Tax Reform Makes Cost Segregation Studies more Important than Ever for Real Estate Businesses by Joshua P. Heberling
The Tax Cuts and Jobs Act (TCJA) brings a broad range of potentially significant tax savings to individuals and businesses involved in the construction, acquisition and renovation of commercial real estate. Property developers, owners and investors seeking to leverage these benefits will need to engage in advance planning and put into place appropriate strategies and structures in order to maximize their savings opportunities. This is especially true when considering how cost segregation studies may complement the expanded depreciation deductions that the new law allows taxpayers to apply to their investments in newly constructed or acquired commercial property as well as renovations or improvements to existing properties.
Bonus Depreciation and Section 179 Property Expensing
One of the easiest ways that businesses can increase cash flow is to accelerate depreciation deductions for the wear and tear, deterioration, or obsolescence of property and equipment used for business or income-producing purposes. The faster a business can claim the deductions, the faster they can recover the basis, or purchase price, of that property.
There are two provisions in the TCJA that can expedite taxpayers’ recovery period and expand their ability to accelerate depreciation deductions for tangible property used in a trade or business, including, but not limited to, machinery, equipment, furniture, computers and off-the-shelf software.
Beginning in 2018, businesses may qualify for bonus depreciation and immediately write off 100 percent of the costs they incur for both new and used tangible business property purchased or financed after Sept. 27, 2017. It is important to point out that the new rules make used property eligible for bonus depreciation. Under the old rules, bonus depreciation was limited to new properties only. This has provided taxpayers with an expanded avenue for deduction acceleration when they plan accordingly. In addition, the law increases the amount that certain businesses may elect to deduct for qualifying new and used Section 179 property from $500,000 to $1 million, while also expanding the definition of qualifying property to include non-structural components attached to commercial buildings and improvements made to a building’s roof, air conditioning/heating, fire protection and security systems.
While both of these provisions can yield significant and immediate tax savings, there is another way for business taxpayers to recoup even more of a buildings’ value in a shorter period. Enter the cost segregation study.
Benefits of a Cost Segregation Study
Under U.S. tax laws, the depreciation period for a commercial building is typically 39 years, whereas personal property, including plumbing, lighting, electrical systems, machinery and other assets that cannot be removed from the building, can be depreciated in as little as five, seven and 15 years. In order to identify the parts of a building that may qualify as tangible personal property eligible for accelerated depreciation deductions, taxpayers must engage qualified professionals to conduct what is known as a cost segregation study.
Engineers involved in a cost segregation study will typically conduct a thorough and in-depth analysis of a building’s blueprints and site plans to break down all of the assets and costs involved with the construction, purchase or renovation of a property into separate components with different costs basis and recovery periods. Taxpayers may use the final report to document asset classification and substantiate to the IRS any claims they have to depreciate some of those assets over a shorter life than the building itself.
As an example, consider the benefits of a cost segregation study on a commercial rental building purchased for $975,000 in 2018 (net of purchase price allocated to land). Typically, a taxpayer in the highest tax bracket of 37 percent for 2018 would be able to depreciate the property straight line over 39 years for an annual depreciation deduction of $25,000. This yearly depreciation would provide the taxpayer with a reduction in his or her taxable income, which, in turn, would reduce his or her tax liabilities by an estimated $9,250 in 2018.
However, a cost segregation study may help the taxpayer identify portions of the building that are eligible for depreciation at accelerated rates. For example, the study may be able to divide the purchase price of the property into $100,000 as 5-year tangible property, $50,000 as 15-year land improvements and the remainder as 39-year real property. In addition, the study may identify that the 5-year and 15-year property are eligible for bonus depreciation. Not only will this result in a new annual depreciation of $21,153 ($825,000/39 years), the taxpayer will also receive an immediate bonus deduction of $150,000 during 2018. All told, with the benefit of a cost segregation study, the taxpayer may increase his or her 2018 deduction to $171,153 from an original amount of $25,000 and reduce his or her taxes by $63,327 for the year. While a cost segregation study does not change the overall depreciation deduction over the life of the property, it does change the timing of the deduction, which the taxpayers can accelerate into the current period as opposed to spreading it over a longer life. This acceleration of deductions creates current tax savings, which, in turn, increase cash flow to taxpayers and provide a time value of money savings.
Cost segregation studies are practical and beneficial for businesses that own or lease recently acquired, constructed or substantially improved or renovated commercial property. However, planning for a cost segregation study should begin prior to the construction or remodeling process with the understanding that it is never too late to perform a cost segregation study in the years after the property is placed in service. A typical report will identify a percentage of a building that can qualify for shorter recovery periods, often in the first year of the study, which can yield taxpayers significant deductions, reduced tax liabilities and increased cash flow as well as catch-up deductions when performed in a year after the asset was placed in service.
The best way for taxpayers to know if a cost segregation study is right for them is to consult with qualified tax accountants and advisors with experience in commercial real estate.
About the Author: Joshua P. Heberling is a senior manager with Berkowitz Pollack Brant’s Tax Services practice, where he focuses on tax planning and compliance services for high-net-worth individuals and businesses in the commercial real estate, land development and office market industries. He can be reached at the firm’s Boca Raton, Fla., office at (561) 361-2000 or via email at firstname.lastname@example.org.
Information contained in this article is subject to change based on further interpretation of tax laws and subsequent guidance issued by the Internal Revenue Service.