Businesses in asset intensive industries like manufacturing and real estate have for decades looked to Cost Segregation (“Cost Seg”) as a useful tool for accelerating depreciation deductions. Accelerated depreciation allows businesses to defer tax liability and offset the high cost of acquiring capital assets. By increasing 1st year Bonus depreciation (“Bonus”) from 50% to 100%, the Tax Cuts & Jobs Act of 2017 (“TCJA 2017”) further enhances already significant benefits of Cost Segregation studies.
Cost Segregation Overview
A Cost Segregation study is a detailed analysis of real estate acquisition and construction costs that allows real estate owners to identify and quantify property eligible for accelerated tax depreciation. Cost Seg studies take building costs depreciable over 39 years or 27 ½ years, and reclassifies certain building components instead as personal property depreciable over 5 or 7 years, or as land improvements depreciable over 15 years. By shortening the tax lives and accelerating depreciation methods, taxpayers reduce income tax liabilities by maximizing immediate tax deductions. Cost Seg studies are often completed for core asset classes like office, retail and multi-family, but, can also apply to less common building types, including factories, cinemas, self-storage facilities, gas stations, and even golf courses.
Cost Segregation is a well-established tax planning strategy utilized by savvy owners of commercial and rental real estate. The popularity of Cost Seg studies has soared over the last two decades, in part due to the availability of and correlation to Bonus depreciation. The core principles behind Cost Seg have remained mostly unchanged, but, resulting tax benefits have increased as Bonus rates have risen. Near term cash flow benefits resulting from Cost Seg studies increase in almost direct proportion to Bonus depreciation rates.
Bonus depreciation (“Bonus”) is a tax incentive that allows businesses to immediately deduct a portion of the cost to acquire eligible business property. Bonus-eligible property includes furniture and equipment used for business, as well as “personal property” and land improvements commonly identified in Cost Segregation studies. The increased rate of Bonus at 100% effectively allows building costs reclassified through Cost Segregation studies to be expensed immediately (whereas they would ordinarily be capitalized then recovered over periods as long as 39 or 40 years).
For each dollar of property reclassified through Cost Seg (under 50% Bonus), a taxpayer would historically have expected to realize somewhere between 11 to 20 cents of net present value (“NPV”) tax benefit (on average 16 cents of benefit per dollar). With 100% Bonus, that NPV benefit increases to about 25 cents per dollar (a 54% increase over benefits under 50% Bonus). Under the outgoing 50% bonus rules, Cost Segregation on a commercial building will typically yield on average about $40,000 of tax benefit per $1 million spent on building, in the year the property is placed into service. Under 100% Bonus depreciation, 1st year tax benefits go up to about $70,000 per $1 million spent on building.
In short, Cost Segregation studies under the new 100% Bonus rules will net a taxpayer about 75% more tax savings up front, and overall 54% more in NPV savings over time, compared to the outgoing 50% Bonus rules from last year. And, unlike the Section 179 deduction, Bonus does not have dollar limits, making it much more powerful with savings potentials limited only by the taxpayer’s ability to utilize deductions.
Businesses that already utilize Cost Seg should be excited about increased benefits associated with enhanced Bonus depreciation. Property owners who have not historically used Cost Seg should consider the added benefits it can offer in the areas of tax savings, improved cash flow, and higher after tax returns for investors. And, with another 5-years before 100% 1st year Bonus depreciation is expected to phase out, companies have a much longer runway to properly plan and complete significant acquisitions of capital assets.
James Su is a managing director, specializing in real estate and cost segregation matters, in BPM’s tax practice. Contact James at [email protected] or 949-439-6616.