Brian Borawski CPA, PC

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This is a twist on my New Forms series because while Schedule D (the form where you report capital gains) has changed, they’ve also modified Form 1099-B as well as added a new form.  First off, just by looking at the new Schedule D, you notice the form has changed quite a bit and there’s several references to a Form 8949.  No longer do you report the detail of the your capital gains and losses on Schedule D but you do it on Form 8949 and this information then flows into the more streamlined Schedule D.

And then this all ties into the revised Form 1099-B.  Now brokerage firms are required to report cost basis.  This is just one more way the IRS is cracking down on things.  Before, this information wasn’t reported to the IRS and it was left up to you to compute.  Since the IRS isn’t very trusting these days, cost basis is now being reported to the IRS so they can make sure you’re reporting the full extent of your gain.  On a good note, since everything is right there on the Form 1099-B, it’ll make filling out the form a little easier because you just drop the appropriate numbers into the right boxes.

Last week we talked about Schedule E and this week it’s Schedule C.  Yes, Schedule C has some changes and they look a lot like the changes on the new Schedule E.

First up is Lines I and J.  This is the IRS’ trap to get more Form 1099 compliance.  Be very careful how you answer these questions because if you have a large amount of expenses like professional fees and repairs, you could be opening yourself up to a notice or having the IRS take a second look at your return.

Also new is line 1a.    This is to report income from the new Form 1099-K that reports merchant card and third party payments.  If you take credit cards or use paypal, look for your 1099-K and this is where you’ll report that income.

Also new is line 27b.  Right now it’s reserved for future use.  I’m not sure where they’re going with that one so if someone knows, feel free to leave a comment.

That’s it.  These are the first changes to these forms in a while and it gives a pretty good indication of what the IRS is on the lookout for.  Their budget is being cut so they’re looking to 1099 compliance to help them out and they’re at least making taxpayers think about the 1099 issue by answering the questions.

For a tax professional, the beginning of year tax season is broken up into stages.  The one that not a lot of people know about (especially if they don’t own their business) is that first month of the year.  If you do payroll, W-2s have to go out as do 1099s.  If you’re small business (or a new CPA who’s never done 1099s before), here are a few tips to make things easier.

The first thing you should have been doing is collecting W-9s.  This form has been revised recently and it gives you all the information you need to both determine whether a company should be sent a 1099-MISC as well as all of the information to prepare the 1099-MISC.  Anytime you pick up a new vendor, it’s a good idea to get a W-9 from them.

Of course this is the end of the year so if you’ve gone an entire year without collecting 1099-MISC’s, it’s time to do some work.  You should reach out to all of your vendors asking them to fill out the form.  Some won’t send them back but others will especially the ones you’re still doing business with.

The next step is figuring out how much you paid each vendor.  If you’re using something like Quickbooks and you’re using it effectively, then this shouldn’t be a problem. Just print out a report of payments made to each vendor.  That’s the one thing you need (the amount paid) that isn’t on the W-9.

As far as preparing the forms, if you have Quickbooks, you can do 1099s within that program (you’ll need to buy forms from Intuit though).  I do some 1099s so I’m still using off the shelf forms from OfficeMax.  Within the forms package, you can get software that’s easy to use and best of all, if you use it from year to year, you can carry over the information from a prior year so you don’t need to replicate a lot of work.

One last suggestion, do something here.  If you haven’t kept up with your 1099s and five of your 50 vendors sent them back, go ahead and send those five a 1099.  Doing something is better then doing nothing.

It’s the end of the year and you want to move some money to your kids for estate tax planning purposes.  Or they just need a helping hand.  What can you do and what can’t you do and when do you have to file a dreaded gift tax return?  As always, these are general rules so be sure to talk to you adviser to discuss your personal situation.

Since 2009, the annual gift tax exemption has been $13,000.  That means you can give anyone a gift of up to $13,000 in a calendar year without filing a gift tax return.  Pretty straightforward but you can do even more if you’re married.  Since you can technically say that your spouse gave the same amount, if you’re married you can give up to $26,000.

To take this a step further, if you’re married and you’re gifting to your child that’s part of a family of four, you could give $26,000 per person, or $104,000, all without needing to do a gift tax return.

