.

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The Real Estate Investor Tax “Status”

Each real estate investor has a tax "status." Your status as a real estate investor is really dependent on your overall activity and what else you do in your life.  

  • Passive Investor 
    • Majority of RE investors considered passive investors
    • Not involved in the day-to-day operations
  • Non-Passive or Active Investor 
    • Certain classes of real estate can be "non passive"
    • Must cross a very strict threshold to be considered a non-passive investor
    • Actively involved in the day-to-day operations

Part 2 of this series will get into some of the special investment classes within real estate that are very easy to switch to non-passive, or active, which can result in enhanced benefits of the real estate investing techniques discussed in this article.
 

Real Estate Tax Advantage Goals

One of the primary reasons that people invest in real estate is because of the tax advantages that come along with it. Two advantages that will be covered in this article are:

1.  Minimize  Taxable Real Estate Income (create tax free income)

Taxable real estate income does not necessarily reflect your cash flow or the cash in your pocket. It reflects how much money on which you have to pay taxes. The goal here is to create tax free income, therefore targeting that number to be zero or in some cases to be a negative number, or a loss.

 

2.  Create RE losses 

Real estate investing has the potential for investors to turn that loss in to a benefit by using it to offset other income. Using the Time Value Money (TVM) concept, investors can maximize that benefit and possibly use that loss in the current year.

What is Depreciation?


Definition

The IRS defines depreciation as the "annual income tax deduction that allows you to recover the cost or other basis of certain property over the time you use the property." It goes on to say that the purpose of depreciation is "to give you benefit for the wear and tear of that property".
 

Benefit

Depreciation is a non-cash deduction meaning it is a tax only deduction that does not affect your cash flow.

  • Money does not actually leave your pocket
  • Taxes are reduced with depreciation deduction
  • Market value of real estate continues to go up
    • Real estate is appreciating year-over-year
    • Write off the wear and tear over a certain period of time
       

Lifetime of Real Estate for Depreciation Purposes

  • Residential Real Estate - 27.5 years 
  • Commercial Real Estate - 39 years
  • Short Term Rental - 39 years 
     

Cost Segregation - Boost your ROI


What is Cost Segregation Study?

  • An advanced, specialized technique to "segregate" the price of the property across shorter asset lives (i.e., 3, 5, 7, or 15 years)
  • A cost segregation study will break down the property into its component parts, such as flooring, wiring, HVAC, lights, furniture, plumbing, etc.
  • The component parts of the property can then be depreciated over varying lifetimes depending upon the classification they are segregated into. 
     

Why Do a Cost Segregation Study?
 

In our opinion, a cost segregation study is something that almost always should be done to ensure the real estate investor is depreciating the assets of the property over the proper lifetimes so they can take advantage of the optimal depreciation deduction available. 

For example, a property fixture might have a 7 year depreciable life, but without the cost segregation study that fixture is being incorrectly depreciated over 27.5 years instead. With a cost segregation study, the real estate investor is correcting the method for depreciating all of the applicable assets that make up the purchase price of the property. 

  • Accelerate the depreciation, or "paper deduction"
  • Time Value Money concept - the quicker the deduction can be utilized, the quicker the investor is going to be able to have more money to invest
    • The value of money that is not invested erodes over time due to inflation
    • Take the depreciation deduction sooner rather than later so money can be invested sooner


NOTE - Anomaly CPA is now offering Cost Segregation Services for Short Term Rentals and Properties up to $1,000,000!
 

Bonus Depreciation
 

The best part about cost segregation right now is that in 2022, 100% of the items in the 3, 5, 7, and 15 year improvement property classes can be written off now. In other words, once a cost segregation study has been done and the assets that make up the property are put into the different classes, the real estate investor can write the depreciation off today using a concept called bonus depreciation. The investor does not have to wait to take the depreciation over the requisite number of depreciable years, and instead can do it immediately using bonus depreciation.
 

Example: A real estate investor buys a $600,000 single family rental property.

 

Without a Cost Segregation:

  • The investor has to use straight line depreciation on the property.
    • Equates to a tax deduction of approximately $22,000 per year
  • No Cost Seg = $22k per year in deductions


 

With a Cost Segregation:

  • General rule of thumb is between 20% and 30% of the building basis will be available for 3, 5, 7, 15 year depreciation classes. 
  • The $600,000 property has $180,000 of depreciation and the investor can choose how to use it:
    • Use 100% of it as bonus depreciation (tax deduction) in the first year
    • Use it as accelerated depreciation over the 1 to 15 year classes
    • Unless there is a reason not to, our recommendation in most cases would be to choose to use the bonus depreciation.
  • Depending on real estate status or the particular real estate class of real estate being invested in, the investor MAYbe able to use the $180,000 against the active real estate business income, against other business income, or even against W2 income. 
    • This can be complex so Part 2 of the series will talk about this strategy  and what the considerations are.
      • Can a real estate investor accelerate depreciation and use it against other things?
      • If it is possible, the investor could get a cash return right away. 
  • WITH Cost Seg = $180k of "bonus" deductions possible in year 1  OR $180k over years 1-15 (accelerated)

 


 

Partial Asset Disposition Deduction
 

One other added benefit of cost segregation that is often overlooked is Partial Asset  Disposition (PAD).

  • PAD allows for items that have been segregated through a cost segregation study to be written off as they are taken out of service.
    • If an asset needs to be replaced, the old asset may still have depreciable life so the undepreciated cost can be written off.
    • The new asset will begin a new depreciable life span.
  • If a cost segregation was not done, the real estate investor could not take advantage of PAD. 
     

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