Cost Segregation Studies for Rental Real Estate

Introduction

Last week we discussed how Section 179 depreciation generates upfront cashflow for businesses by deducting the full cost of an asset in the year it is purchased. And while the tangible property we discussed had a useful life for tax purposes of 5 to 7 years, the life for residential rental real estate is far longer: 27.5 years.

For obvious reasons, owners of residential rental real estate are eager to utilize the tax benefit from their purchase more quickly. Cost segregation is a process of identifying assets that are personal property that can be depreciated more quickly than their corresponding real property. While residential rental buildings must be depreciated over 27.5 years, assets like wiring, flooring, plumbing, appliances, fixtures, and air conditioners can be depreciated in just 5 to 7 years.  By capturing depreciation earlier in the life of the property, owners can free up cash and use it for their operating and investment needs now.

Projected Tax Savings

The tax savings generated by a cost segregation study depend upon the price of the rental property. Typically, the higher the cost the property, the greater the benefit of a cost seg will be. For a $500,000 rental property, depreciation expense under the straight-line method would be just $13,940 in the first year. However, our in-house cost segregation method that classifies assets and utilizes bonus depreciation yields a depreciation expense of $168,364—a difference of over $150,000.

If the tax loss on the rental is limited due to your income level, the loss will carry forward into future years. That means that you could earn money from your rental property for years before paying income taxes on it.

Impact of the TCJA

Changes to the tax law in the Tax Cuts and Jobs Act of 2017 fueled the efficacy of cost segregation studies. For certain assets, bonus depreciation was increased from 50% of the cost of the asset to 100%. Therefore, the cost of many building fixtures can be completely depreciated in the first year.

The 100% deduction for bonus depreciation applies to property acquired and placed in service after September 27, 2017, and before January 1, 2023. Beginning in 2023, the rate of bonus depreciation will be gradually phased out, unless Congress passes a law to extend it.

Conclusion

If you invest in real estate, we encourage you to schedule a consultation to discuss your most tax-efficient option. We can assist with the allocation of real assets and personal property, and we have contacts for cost segregation firms for very large projects. We ask that clients provide a copy of the settlement statement from the purchase of their rental property.

To schedule your appointment, call our office at 480-392-6801.

U.S. Energy Investments

Overview

While many potential tax saving strategies are limited to business owners, oil and gas deductions can benefit high-earning W-2 employees as well. Energy investments avoid the phased-out deductions for real estate losses that investors face between $100,000 and $150,000 in income. These investments offer large tax deductions in the first year followed by attractive returns in future years.

Upfront Tax Savings

Large deductions in the first year of investment provide immediate tax benefits. Intangible Drilling Costs (IDCs) are the expenses to develop an oil or gas well that are not a part of the final operating well. With an upfront investment of $100,000, a typical investor would receive $70,000 in IDC deductions in the first year. Furthermore, they would also receive a deduction of about $5,000 in the first year for depreciation of tangible equipment.

Future Returns

The deduction for depreciation of equipment is an estimated $5,000 per year for 7 years. Earnings on investments are estimated at 8.3%, and oil and gas fields generally have a lifespan ranging from 15 to 30 years. These investments are located on U.S. soil which increases the nation’s energy independence and protects the stability of the investment.

Next Steps

The best way to utilize the tax savings in oil and gas is to become a direct investor. We recommend investing with the U.S. Energy Development Corporation as a General Partner. For more information, contact K&R’s in-house financial advisor Rick Montgomery at [email protected].

Overview of the Inflation Reduction Act of 2022

Background

The Inflation Reduction Act that was signed into law in August is a remnant of the “Build Back Better Plan.” The original $6 trillion dollar proposal was supported by President Biden and essentially comprised his domestic agenda. While most of the original proposal died in legislation, a very limited portion of the plan was passed in the bipartisan Infrastructure Investment and Jobs Act.

Unlike the Infrastructure Investment and Jobs Act, the Inflation Reduction Act passed much more narrowly with a 220-207 vote in the house. In the Senate, Vice President Kamala Harris cast a tiebreaker in the final 51-50 vote.

The focus of the resurrected proposal was likewise narrow: investment in green initiatives and healthcare. What does this bill mean for American Taxpayers?

 

Key Provisions

Residential Energy Credits

Residential Energy Credits that were set to expire have been extended for 10 years to encourage investment in clean energy by American families. Congressional leaders hope that these incentives will reduce carbon emissions.

