As a real estate investor, you likely understand the importance of maximizing your profits and minimizing your taxes. One way to do this is through cost segregation, a tax strategy that involves identifying and reclassifying certain building components as personal property rather than real property. This can significantly reduce your capital gains taxes when you sell a property.
To understand how cost segregation works, it’s important to first understand the difference between personal property and real property. Real property refers to land and anything permanently attached to it, such as buildings, fences, and permanent fixtures like plumbing and electrical systems. Personal property, on the other hand, refers to movable items that are not permanently attached to the land or building, such as furniture, appliances, and equipment.
When you sell a property, you are required to pay capital gains tax on the profit you make from the sale. The tax rate for capital gains varies depending on your income and the length of time you held the property, but it is typically lower than the tax rate for ordinary income. However, if you have made significant improvements to the property, such as adding a new wing or renovating the kitchen, the cost of those improvements can be added to the tax basis of the property, which reduces your capital gains.
This is where cost segregation comes in. By identifying and reclassifying certain building components as personal property, you can significantly reduce your tax basis and, in turn, your capital gains. For example, if you add a new wing to a property, the cost of the materials and labor used to build it can be added to the tax basis of the property. However, if you use cost segregation, you can reclassify certain components of the wing, such as the carpeting, paint, and light fixtures, as personal property, which means they can be depreciated over a shorter period of time. This can result in significant tax savings when you sell the property.
So, how do you go about using cost segregation to lower your capital gains?
The first step is to hire a qualified cost segregation specialist to conduct a detailed analysis of the property. The specialist will identify and reclassify certain building components as personal property, and provide you with a report detailing the potential tax savings.
Once you have the report, you can use it to negotiate with the Internal Revenue Service (IRS) to amend your tax returns for the years in which you owned the property. This process, called a cost segregation study, can be complex and time-consuming, but the potential tax savings can make it well worth the effort.
There are a few things to keep in mind when considering cost segregation. First, it is important to note that this strategy is not suitable for all properties. In general, it is most beneficial for properties that have undergone significant renovations or improvements, or for properties that were built within the past 20 years. Additionally, it is important to work with a qualified cost segregation specialist to ensure that your reclassifications are in line with IRS guidelines.
Another thing to consider is the timing of the cost segregation study. In general, it is most beneficial to conduct the study before you sell the property, as this will allow you to negotiate a lower tax basis with the IRS before you sell. However, it is possible to conduct a cost segregation study after you sell the property, but this can be more complex and may result in higher tax savings.
In summary, cost segregation is a powerful tax strategy that can significantly reduce your capital gains taxes when you sell a property. By reclassifying certain building components as personal property, you can reduce your tax basis and, in turn, your capital gains. If you’re interested in real estate investments, visit norfolkcapital.com or give us a call today to speak with one of our experts.