Sweeping tax reform in 2017 brought about a number of changes to drastically alter the tax environment in the United States. Between a lowered corporate tax rate, lower rates for certain “pass-through” entities and decreased individual tax bracket rates, there was a lot to ingest and process. However, notable changes to the depreciation laws went relatively unnoticed.
Under the changes to bonus depreciation in the Tax Cuts and Jobs Act (TCJA), new opportunities and benefits emerged for cost segregation studies. To determine whether or not a cost segregation study is the right option for you and your business, read about what a study entails, the impact of the TCJA and the potential tax savings.
What is cost segregation?
Cost segregation is the act of distinguishing tangible personal property, known as Section 1245 property, from real estate property, known as Section 1250 property. The principal goal of a cost segregation study is to accelerate assets out of the 39-year depreciable life for real estate (27.5 years for residential real estate) and into five-, seven- or 15-year lifespans for personal property and land improvements. More specifically, cost segregation identifies personal property (generally a five- or seven-year recovery), land improvements (generally a 15-year recovery), and other short-lived properties that have been erroneously classified as building property (39- or 27.5-year recovery). By identifying misclassified components and reallocating them to a more accurate category – with shorter depreciation life cycles – the cost segregation study sets up the taxpayer for cost savings.
Cost segregation studies are vital for commercial real estate investors, real estate owners, construction companies, and others involved in the real estate and construction industries as shortened depreciation periods increase deductions, reduce tax liabilities and stimulate cash flow. A cost segregation study is particularly helpful for businesses that are building, purchasing or renovating property, as properly classifying assets can reduce short-term liabilities and free up resources to reinvest in the business.
In relation to cost segregation, personal property assets include items affixed to the building but do not relate to the overall operation and maintenance of the building.
Examples of tangible personal property include:
- Grain storage bins and silos
- Blast furnaces
- Brick kilns
Section 1245 property does not include land, land improvements, buildings, inherently permanent structures or structural components. Examples of non-personal property are land, buildings, walls, and garages.
Land improvements, on the other hand, include items located outside of the building but are affixed to the land. They do not relate to the overall operation and maintenance of the building.
Examples of land improvements include:
- Parking lots and other paved areas
- Driveways and decking
- Site utilities
- Sidewalks, concrete stairs and curbing
- Storm drainage
- Fencing, block walls, retaining walls and dumpster enclosures
- Landscaping – trees, plants, shrubs, mulch, rocks and sod
- Security lighting
How did tax reform affect cost segregation studies?
Cost segregation studies are useful planning tools for those involved in real estate or construction and looking to improve their tax positions. The benefits from a cost segregation study have always been there – increased cash flow, uncovering missed deductions, reducing liabilities and more. Then the Tax Cuts and Jobs Act passed in 2017 and the value of a cost segregation study increased even more.
The TCJA enacted significant changes to bonus depreciation which affect the potential benefits of a cost segregation analysis.
What is bonus depreciation?
Established in 2001, bonus depreciation allows taxpayers to write off a portion of an eligible asset in the first year of acquisition and service. Prior to the tax reform laws, the tax code limited bonus depreciation to new property and primarily assets with a lifespan of less than 20 years. Additionally, the write off percentage was equal to 50% of the asset in 2017 and 40% in 2018.
What changes did the TCJA make to bonus depreciation?
First, under the TCJA, bonus depreciation increased to 100% for assets acquired and placed in service after September 27, 2017 and before January 1, 2023. After 2022, the bonus depreciation percentage for qualified property placed in service decreases to 80% for 2023, 60% for 2024, 40% for 2025 and 20% for 2026. Similar to previous tax laws, taxpayers have the option to elect out of bonus depreciation for any class of property on an annual basis. Also, for the first taxable year ending after September 27, 2017, the taxpayer can elect to apply a 50% bonus rate instead of the 100% bonus rate.
Second, Congress expanded the definition of eligibility to include used assets. The amendments to Section 168(k)(2) extend bonus depreciation to used property, as long as it is the first use by the acquiring taxpayer and the property is obtained from an unrelated third party.
How do the changes to bonus depreciation affect cost segregation?
