Cost segregation analysis when purchasing your medical office

We interrupt our regularly scheduled programming to talk about the benefits vs disadvantages of owning your office rather than renting it.

One advantage often touted is the ability to take lots of deductions up front for the building. You will need to pay the IRS back for the deductions (unless you reset the basis on death, more later) but you do get the time value of money.

Someone asked:

Has anyone paid for this service?  My CPA introduced me to an engineering firm that provides this service.  Their cost is $5,000.  With their analysis,  I can depreciate the cost of my building over a 5, 7 or 15 year period rather than the standard 39 years.  I really don’t understand it but supposedly I can save over $50,000 on taxes from their engineering analysis.  If true, is $5,000 a reasonable fee?

Here’s the answer:

nutshell:  your accountant is right. By separating the value of the entire property into components such as fixtures, carpets, carpeting, wiring, plumbing, appliances etc which have a shorter depreciation life (5-15 years), you can increase the amount you depreciate in the next few years which creates a bigger tax break while your income is high (you’re in a high bracket).

Usually this works in your favor, even considering when you sell the building the depreciation is recaptured- there’s no such thing as a free lunch.

The cost of $5000 is less than the $10-20k I find online for commercial properties although for residential properties they have online calculators which cost a few hundred bucks.

In detail: if you lease out a personal residence to a tenant, you depreciate the price of your property per year (minus land, which is typically 10-20% so for a $400,000 house the property is worth $340,000). For personal property the depreciation is over 27.5 years, for commercial property 39 years.

So for the example I give above for the $400k house, every year you rent it you get $340/27.5= $12,363 which you don’t pay taxes on. So any rents paid to you, you’d subtract the $12,363 depreciation plus property tax, maintenance, etc. You’d pay taxes at ordinary rates (or take loss) on the difference.

You get a immediate tax break of $12,363 for depreciation in this case. If you’re in the highest bracket that’s about $5000 back in your pocket every year!

Sounds good, but when you sell the house the depreciation is recaptured. So after five years you took $61,500 depreciation- but when you sell you pay it back at a special rate (section 1250) of 25% (so you’d owe about $15,000 back to the IRS, plus capital gains for any amount the price of the home went up.

For commercial property- say your place costs $700,000. At 39 years for depreciation, you’d be taking $700k divided by 39 or $18000 per year. At the highest bracket that’s only $7200 in tax savings.

Cost segregation allows you to take more of the depreciation sooner. By separating the property into components such as carpeting, flooring, wiring etc that have a shorter depreciable life, you get a tax break sooner- which helps your cash flow, if you invested the money you’d typically come out ahead rather than letting the IRS hold onto it!

(Continued below)

For example, if $80,000 of the $700,000 property is for the above (plumbing, carpet etc), you would take the remaining $620,000 over 39 years, but for the $80,000 you could section 179 it- if your practice income is over $530k and the $80k is depreciated over the highest bracket, that’s an immediate $32,000 back in your pocket plus another $6500 (from the property over 39 years) back in your pocket!  Or if you use MARCS depreciation over five years it would be about another $6000 per year ($32k divided by five) in your pocket.

So this works well if you’re in a high tax bracket and will be the next five years. If you aren’t, I don’t totally understand but read in year 3 or 4 you can “go back” and get a big depreciation in one year.

I’m wondering what percent of your property is segregated- obviously this affects whether it is cost effective to pay the $5000 or whatever for the engineering study.

One disadvantage of doing this is when you sell the segregated costs (wiring, carpeting, flooring etc) if you expect to get any value you paid for it it’s taxed at regular rates which depending on your bracket could be 39.5% rather than the section 1250 special rate of 25%. But if it’s over a long timeframe you’ll come out ahead with proper investing etc.

Personally, I wouldn’t buy a property, commercial or residential, just for this tax break. But if you are buying a property, might as well take advantage of it!

I plan to retire early so wouldn’t be in any building too long, and don’t want to deal with selling a building. My own opinion is real estate, commercial or residential just creates headaches and extra work.

As I said, profits from real estate are taxed at the regular rate or 25% rate rather than the more favorable capital gains rates (15, 18.3 or 23.8% for stocks). Diversification is another issue- in my viewpoint less risk with a REIT in which multiple properties are owned, rather than one individual property.

But to each their own… good luck to those of you who have chosen this route.

Two things about deferring or avoiding taxes with real estate:

1. 1031 exchange- when you sell a residential or commercial property if you purchase another property then you don’t have to immediately pay depreciation recapture (25% tax on anything depreciated while you owned the property) as well as capital gains. It gets rolled into your next property. Once you sell the second property then you’d be responsible for ALL taxes. So it only defers taxes, not avoids them.

BUT- there may be a loophole due to sale of personal residence free of gains if you’ve lived there 2 of last 5 years. If you have a big increase in value of the property, you can find a personal residence when you sell your business property that’s of equal value, buy it and rent it out for a few years. Then move in, if you live at least 2 of last 5 years then $500,000 of capital gains is excluded- but you’d still pay the 25% depreciation recapture under section 1251.

This works well if the value of your property has shot up. But if it’s about the same probably not worth the hassle.

2. Capital basis step up at death- say you own your practice building for 26 years and depreciate 2/3 of it. And say the value has went up $100,000, then unfortunately if you pass away, at least you can leave the building to your heirs, they can resell it immediately- without paying depreciation recapture or capital gains!  This is also true for stocks, mutual funds, gold, etc.

However, if you’re unhappy with your real estate investment for whatever reason (typically the slow growth of real estate barely beats inflation, compared to stocks) and want out it may make sense to pay up the taxes.

Leave a Reply