You can give gifts to your spouse without any gift tax implications so that’s one of the exclusions.  Also keep in mind, if you exceed the limit and have to file a return, you probably won’t have to pay tax because of the unified credit but once you start chewing into your unified credit, it could eventually affect how much your estate can shield from taxes.

For more information, be sure to check out Publication 950.

Here’s a great story by The Tax Guy about how you can deduct some or even all of the costs incurred in going into some retirement homes. The story talks about the specifics of Continuing Care Retirement Communities and how they qualify for the medical expense deduction.  There’s even a great example in the story.

Sometime, common sense prevails.  In this interesting WSJ article, Jan Van Dussen took on the IRS and while it wasn’t a total victory, the merits of her case prevailed.  She incurred thousands of dollars in personal expenses to take and care for stray cats at her home and when she tried to deduct them, the IRS eventually came and said they were personal in nature.  Tax Court disagreed and said that most of the expenses were deductible as “unreimbursed expenses incurred to help a charitable group in its mission.”

The primary reason she didn’t get all of her deductions was because she didn’t get a letter from the charity acknowledging the fact she provided more the $250 to the charity.

One of my favorite places to get tax information is Taxgirl. I mean this as a compliment but she’s not your typical tax attorney.  She can take an issue and break it down and write about it in an easy to understand way.  It’s a daily read of mine.

Her latest piece is on charitable organizations.  Yesterday, the IRS took away the tax exempt status of around 275,000 organizations because they failed to file their returns.  She talks about how the rules changed in 2006 for smaller charities and that with three years of missed returns, a lot of organizations find themselves in hot water.  She also recommends that you check out the IRS website and in a week or two, Publication 78 because that will show you which organizations lost their status so you can make sure the charities you give to are still considered charitable organizations for tax purposes.

A while back, I wrote a column for the Oakland County Real Estate Investors Association on cost segregation studies, or the abbreviated cost seg studies.  Here’s that column in its entirety.

Get More Money Out of Your Real Estate Investment by using a Cost Segregation Study

“Accounting and tax rules allow me to depreciate my property, which means I am making money but it looks like I am losing money, I am making money because I am legally allowed to pay less in taxes, So this is money coming in because less money is paid out in taxes. It is also known as phantom cash flow.” Robert Kiyosaki, The Real Book of Real Estate

“In recent years, increasing numbers of taxpayers have submitted either original tax returns or claims for refund with depreciation deductions based on cost segregation studies. The underlying incentive for preparing these studies for federal income tax purposes is the significant tax benefits derived from utilizing shorter recovery periods and accelerated depreciation methods for computing depreciation deductions.” Internal Revenue Service Cost Segregation Audit Technique Guide

There are several tax advantages to rental real estate but near the top of the list is the ability to depreciate the purchase price of your investment and utilize that as a tax deduction each and every year. The current rules allow you to depreciate residential rental real estate over 27 ½ years so if you bought a house for $100,000 and do the standard allocation of 80% going to the house and 20% going to the land, you end up with nearly $3,000 in tax deductions each and every year. In a lot of cases, this can turn an investment with a marginally positive cash flow into a tax loss allowing you to escape paying taxes. Even better, it’s not like a typical expense, such as interest expense, where money is coming out of your pocket. As Robert Kiyosaki described in his quote, it’s like phantom cash flow. With that, it can’t get much better then that, can it?

Actually it can. By utilizing what’s commonly referred to as a cost segregation study, you can significantly narrow the window used to depreciate your investment. While you’re robbing the future to pay for the present, in a lot of cases you’re giving yourself tax deductions in the current year that you might be not be able to normally utilize until over 20 years in the future. We all know that a dollar in our pocket now is worth more then a dollar 20 or 30 years from now so let’s take a look at how this is done.

What Is a Cost Segregation Study?

When depreciating both real and personal property, it’s necessary to classify each asset so a useful life has been determined. Computers are depreciated over five years while non-residential real estate is depreciated over 39 years. The shorter the useful life, the better the depreciation deduction is in the early years of the asset. Sometimes, you can’t break down each and every asset (like for a house), so the Internal Revenue Service let’s you use estimates to segregate or allocate costs to various buckets of assets. A house or apartment building consists of a structure, but there’s also wiring, personal property (cabinets and lighting fixtures as an example) and even furniture. This allocation estimate is what a cost segregation study provides for you.

