Real estate investors could be saving $50,000 to $1 million on federal income taxes this year, but most wont because they and their accountants overlook a relatively new issue called cost segregation or accelerated cost recovery.

Opportunities for cost segregation grew out of the 1997 court case allowing practitioners to support significant tax benefits related to depreciation of property. The court ruled that Investment Tax Credit rules should be used by the taxpayer to make asset classifications. Certain costs previously classified as subject to a 39-year depreciable life could instead be classified as personal property or land improvements, with a 5-, 7- or 15-year depreciation rate using accelerated methods.

Cost segregation involves separating up to 135 components of real estate that depreciate faster than the building itself. Identifying these depreciable items is often an involved process and should be done by a third party. The IRS allows taxpayers to use third-party cost segregation studies for the allocation of certain costs in a new building as either assets that qualify for the ITC (tangible personal property), or costs properly treated as part of structural building components. A real estate appraiser can accurately value and document 5-, 7- and 15-year depreciable items.

Effects of Higher Depreciation

Increasing depreciation offers two benefits: 1) It converts ordinary income into capital gains income; and 2) it defers income until a gain on the sale of the property. Because cost segregation reclassifies Section 1250 property (real property) as Section 1245 property (personal property), the subject of depreciation recapture should be considered. By and large, the effect of depreciation recapture on a Section 1245 property, identified in a cost segregation study, is nominal compared to the substantial reduction in ordinary income tax.

Correcting a depreciation schedule makes a difference if you recently sold a property because the additional depreciation will be taxed at the capital gains rate instead of the ordinary income rate. For example, assume an investor sold a property in late 2005, does a cost segregation study, and increases depreciation by $100,000. The net result is the ordinary income taxes will be reduced by $35,000 ($100,000 x 35 percent) and the capital gains taxes will be increased by $15,000 ($100,000 x 15 percent). This nets the owner $20,000 in federal tax savings by simply correcting an error in the depreciation schedule after the property sells.

Unfortunately, many accountants havent focused on this issue for several reasons. Some are aware of cost segregation as an option to increase depreciation and reduce federal taxes but mistakenly believe its very expensive (at least $10,000 per property) and is financially feasible only for large properties (more than $10 million). Other accountants may not even be familiar with this option.

Cost segregation clearly makes sense for properties with an improvement basis of at least $500,000, but even smaller properties can benefit. While accountants are becoming more aware of options for depreciating real estate, self-storage owners may need to take the lead role by educating their accountants.

While federal taxes may seem too complicated for storage owners to fully understand, this concept is simple: If you pay federal taxes and can use additional depreciation, you benefit from obtaining cost-segregation studies.

Adding It Up

The following example is for a facility purchased 10 years ago for $500,000. The value of the land is 10 percent$50,000. The analysis without cost segregation assumes all the value for improvements is placed on the building. Cost segregation estimates a value of $70,000 for the five-year property, $5,000 for the seven, $70,000 for 15, and $305,000 for the 39-year property.

Notice the first years savings without catch-up is $5,481, and tax savings for a building purchased 10 years ago including catch-up depreciation is $29, 570. Even without catch-up, the tax savings are substantially higher than a typical fee for a building this size. The results for the 10-year catch-up are truly compelling. Its hard to believe 99 percent of owners of $500,000 properties arent correctly setting up depreciation schedules.

Getting Started

Ask yourself the following questions when deciding if you can benefit from a cost segregation study:

Some self-storage owners are passive while others are active. If youre a passive investor you may not be able to use additional depreciation. On the other hand, if youre an active investor, youre entitled to deduct additional depreciation.

Call a cost-segregation expert and request a preliminary analysis, which will estimate the amount of a 5-, 7- and 15-year property. It will also identify the catch-up depreciation. It wont involve a site inspection or be precise, but should be accurate enough to help you decide whether a cost segregation study is financially feasible.

Once you obtain the preliminary analysis, you should consult your accountant, since hell be completing and signing your tax return. In many cases, it makes sense for the accountant, property owner and cost-segregation advisor to meet and discuss options jointly. Together you should decide if the extra depreciation should be used in the current or prior year, which would involve filing amended tax returns.

Correctly calculating real estate depreciation is important because it substantially reduces federal taxes for real estate investors. Dont be left in the dark: Let cost segregation work for your self-storage properties.

Patrick OConnor, a designated member of the Appraisal Institute, is president of OConnor & Associates. The firm, in business since 1974, specializes in real estate appraisals, research, and state and federal tax-reduction services nationwide. For more information, visit www.cutmyfederaltaxes.com.