4 Ways Real Estate Investors Avoid Overpaying Income Taxes

Until recently, there were pretty simple guidelines that determined whether to expense a cost or capitalize and depreciate it. For real estate investors, those days are over.

The bad news is that there are new, more complicated rules that the IRS requires you and your CPA to use when deciding whether to capitalize or expense. The good news is that the regulations contain several taxpayer-friendly features that enable property owners to expense many big-ticket items that, in the past, were normally capitalized.

For example, I’ve had several clients buy new roofs for their buildings and they were able to expense them instead of capitalizing them as they would have before these new regulations hit.

So this change is a boon for savvy investors who adopt these regulations because they can significantly increase cash flow.

What’s Changed?

In the past, accountants generally set dollar thresholds for expensing vs. capitalizing. If a costs were over a certain dollar amount, they advised capitalizing and depreciating it, otherwise, expense. Pretty straightforward.

Beginning in tax year 2014, the IRS introduced new regulations that provide a more complex framework for determining what may be expensed and what must be capitalized. There are several layers of decision logic to consider (see my infographic), although there are some “Safe Harbors” that give a “free pass” to expense costs in certain situations, including costs not exceeding a flat dollar amount. Above that amount, things get complicated.

The new regulations, called the Repair and Capitalization Regulations, are often nicknamed the “Tangible Property Regulations,” or “TPRs.” For real estate owners and investors, they are the biggest change in fixed asset accounting in many years.

What You Need to Know

I give an hour long continuing education course to CPAs on this topic, but I can give you a quick synopsis, and links for further reading if you want to dive deeper (and I encourage that because it’s important to avoid missing out on potentially large deductions).

  1. Any individual cost up to $2,500 per invoice or per item can be expensed. If you have the equivalent of audited financials the limit is $5,000.
  2. If a cost meets a very specific definition of “routine repair and maintenance” then it may be expensed. Fortunately, the definition covers quite a few real-life costs so this feature is useful.
  3. A new definition is given for what must always be capitalized, which include things such as “Betterments, Adaptations and Restorations.” These are common occurrences for building owners and operators. This definition will change things greatly for some property owners.
  4. There’s an exception for “Betterments” when the number of units or dollar amount do not exceed a certain threshold (typically 30% of something, too complex to explain here).
  5. Surprisingly, the IRS lets you mine your depreciation schedule for items booked as capital costs in the past that meet the tests in items 2 and 4, above. If they pass, you may write off their remaining tax basis as an expense in the current year. That’s a boon, and at my firm we’ve conducted studies to root out and write off many millions in costs of this type for clients.
  6. If you remove physical assets from your property, typically as a by-product of renovations, you can get “cash for trash” by writing off the remaining tax basis of retired or abandoned assets. Although some accountants have written off partial asset dispositions in the past, it was not always clear that this was allowed. The new regulations have created, for the first time, a clear mechanism to write off abandoned assets in a way that the IRS accepts. It does require some special paperwork, but the main challenge is coming up with acceptable costs for assets that are probably not broken out separately on the depreciation schedule.

Potentially Large Deductions

That situation, as well as others implied by the above rules, have created new uses for cost segregation studies. In essence the cost segregation study has become the tool to make use of the taxpayer-friendly features of these new regulations by providing data needed by accountants to document tax treatment of repair and maintenance costs, non-material additions and partial asset dispositions.

Not every property owner will benefit to this level, but one of my clients saved over $6 million in income taxes by hiring my firm to identify qualifying assets and help them justify the write-offs made available by these new regulations.

WHAT TO DO

Learn more by reading/watching the following, then contact Jeff for a complimentary benefit analysis:

thumb-download-unlocking-hidden-tax-benefits

PowerPoint Presentation

FREE REPORT: Unlocking Hidden Tax Benefits with Cost Segregation

WEBINAR: 4 Income Tax Crushers for Real Estate Investors

About the Author Jeff Glass

Jeff helps real estate owners increase their cash flow. He started his career as a Financial Analyst with the Irvine Company, and worked in various management/executive positions in the mortgage industry for many years. He's been a Cost Segregation consultant for several years and is considered one of the industry's top experts in TPRs. As Director of Business Development for Bedford Cost Segregation, Jeff helps his clients increase cash flow by accelerating their depreciation deductions, and by writing off assets that no longer need to be depreciated under recently changed tax rules. Jeff has a B.S. in Economics from Claremont McKenna College and an MBA with an emphasis in Finance from UC Berkeley.