Arcane Income Tax Tip

Sam sold 2 commercial properties in June 2008 and was discussing tax planning with his CPA and cost segregation provider. The sales price for the properties was $5.2 million and $3.3 million. Sam had owned both properties for about 8 years. The cost segregation specialist estimated Sam could save more than $175,000 in 2008 income taxes. This would be accomplished by using cost segregation and "catching-up" previously under-reported depreciation.

Sam has passive income from oil and gas investments and from his real estate. Sam is in the property management business and is actively involved in managing his real estate investments. Sam's net income from his management company is about $400,000 per year. The fascinating question is, how does Sam reduce his income taxes by over $175,000 after he sold the properties?

Tax Rate Arbitrage Sam is benefiting from tax rate arbitrage. The income tax rate for Sam on ordinary income is 35%. His capital gains rate is 15%. Sam did not obtain a cost segregation study when he purchased the properties 8 years ago. Therefore, he has been reporting too little depreciation and unknowingly paying excessive income taxes. By claiming the depreciation on his 2008 tax return, he is able to use the additional ("catch-up") depreciation to reduce ordinary income, just as if he had claimed the depreciation during the prior 8-year period.

The preliminary cost segregation analysis indicated Sam had understated real estate depreciation during the prior 8-year period by $885,000. The tax rate arbitrage between ordinary income tax rate (35%) and the capital gains rate (15%) is 20%. Sam can reduce his 2008 income taxes by $177,000 ($885,000 times 20%) by claiming the depreciation not used in prior years. (Precisely correct calculations are more complex but the end result is very similar.)

What is Cost Segregation? Cost segregation is simply an accurate way to allocate the cost basis of real estate and establish a depreciation schedule. The real estate depreciation schedule is often established by allocating a portion of the cost basis to land and allocating the balance to a long term depreciation recovery period (27.5 or 39-yr straight-line depreciation). Cost segregation fine-tunes the depreciation schedule by identifying short-life items. These can generally be depreciated over 5, 7 or 15 years. In preparing a cost segregation report, an appraiser or engineer will visit the property and identify, quantify and evaluate the quality of various types of short-life property. After the site visit, the appraiser will literally establish a beginning cost basis for each of the short-life items, as of the acquisition date. In a typical engagement, there may be 35 to 50 types of short life property items depreciable 5, 7 or 15 years.

What are the Short-Life Items? Some of the common short life items are carpet, vinyl tile, blinds, landscaping, fencing and paving. Others, more unassuming, are underground utility infrastructure, storm sewage, specialized plumbing and electrical, etc.

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