Tax Deductions For Real Estate Investments

Changing Tax Codes Make Real Estate Investments the Most Viable Investment – No Other Investment in the U.S. Comes Close

When it comes to making any sort of investment, it’s important to do your research to find the most viable option for you and your money. But what is the best way to vet your choices? The best place to start is by asking some questions to help narrow down the most profitable options:

  • Which investments are eligible for 100 percent expensing?
  • Which investments can be expensed at an accelerated rate due to very favorable tax codes?
  • Which investments have a low buy-in basis?
  • Which investments have a low capital rate?

To help you get started, we’ll answer these questions for you. Here’s a hint: the answers to the above are NOT:

  • The Stock Market: We’ve all been educated to know that stocks were the safest bet for long-term appreciation, so they’re the safest bet overall right? Unfortunately the past few decades have demonstrated that the only thing we can anticipate about stocks is that they are a high-risk proposition at best. The stock market is more and more like Las Vegas for investors – in more cases than not, the house wins.. And in recent times, we as a country have been left to bail out those (the house) who have deceived the common investor. Blackjack is suddenly becoming a safer bet than highly rated mutual funds.
  • Government Securities: One word – Detroit. Now will the dominoes continue to fall? Very likely.
  • CDs: Inflation has now outpaced average bank rates, including the free toaster, which you now pay for through you bank fees. So much for the “free” toaster..

So if the tried and true suggestions aren’t viable investment options, what is the answer? More and more it seems to be investment real estate.

Why? Let’s look at it from an expense standpoint first. Real estate is the only investment you get to expense dollar for dollar. If you buy a million dollar property, the government allows you to expense a million dollars. There is no other investment in the United States where you are allowed to expense every single dollar you invest. Perhaps you wrote off your (capital loss, not dollar for dollar loss) stock because it became valueless. Called capitol loss, you recoup some money, but it’s not a straight dollar for dollar recapture. Many investors have experienced that scenario, thinking capitol loss will help them out, only to realize they aren’t getting nearly as much as they anticipated. Reaching back to our Vegas analogy, in this instance, the broker has become the dealer, they take the commission and the house wins. But this is not the case with real estate. When investing in real estate, you have considerably more control over your destiny and can reap some amazing tax benefits associated with such an investment.

How did real estate become such a great tax investment? In 1999, the IRS issued a new memorandum allowing taxpayers to segregate various building costs into shorter depreciable lives. This was combined with an additional memorandum which dictated that personal property such as furniture, fixtures and equipment should be depreciated over a five year recovery period and not seven years, as included in the instructions for Federal Form 4562 “Depreciation and Amortization.” What does this mean to an investor? Not only do real estate investors get to expense their investment – they get to accelerate the expenses quickly to generate greater and immediate tax deferrals.

Now that we have your attention, let's get to the how these memorandums can help you today. These memorandums were significant to all real estate investors because the structure of a building does not only consist of the walls and roof and some interior rooms, but such other items as land improvements (storm sewers, curbs and sidewalks, parking lots, swimming pools, landscaping, etc.) and personal property (flooring, interior finishes, decorative lighting, kitchens, interior glass, electrical wiring for appliances, etc.) All of these can now be taken into consideration for tax purposes.

While a property's structure is subject to a 39-year recovery period, land improvements qualify for a 15-year recovery period and personal property qualifies for a five-year recovery period. The IRS allows for owners through the process of a Cost Segregation Study to identify land improvements and personal property, which can be separately depreciated over the shorter recovery period. A building will typically yield 25 to 35 percent of the total costs that can be segregated into land improvements and personal property. This can translate to major tax savings for savvy real estate investors.

Once a taxpayer files two federal income tax returns using a specific depreciable or non-depreciable life for a particular asset, an accounting method has been adopted for that asset for federal income tax purposes. Prior to the issuance of Rev. Proc. 96-31 – the predecessor of Rev. Proc. 97-37, Rev. Proc. 98-60 and now Rev. Proc. 99-49 – there was no procedure for an automatic change of accounting method for an asset that erroneously was being depreciated over too long a life or not depreciated at all.

Since depreciation is a non-cash flow item, application of this Revenue Ruling could provide a significant impact on a tax return. For example, a substantial tax benefit is achieved in the case where depreciation has not been taken on a building constructed for $8,000,000 with eligible improvements of $2,000,000 placed in service on January 1, 2000. The cumulative depreciation of $1,114,200 that was previously overlooked can now be deducted in the first year of change. Additionally, the balance of the depreciable assets continues to be depreciated over the remaining life. With the depreciation deductions over the remaining useful life, an investor is provided an after tax present value benefit of $600,000.

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. Rev. Proc. 99-49 provides that a taxpayer may file for an automatic change of accounting method for an asset for which depreciation was not taken, or for which depreciation claimed was less than the allowable amount. The amount of “missed depreciation” from the date the asset was placed in service (the Section 481(a) adjustment) can be deducted in the first year of change.

The benefits of this procedure were solidified by the U.S. Tax Court decision in Hospital Corporation of America (HCA) v. Commissioner, 109 T.C. 21 (1997). In a pro-taxpayer decision, the Tax Court narrowly defined what is considered “real property” for income tax purposes, clearing the way for many tax benefits for real estate investors.

On top of that, the Federal Government passed the Energy Policy Act in 2005 (code section 179D) that allows property owners even further tax deductions. The tax benefits are quite simple to understand. When a new property is constructed or an existing property is renovated post January 1, 2006, the property owners are eligible for significant federal tax deductions when they install new energy efficient lighting, HVAC and/or systems put into the building envelope such as a roof, new insulation, roof coating and windows. These incentives were developed by Congress in 2005 to encourage property owners to invest in energy efficiencies in hopes of reducing energy demand in the U.S. The IRS requires an independent energy study by a licensed engineering firm to ensure proper compliance for qualifying. The great fact about this tax benefit is that the IRS allows investors to go back and apply for and receive refunds for these types of renovations or new construction completed since 2006.

A further federal tax benefit “gift” was established recently to help property investors generate even greater ROI on their investment properties. The newly quantified IRS benefits revolve around the “Repair and Maintenance” of investments. Congress recently created more favorable taxpayer rules (code section 263a) that allow property owners to use the cost segregation studies to immediately expense certain renovations and expense components of the property. These benefits were not previously afforded to property owners and investors. Due to these tax code changes, the IRS now allows these significant benefits, which further add to cash flow preservation – great news for real estate investors.

The bottom line is that it can be a really great time to invest in commercial properties that could afford you significant tax benefits not found in any other investment vehicle. Additionally, if you already own property, you could be eligible to retroactively receive the tax benefits today. You may have money sitting in the walls of your properties that could be better used in many ways…like to pay for a trip to Vegas!

About ETS:
ETS is a licensed engineering tax firm that brings real estate engineering tax services to mainstream property owners. They work with them and their CPAs, at no cost, to initially conduct an analysis to determine the tax benefits/refunds.

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