Tax benefits of Owing Property

Tax tips and tax help to assist taxpayers by describing options for tax reduction and tax cuts through lawful tax deductions.

Income taxes are too high. However, real estate investors have found many options to reduce the level of federal income taxes. Congress has provided a number of income tax benefits for real estate investment. These include depreciation, cost segregation, tax-free exchanges (1031 exchanges), casualty losses and capital gains treatment.

Real estate investors who utilize these income tax benefits are able to reduce or even eliminate federal income taxes. Tax reduction reduces the risk endured by real estate investors since they have more liquid capital.

Income taxes are calculated based on taxable income. Taxable income is calculated by deducting allowable expenses from revenue/income. The amount of revenue for real estate investors is generally a fixed number.

There may be modest variances for cash basis versus accrual basis. However, it is typically difficult to materially modify the level of revenue. However, there are many options for judgment in calculating expenses.

These include whether or not to capitalize or expense repairs, the level of debt and interest, and depreciation. The resultant tax cut can be substantial.
Depreciation is a non-cash expense which increases total expenses and reduces taxable income.

Real estate depreciation is based on the concept that improvements to land physically deteriorate overtime. Real estate owners are allowed to depreciate a portion of the cost basis to account for this physical depreciation. (In reality, the market value of improvements typically appreciate in value over five or 10 years even though depreciation is recorded for accounting purposes.)

Real estate depreciation both defers and reduces federal income taxes. Depreciation defers income taxes from the time income is earned until the property is sold, or a gain from the property is recognized. (Real estate investors may defer recognizing the gain on the sale of property by utilizing a 1031 exchange.)

Depreciation reduces federal income taxes by converting the character of income from ordinary income to capital gains income. The maximum income tax rate for ordinary income is 35% while the maximum income tax rate for capital gains income is 15%. Although some depreciation is recaptured at a 25% rate, it is possible to have much of the income shielded by depreciation recaptured at 15%.

Furthermore, even if depreciation simply reduces the tax rate from 35% to 25%, and defers payment of taxes for a period of years, the savings are meaningful.
Cost segregation is a specialized service real estate investors use to maximize depreciation. Cost segregation is typically performed by real estate appraisers or engineers to fine tune the real estate depreciation schedule. Cost segregation identifies and quantifies up to 130 components which qualify for short-life depreciation.

The building structure is depreciated over 27.5 years (rental residential property) or 39 years (commercial property). Short-life property is typically depreciated over 5, 7 or 15 years. Obtaining a cost segregation report often allows real estate investors to allocate 20 to 40% of the cost basis to short-life depreciation. Shifting a significant portion of the cost basis from long-life components to short-life components can increase depreciation by 50% to 100% during the first five to seven years of ownership.