Publish Date
Oct 15, 2024
A&M Tax Advisor Weekly
When a business acquires, constructs or substantially renovates a building, a cost segregation study may be a great way to take advantage of permanent cash-flow benefits. Cost segregation is an engineering-based approach that identifies the proper classifications of the various building components of a property and accurately allocates the costs among those components to calculate depreciation for tax purposes.
A cost segregation study is prepared in accordance with current U.S. Tax Code. Typically, buildings are depreciated over 27.5 years for residential rental properties and 39 years for commercial properties. However, certain components within these buildings, such as fixtures, certain flooring and landscaping, can be depreciated over much shorter periods, such as five, seven or 15 years. Accelerated depreciation deductions result in deferred taxes which creates a cash-flow benefit.
A key consideration is timing. By correctly applying the concepts and accelerating depreciation deductions, property owners can reduce their taxable income in the early years of ownership of the property, resulting in lower tax liabilities and more cash on hand. This increased cash flow can be reinvested into the business, used to pay down debt, or allocated to other investment opportunities.
Engaging in a cost segregation study ensures compliance with the Internal Revenue Service (IRS) regulations regarding depreciation. The IRS has specific guidelines for how different types of property should be depreciated, and a professional cost segregation study helps ensure that these guidelines are followed. This can reduce the risk of audits and penalties, providing peace of mind for property owners.
Bonus depreciation—also known as the additional first-year depreciation deduction or the 168(k) allowance—accelerates depreciation amounts by allowing businesses to write off a large percentage of an eligible asset’s cost in the first year it was purchased. The remaining cost can be deducted over multiple years using regular depreciation methods until it phases out.
The Tax Cuts and Jobs Act (TCJA) was signed into law by President Trump on December 22, 2017, which significantly changed the rules for bonus depreciation by allowing businesses to immediately write off 100 percent of the cost of eligible property acquired and placed in service after September 27, 2017, and before January 1, 2023. Prior to TCJA, it was 50 percent.
Now, the 100 percent write-off of eligible property expired December 31, 2022. Further, unless the law changes, the bonus percentage decreases by 20 points each year. In 2023, bonus depreciation was reduced to 80 percent.In later years, the rate is scheduled to be 60 percent in 2024, 40 percent in 2025, 20 percent in 2026, and gone in 2027. For certain property with longer production periods, the preceding reductions are delayed by one year.
The Coronavirus Aid, Relief, and Economic Security Act (CARES Act), signed into law on March 27, 2020, includes a technical correction of an error in the TCJA related to the depreciation of QIP.
The term QIP means any improvement made by the taxpayer to an interior portion of a building which is nonresidential real property if such improvement is placed in service after the date such building was first placed in service. Such term shall not include any improvement for which the expenditure is attributable to the enlargement of the building, any elevator or escalator, or the internal structural framework of the building [IRC Sec 168(e)(6)].
In the TCJA, Congress intended to allow a 15-year recovery period and bonus depreciation eligibility for QIP. Due to a drafting error, the statute failed to include QIP as eligible property for purposes of the recovery period and the bonus depreciation rules. As a result, QIP was subject to a 39-year recovery period and was not eligible for bonus depreciation.
The CARES Act corrected the error and allows the 15-year recovery period and bonus depreciation eligibility retroactively for property placed into service after December 31, 2017. The correction is retroactive to 2018 allowing taxpayers to claim additional depreciation for QIP placed in service in 2018 and 2019.
This is a “must consider” planning opportunity for property renovation and adaptive reuse projects.
A cost segregation study does not always need to be performed in the year of acquisition or construction. The IRS has provided a method to take advantage of the deduction through a catch-up adjustment in a later year. The adjustment is reported as a deduction on the current tax return.
This is a planning opportunity to strategically decide the best year to take advantage of the catch-up adjustment. For example, using the catch-up adjustment in a year with a significant spike in taxable income can offset overall tax burden.
For commercial property owners, proper identification and allocation of construction related costs into assets with shorter recovery periods is still one of the most significant opportunities to manage federal income tax liability and create cash-flow benefits.
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