By adjusting the regulations regarding bonus depreciation, the TCJA raised the appeal of cost segregation studies. First, the bonus depreciation rate change incentivizes the act of correctly classifying assets, as not doing so leaves considerable tax savings on the table. Second, the inclusion of used assets also elevates the benefits of a cost segregation analysis. Under previous law, taxpayers could benefit from a shorter recovery period, but not from bonus depreciation because they did not meet the original use requirement. However, under the new law, used property is eligible for bonus depreciation. Therefore, property or assets classified to shorter lives can generally be expensed at the time they are placed in service.
As bonus depreciation only applies to property in the United States, this is particularly relevant for U.S.-based real property acquisitions, including commercial and residential property.
What is an example of cost segregation with the new bonus depreciation rules?
Under the new tax laws instituted by the TCJA, consider the following cost segregation example:
A taxpayer purchases a building worth $10 million. After a cost segregation study, the taxpayer is able to reclassify 10% of those costs to personal property and/or land improvements. As a result, those assets take on a shorter depreciable life and qualify for bonus depreciation. With the new 100% bonus depreciation rate, the taxpayer receives a write off of $1 million of that $10 million purchase price in the first year. If the taxpayer sits in the 25% marginal tax rate bracket, they would save $250,000 in taxes, equating to 2.5% of the purchase price, in the first year.
What are other post-TCJA benefits of cost segregation?
The TCJA brought about a number of significant tax law changes. Among those are certain components that increase the benefits of a cost segregation study.
For instance, as noted above, the new bonus depreciation rate of 100% through 2022 makes the tax environment extremely favorable for cost segregation studies. Furthermore, accelerating depreciation into the 2017 tax year presents a one-time transition opportunity to generate a permanent benefit due to the lowered corporate tax rate from 35% in 2017 to 21% in 2018.
Other benefits come from combining certain tax saving opportunities.
Cost Segregation and Section 1031 Exchanges
With modifications to both 1031 exchange rules and bonus depreciation regulations, the interplay yields new opportunities for taxpayers. Among those is the ability to utilize a cost segregation study to identify short life assets that will be fully depreciated and ultimately retired. In turn, these no value assets avoid consideration as part of a 1031 exchange – thus resulting in no depreciation recapture tax.
Prior to tax reform, the 1031 exchange rules applied to both real and personal property. However, the TCJA eliminated personal property in regards to 1031. This means that the beneficial tax deferral of a like-kind exchange is now only available to the exchange of real property.
Thus, with personal property eliminated from a 1031 exchange, taxpayers are able to take advantage of both a 1031 like-kind exchange and a cost segregation study. To maximize tax benefits, the taxpayer retires components on the front end and immediately expenses on the back end. Therefore, investing in a cost segregation study is key for identifying the property assets on the verge of full depreciation and/or retirement.
Cost Segregation and Section 179
The 2017 tax reform laws also updated the Section 179 regulations. Under the new laws, Section 179 includes improvements to nonresidential property, such as roofs, HVAC systems, fire protection systems, alarm systems and security systems.
Therefore, with the updates, taxpayers receive even greater opportunities to stimulate immediate cash flow with a cost segregation study to allocate basis to short-life property.
Also, the TCJA increased the limits on Section 179 expensing. Per Section 179 expensing, taxpayers are able to take a current deduction for the cost of qualified new or used business property placed in service in the tax year, up to a certain limit. For 2018, the TCJA doubled the maximum Section 179 deduction to $1 million with a phase-out threshold of $2.5 million. Each amount adjusts for inflation each year after. Thus, with the new Section 179 laws in place, the enhanced depreciation-related tax break indirectly increases the benefits of an analysis.
How can Squar Miler help you?
Squar Milner features tax professionals with considerable experience working in and with the real estate and construction industries. We are committed to delivering quality studies to ensure that you are maximizing your tax savings opportunities. And we can do so by diligently identifying and reconciling certain assets on your property. Our thorough cost segregation studies allow you to adjust the timing of taxes owed on property related to capital investment projects, or even make retroactive adjustments which lead to tax refunds. To learn more about our cost segregation studies and tax planning strategies, please reach out so we can connect you with our key real estate and construction tax leaders.
Disclaimer: This material has been prepared for informational purposes only, and is not intended to substitute for obtaining accounting, tax, or financial advice from a professional tax planner or financial planner. All information is provided “as is,” with no guarantee of completeness, accuracy, timeliness or of the results obtained from the use of this information.