Who Performs Cost Segregation Studies?
There are no requirements to do cost segregation studies but in my experience, the best combination is to have a certified public accountant (CPA) and an engineer work together. This way, you have both the tax side (CPA) and the structural/construction side covered. A CPA could do a cost segregation study by himself but without the proper experience that an engineer could bring to the table, things usually get missed. Of course an engineer could do it by himself, but they usually lack the necessary tax knowledge to fully take advantage of the study. In addition, a cost segregation study that doesn’t utilize an engineer is usually going to be more closely scrutinized by the IRS if there’s an audit because a CPA isn’t a construction expert.

When’s the Best Time to do a Cost Segregation Study?

The best time to do a cost segregation study is when you buy the property. It’s a lot easier to do it on day one when all of the paperwork is fresh and the CPA and engineer can get in there before any work is done on the house. It also establishes all of the useful lives associated with property on day one and doesn’t require any additional paperwork.

What if I bought my a rental property five years ago? Can I still do a cost segregation study?

You can still do a cost segregation study if you have a house that you bought several years ago although the benefit could diminish over time. There is additional paperwork because you have to provide the Internal Revenue Service documentation to show them you’re changing your method of account. This involves filing Form 3115 (Application for Change in Method of Accounting). The good news is, for cost segregation studies, the change in method of accounting is automatic (some changes need IRS approval) and you also get to take advantage of the depreciation benefits entirely in the year that you apply for the accounting method change.

How Much Money Can I Save by Doing a Cost Segregation Study?

The short answer is there will be no savings, at least over the useful life of the asset. If you have a $100,000 depreciable asset, the total depreciation expense will be $100,000 over its useful life. What a cost segregation study can do is give you more of your depreciation deductions now so you have more money to put to use here in years one through five rather in year 20 or year 28.

Here are a few simple examples of what a cost segregation study can accomplish (note: I have spreadsheets that provide more detail on the numbers I’ve provided. These are available upon request by emailing brian@briancpa.com).

Example 1 – Assume you buy a rental property for $100,000. A quick and easy calculation has 80% going to the building ($80,000) and 20% going to the land ($20,000). Say you bring in a cost segregation study expert and he’s able to determine that 15% ($15,000) should actually go to the land, 50% ($50,000) should go to the building, 15% ($15,000) should go towards land improvements and then 20% ($20,000) should go towards what’s called distributive trade or service property (these are items like wiring, lighting fixtures and personal property). In the first five years, this would result in an increase of $19,545 in depreciation expense when you use the cost segregation study versus a traditional allocation.

Example 2 – Assume you buy an apartment building for $500,000. A traditional allocation would have 20% ($100,000) going towards land and 80% ($400,000) going towards the buildings. With a cost segregation study, you might get 17% ($85,000) going to land, 56% ($280,000) going towards the building, 10% going towards land improvements ($50,000) and 17% ($85,000) going towards distributive trade or service property. This would give you an increase of $79,128 in depreciation expense when you utilize the cost segregation study.

This sounds great, but how much money am I going to save?

This is where I get to hedge with my favorite answer, “it depends.” If you can use all of the extra depreciation deductions and you’re in a high tax brackets, example 2 could save you in excess of $30,000 in the first five years. On the other hand, if the extra deductions put you in a loss situation and you can’t take advantage of those losses because you fall under the passive activity rules, it might not benefit you at all. As always, you should consult with your personal tax advisor as to whether a cost segregation study is good for you.

This sounds fishy. What is the IRS going to do if you do a cost segregation study?

The IRS not only acknowledges that cost segregation studies are valid, but they also told everyone how they’re going to audit them. If your cost segregation expert knows what he’s doing, he’s read the IRS’ cost segregation study audit technique guide to know exactly what the hot spots are and how to protect the client as much as they possibly can.

In Conclusion

Cost segregation studies aren’t for everyone, but if you buy and hold real estate, whenever you buy a property you should at be thinking about doing a cost segregation study. I know some cost segregation study experts will analyze the property to see whether you’ll benefit or not before they even do the work so finding someone who will give you a quick review would limit your risk. Cost segregation studies are just one of the many tools that a real estate investor can keep in their tax planning toolbox.