First, the credit for rooftop solar panels has been extended. Homeowners can also receive credits for making energy-efficient improvements to their homes. Qualifying projects include energy-efficient:

  • Water heaters
  • Heat pumps
  • HVAC systems
  • Windows
  • Doors

Starting in 2023, the credit for energy efficient residential improvements will be equal to 30% of the costs for all eligible home improvements made during the year. Furthermore, the $500 lifetime limit will be replaced by a $1,200 annual limit on the credit amount. To maximize tax savings, homeowners can time their qualifying home projects to claim the maximum credit each year.

Electric Vehicle Credits

Like the residential energy credits, electric vehicle credits are extended for 10 years. The credit applies to both new and used electric vehicles. One major change is the expansion of the credit from solely electric vehicles to any “clean vehicle” which includes hydrogen fuel cell cars.

Notably, the law limits the credit with caps on the taxpayer’s income and the retail sales price of the vehicle. The limits effectively exclude higher-priced luxury electric vehicles. On the other hand, the new law eliminates the 200,000-car cap for claiming the credit, which will allow manufacturers like Tesla, General Motors, and Toyota to qualify for the credit.

In addition, the law revived the tax credit for installing EV recharging equipment at personal residences. These residential and electric vehicle credits aim to incentivize taxpayers to reduce carbon emissions.

Healthcare

Beyond these “green”-focused credits, the Inflation Reduction Act also subsidizes healthcare initiatives. It extends premium reductions from the Affordable Care Act through 2025. Eligible individuals and families who purchase their health insurance through the federal Health Insurance Marketplace can continue to benefit from lower health care premiums, a policy that has been popular with taxpayers.

The Inflation Reduction Act also makes changes to Medicare prescription drug policies. First, it allows Medicare to negotiate the price of certain prescription drugs, bringing down the price beneficiaries will pay for their medications. In addition, Medicare recipients will have a $2,000 cap on annual out-of-pocket prescription drug costs, starting in 2025.

 

Funding the Bill

Since the environmental and healthcare programs in the bill will likely carry a high cost, taxpayers and experts alike have questioned how the act will be funded. Provisions include a 15% corporate minimum tax, an excise tax on stock repurchases, and, perhaps counterintuitively, an increase in IRS funding.

Corporate Minimum Tax

Media outlets have famously pointed out very large companies that pay very little in federal taxes—Amazon, Nike, and FedEx, just to name a few. Under the new law, large businesses with more than $1 billion in annual adjusted income will pay a minimum corporate tax rate of 15%. While there are significant differences in calculating income for tax purposes and income for financial statements, the corporate alternative minimum tax is based on financial statement income. Corporations will need to compute two separate calculations and pay the greater of the two.

Excise Tax on Stock Repurchases

A stock buyback occurs when a company that issues stock pays shareholders the market value per share to reacquire a portion of its ownership. Corporations might repurchase stocks for reasons including company consolidation, equity value increase, and looking more financially attractive. After December 31, 2022, covered corporations that repurchase stock will be subject to a 1% excise tax. This policy might incentivize corporations to return capital to shareholders through dividends rather than through stock repurchases, but it is unclear how companies will react.

IRS Funding

Over the next 10 years, the Inflation Reduction Act allots $80 billion of additional funding for the IRS. Proponents argue that the budget increases will allow the IRS to close the “tax gap.” The tax gap is the difference between what taxpayers owe in taxes and what they actually pay. Some estimates place the tax gap at $600 billion. Priorities will likely include increasing staffing levels and modernizing outdated processing systems. In the bill, $5 billion in spending is allotted for technology.

A Government Accountability Office report found that historically, lower-income taxpayers have faced higher-than-average IRS audit rates. 2021 data show that IRS audit rates for people with an annual income of less than $25,000 were five times higher than audit rates for high-income taxpayers. However, the Treasury Department has indicated that low or middle-income earners and small businesses will NOT be the focus of increased IRS enforcement activity.

 

Impact on Inflation

Despite the promising name, most experts suggest that the Inflation Reduction Act is unlikely to have an impact on inflation. The Penn Wharton Budget Model, a nonpartisan, research-based organization at the University of Pennsylvania, and the Congressional Budget Office, a federal agency that provides budget and economic information to Congress, are among the organizations that have expressed a lack of confidence in the legislation’s likelihood to lower inflation. While the opportunities for extended tax credits and lower healthcare costs are attractive to many taxpayers, the strain of inflation continues to weigh on American families.

Even faced with uncertain economic conditions, proactive tax planning can help taxpayers keep more of their income. If you have a question about qualifying for extended tax credits or want to explore strategies to lower your income tax burden, call our office at 480-392-6801.