Brian Borawski CPA, PC

Archive for the ‘Real Estate’ Category

Many people feel that the two absolutes in life are death and taxes.  In my experience, if there’s something that comes to close to a third absolute it’s that you should never hold real estate within a structure that’s taxed as a corporation.  I can give you some examples of where it works out okay but still not as well as under a structure taxed as a partnership but I can give you a few different examples of where you can have some disastrous tax circumstances when holding real estate in a corporation.  The primary pair of reasons are basis rules and distribution rules.  As always, I’m keeping this simple so if you have a specific situation that applies to you, be sure to contact a professional.

Let’s say you get a great deal on a property.  You’re able to buy a $1 million piece of property for $500,000 and because of the great purchase price, you’re able to finance the entire $500,000 with  a bank loan.  Let’s take a look at what happens in two years when you try to distribute this piece of property out of your legal entity.

If you bought the property under an LLC that’s taxed as a partnership, you’d be in pretty good shape.  You’d probably (it would depend on the bank note) be able to pass through any losses from the partnership because your debt has given you basis.  In two years, if you distribute the property out of the LLC, it’s a tax free transaction and the property would come through with its basis and carrying period intact.

If you bought the property under a C-Corporation, you’d have a mess.  When you distribute property, it’s the same as if you sold it then distributed the proceeds so you’d have about a $500,000 gain that the C-Corporation would have to pay (plus any depreciation that you took in those two years).  On top of that, the distribution would be taxable to the shareholder at the value of the property or in this case, $1,000,000.  Those two layers of tax that will chew into that $500,000 in savings you picked up when you bought the property pretty quickly.

While not as bad as the C-Corporation example, if you had put it under a corporation that had made a Subchapter S election, you’d still have some tax to pay.  You wouldn’t have any basis in the corporation because the debt from the bank note isn’t eligible as basis.  You’d have the capital gains hit that would occur at the S-Corporation level (which would ultimately flow through to the owner’s personal return) but not the second layer of tax because the dividend would come through half tax free and half as a taxable S-Corp distribution because you’ve established some basis when the capital gain was taxed but not enough to cover the entire $1 million.

In short, putting into an LLC is pretty much a no lose situation.  Putting into a corporate structure, you could have a tax mess on your hands.  Be sure to discuss your personal situation with you tax adviser.

Yesterday I gave the ins and outs of cost segregation studies.  Today, I’m giving you some of the research resources attached to it.  One good place to start, if you don’t mind the investment is CCH’s U.S. Master Depreciation Guide (2011). This guide book will give you the ins and outs of the depreciation rules like nothing else will and it comes with CCH’s top notch explanations.

If you don’t want to spend the money, then I’d recommend Publication 535 which has a section on capitalizing assets in it.  I’d also highly recommend the Audit Technique Guide on Cost Segregation. Between those two things, you should have the tools to at least get started.

Whether you call them quickturns or flips, real estate investors who primarily rehab a property and then sell those properties rather quickly may fall into a trap.  If the IRS considers you a “dealer” then they basically consider you to be no different then a retailer.  Your houses are you inventory and the sales are your proceeds and more importantly, the gross margin is subject to self employment tax.

One easy way to get out some of the self-employment tax is to incorporate.  Whether it’s an S-Corporation or a C-Corporation, there is no self employment tax.  Of course then you have the complications that surround corporations including payroll and corporate entity maintenance.

There are some other factors the IRS may look at to determine whether you’re a dealer or not.  Here’s a good piece on some of the things the IRS considers.

I was recently on the Just Start Real Estate podcast sharing tax and business tips for new and prospective real estate investors.  You can check out the show notes here and you can download the podcast here. It was a lot of fun and if you have further questions (or you’re making your way here after listening to the podcast), feel free to leave a comment here.

Let’s start with a case study to set this up.  You live in the Detroit area so let’s assume a major sporting event is coming back to town like the U.S. Open and they’re holding it at Oakland Hills.  You’re lucky enough to own a home less than a mile away from the golf course and an international financier agrees to rent your house for an obscene amount of money to live in your house for the week.  You move into a local hotel and a week later, you move back into your house.  Tax time rolls around and now you’re worrying about how to report this on your taxes.

Fortunately, the answer is, you don’t have to do anything.  If you rent your home (or your vacation home) for less then 15 days, you don’t have to report it all.  There is no income limit so if someone was stupid enough to pay your$100,000 to rent your house for a week, you wouldn’t have to show it anywhere on your tax return.  The safe harbor period is two weeks. As long as you rent your home less than 15 days, then no reporting is required.

Things get a trickier if you rent your house for a longer period of time.  Then it’s a big proration exercise.  So if you spend $2,400 on property taxes that’s $200 a month and if you rent your house for the four winter months, then $800 would be reported as a rental expense and the rest would show up on Schedule A if you itemize.  This also creates some extra reporting when you sell your house because if you qualify for the principal residence exclusion, you’ll have to recapture and pay tax on any depreciation you took while renting out the house.

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.