Cost Segregation: Is This Strategy for You?

One of the biggest tax benefits of owning residential rental or non-residential commercial property is depreciation, which allows for deductions without additional spending. However, traditional depreciation schedules for real property are lengthy—27.5 years for residential rental properties and 39 years for non-residential properties—resulting in small annual deductions.

A strategy called cost segregation can accelerate depreciation deductions, especially during the early years of ownership. This technique involves identifying and separately depreciating elements of a property that are not classified as real property, such as:

• Land improvements, including landscaping, paved areas, swimming pools, and fences

• Personal property inside the building that is not a building component, such as appliances and carpeting in rental units

While cost segregation does not increase total depreciation, it front-loads deductions by utilizing shorter depreciation periods: five or seven years for personal property and 15 years for land improvements. Additionally, property owners can leverage bonus depreciation or Section 179 expensing to deduct most or all of these costs in the first year of ownership.

Conducting a cost segregation study is necessary to determine which building elements qualify. Studies are typically done by engineers or through less expensive but potentially less reliable methods. However, cost segregation may not be ideal in every situation, such as when passive loss limitations prevent immediate deductions or when a property owner intends to sell soon and faces depreciation recapture.

The optimal time to conduct a cost segregation study is the same year you purchase, build, or renovate a property, though it can be delayed until it provides the greatest tax benefit.

Tax Implications of Shutting Down a Sole Proprietorship

Closing a sole proprietorship or a single-member LLC taxed as a sole proprietorship carries significant tax implications. Consider the following key points:

1. Asset Sale Tax Implications – Selling a sole proprietorship means selling its assets, not the business itself. The sale price must be allocated among the assets, influencing taxable gains and losses.

2. Taxable Gain and Loss – A gain occurs when the sale price exceeds the asset’s tax basis, while a loss happens when the basis is higher than the sale price.

3. Special Rules for Depreciable Real Estate –

   • Section 1250 recapture: Additional depreciation is taxed as ordinary income.

   • Section 1231 gains: Treated as long-term capital gains if they exceed past losses.

   • Unrecaptured Section 1250 gain: Taxed at a maximum rate of 25%.

4. Other Depreciable or Amortizable Assets – Gains tied to depreciation are taxed at ordinary rates, while those held over a year may qualify for lower long-term capital gains rates.

5. Non-Compete Agreement Payments – These payments are ordinary income but not subject to self-employment tax.

6. Tax-Saving Strategies – Allocate more of the sale price to assets generating lower-taxed capital gains.

7. Tax Return Reporting – Use IRS Forms 4797, Schedule D, 8594, and 8960 (if applicable) to report the sale and gains.

8. State Income Tax – Be aware that state tax may apply to the sale.

Careful planning and accurate reporting can optimize tax outcomes when shutting down a sole proprietorship.

Limited Partners and Self-Employment Taxes

Self-employment taxes can be costly, leading many to seek strategies to minimize them. While S corporations allow owners to avoid self-employment tax on distributions (though not on reasonable salaries), partnerships present different challenges.

In a general partnership, all partners pay self-employment tax on their share of business income. However, limited partners traditionally do not, since they are considered passive investors. Some states even allow limited partners to work in the business while retaining their limited liability status.

Could this loophole allow working limited partners to avoid self-employment tax? A recent U.S. Tax Court ruling in Soroban suggests otherwise. The court held that only truly passive limited partners qualify for the self-employment tax exception, excluding those actively engaged in the business.

This ruling follows other IRS victories on similar issues involving state limited liability partnerships, LLCs taxed as partnerships, and professional LLCs. In response, the IRS is drafting regulations requiring a functional analysis of whether a partner qualifies as limited. Increased IRS audits of limited partnerships on self-employment tax issues are also expected.

Given the IRS’s aggressive stance, business owners using partnership structures should carefully evaluate their tax positions and seek professional guidance to avoid potential pitfalls.