Real estate investments offer great potential, but taxes can get complicated, especially when you buy property from someone you know. You may have heard about “related party limitations” and wondered if they prevent you from taking advantage of cost segregation. Don't worry—cost segregation can still significantly reduce your tax bill, even for related party purchases. Let's unpack how this tax strategy works in your situation.
What Makes Something a Related-Party Transaction?
The IRS has guidelines for related party transactions to make sure taxes are fair and accurate. Their aim is to prevent anyone from taking unfair tax breaks by artificially changing property values.
Here's who the IRS considers a related party:
- Family: This includes your spouse, children, siblings, parents, grandparents and even in-laws.
- Businesses: This covers any company you have significant control over (usually owning 50% or more), including corporations, partnerships and S corporations.
- Specific trusts and partnerships: Rules here get more complex because it depends on how much ownership or control you have.
The important thing to know is that these rules are about preventing abuse, not stopping you from doing business with people you know. However, you'll need to pay extra attention to the tax side of any related party property deals.
What Are the Limitations on Related-Party Transactions?
While buying property from someone you know is allowed, the IRS does have some rules to protect against tax manipulation. Here are the key things real estate investors need to keep in mind.
Bonus Depreciation
This tax break allows you to take an immediate deduction of a significant portion of a property's cost. However, for property acquired from a related party, you cannot claim the full bonus depreciation deduction. This prevents inflated prices being used for bigger deductions.
Loss Disallowance
When you sell a depreciated property at a loss, you can typically deduct that loss on your tax return. However, this is not the case for related-party transactions. The loss disallowance rule stops you from selling a depreciated property to a relative for a low price just to get a tax break.
Matching Rule
This applies to deductions for interest and certain expenses paid to a related party. For the deduction to be claimed, the related party must also include the corresponding income on their tax return. This prevents situations where someone might artificially inflate interest rates paid to a related party to create a tax deduction.
Additional Restrictions
These are just the major restrictions, and tax law gets complex. There may be other rules in your situation. Always consult a tax professional to make sure you're handling your related party transactions correctly.
How Can You Claim Tax Deductions on Related-Party Property?
Although there are limitations on certain tax breaks with related party properties, this doesn’t mean cost segregation is useless. Think of your building as a collection of individual parts, each with its own lifespan. Instead of depreciating the entire building over a long period (27.5 years for residential, 39 years for commercial), a cost segregation study lets you shorten the depreciation timelines for many of the property’s components.
This means you might be able to accelerate deductions for:
HVAC systems
Electrical wiring and fixtures
Plumbing
Roof components
Landscaping improvements
The IRS understands that certain components of a property will wear out much sooner than 27.5 or 39 years, so they allow you to depreciate them quicker. This can net you much larger deductions in the early years of ownership.
What Are the Benefits of Cost Segregation?
The best thing about cost segregation is that those faster deductions mean real tax savings, no matter who you bought the property from. You can still get a major tax break in the short term by claiming bigger deductions early on. This lowers your current taxable income and your tax bill.
That extra cash from tax savings is powerful. You could use it for your next down payment, fund renovations that increase rent or even expand your investment portfolio. Ultimately, cost segregation helps you keep more of your money and put it towards your long-term financial goals.
Conclusion: Don't Miss Out on Cost Segregation Savings
Don't let related party restrictions deter you from pursuing significant tax advantages. Cost segregation could be one of your smartest investment decisions, offering the potential to lower your tax liability, improve cashflow and fuel your real estate investment strategy.
At Engineered Tax Services (ETS), we specialize in maximizing cost segregation benefits—even in cases of related-party transactions. Reach out today for a free benefit analysis to find out how much you could save!
