Back to the Future: What if Marty McFly Had Been a Property Investor

In order to keep moving forward and appreciate where we are, you must look back occasionally and evaluate where we have been in years past.


 

Back to the Future with Real Estate Investors

Investors who owned real estate in 1999, specifically those who owned commercial properties, had a great year. Had Marty McFly been a property investor he would have time traveled to 1999 allowing him to take advantage of the April 1999 IRS legal memorandum. Why was 1999 significant for real estate investors and how could taking a look back affect your future?

In a strange but true “Back to the Future” paradox, a 1985 film starring Michael J. Fox and Christopher Lloyd was released. It’s “Strange” because the movie had nothing to do with cost segregation and “True” because had the events of the movie been written by a CPA, they would have undoubtedly proven a more applicable and profitable future for Marty as a property investor – the type of investor who finds purchasing hotels to be more than exciting enough on a daily basis.

In a strange but true “Back to the Future” paradox, a 1985 film starring Michael J. Fox and Christopher Lloyd was released. It’s “Strange” because the movie had nothing to do with cost segregation and “True” because had the events of the movie been written by a CPA, they would have undoubtedly proven a more applicable and profitable future for Marty as a property investor – the type of investor who finds purchasing hotels to be more than exciting enough on a daily basis.

As a property investor, Marty would have time traveled to 1999 in order to take advantage of the April 1999 IRS legal memorandum. The memorandum stated that taxpayers could segregate various building costs into shorter depreciable lives for tax purposes. In other words, personal property within a building and land improvements previously considered 39 or 27.5-year assets could finally be captured as 5 and 1 property via a cost segregation study. This memorandum was significant to all real estate investors because items like carpet clearly will not last 39 years. The structure of a building does not only consist of the walls, roof, and some interior rooms, but includes other items like land improvements (storm sewers, curbs and sidewalks, parking lots, swimming pools, landscaping, etc.) and personal property (flooring, interior finishes, decorative lighting, kitchens, interior glass and electrical wiring for appliances, etc.). It’s easy to see how these strategies serve as a powerful tax tool for property investors. For example, imagine that Marty decided to buy an apartment complex for $1.2M. These memorandums would have allowed Marty to capture $420,000 as 5 and 15-year property via a cost segregation study. With the increased cash flow, he would have had enough money to invest in additional apartment complexes.With 2016 tax planning just around the corner, like Marty, real estate owners should consider the benefits of cost segregation to free up their cash flow. The following will explain how you can take advantage of it while offering a few insider tips to get the most benefit.

As noted, a property's structure is generally subject to a 39-year recovery period while land improvements qualify for a 15-year recovery period and personal property qualifies for a 5-year recovery period. As a property investor, let's say you installed new flooring throughout your building. Every year, you can write that flooring off on your taxes until the end of its useful life. That period of time that the asset depreciates is considered the recovery period and the shorter the recovery period, the greater the reduction in tax liablity. Typically, a building will yield 25%-35% of the total costs that can be segregated into land improvements and personal property. You can become a savvy real estate investor by simply understanding this concept and how it can be used for future investments or repairs and maintenance on current investments.

A cost segregation study applies the correct recovery period to the building from the date it was placed in service. If the property owner has already filed two or more federal income tax returns using an incorrect method of depreciation, an Accounting Method Change can be applied to capture the missed depreciation. This “catch-up” in depreciation is realized in the current year, by means of a 481(a) adjustment calculation and an Accounting Method Change is reported on Form 3115 without the need to amend prior year tax filings. Rev. Proc. 87-56 provides the taxpayer with general depreciation guidelines for use in both a cost segregation study and/or Change of Accounting Method.

Since depreciation is a non-cash flow item, application of cost segregation could provide a significant impact on this years tax return. For example, a substantial tax benefit may be achieved by applying a cost segregation study to a residential rental building which was placed-in-service on 6/15/2010. With a purchase price of $10M (20% land; 80% structure) and an average allocation of 15% to 5-year class property and 10% to 15-year class property, the “catch up” in depreciation, taken in the current year as an “other deduction,” would be in the amount of $1,122,962.00 (see example below).

I think it is safe to say that all current and future property investments should consider the benefits of cost segregation. The April 1999 IRS legal memorandum and associated provisions have made cost segregation one of the most powerful tax strategies for real estate today. Realistically, all properties can benefit from a cost segregation study as long as they are investment properties because they are the only properties subject to depreciation. If you own an investment property, an engineering-based cost segregation study analysis can determine what the benefit will look like in order to ensure a study makes financial sense. As noted herein, the impact of the reclassification is usually significant when pursued properly.

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Engineered Tax Services

Engineered Tax Services

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