The Tax Cuts and Jobs Act of 2017 expanded bonus depreciation to additional assets and allowed for 100% bonus depreciation. While the qualification for bonus eligibility does not change, the amount eligible starts leveraging down in 2023 by 20% per year. This means that bonus depreciation is 80% for 2023, 60% for 2024, and so on until it completely phases out. For cost segregation professionals, this leads to the question, what happens to cost segregation if bonus phases out?
To understand how bonus depreciation affects cost segregation and depreciation decisions, it is important to fully understand bonus depreciation. Under Section 168(k) of the Tax Code, bonus depreciation allows businesses to immediately deduct a percentage of an eligible asset when it is placed in service. In recent years, Sec. 168(k) has become a relatively consistent part of the code. However, this has not always been the case.
Bonus depreciation was first added to the Tax Code as part of the Job Creation and Worker Assistance Act of 2002. At that time, businesses could deduct up to 30% of eligible assets. Bonus depreciation then received multiple extensions and revisions before the Tax Cuts and Jobs Act in 2017. To be eligible, assets need to have a life of less than 20 years and to have not been used by the taxpayer prior to the acquisition. Prior to 2017, the asset also had to have the original use begin with the taxpayer. While bonus seems like a universal part of the Tax Code, it is a relatively new provision.
This still does not answer whether reducing bonus depreciation will affect cost segregation. The answer to this question is yes — and no. While the immediate deduction will be reduced, the taxpayer will still end up saving money with a cost segregation study.
Cost segregation studies are often viewed over three metrics:
1. First-year cash flow savings;
2. Five-year cash flow savings; and,
3. The Net Present Value over the life of the asset.
Obviously, the first-year cash flow will take the biggest hit since the goal of a cost segregation study is to move as much as possible into shorter bonus-eligible assets.
For analysis, let's consider a scenario where $200,000 is moved from a 39-year asset to a five-year asset through a cost segregation study. Additionally, we will assume a 35% tax rate and a 7% discount rate.
With 100% bonus depreciation, the taxpayer saves $69,028 in the first year, and $61,746 over five years, and has an NPV over the life of the asset of $42,731.
These numbers drop to $57,828, $61,031 and $41,338, respectively, when the bonus is 80%. If bonus falls to zero, the first-year savings is $13,028, with a five-year savings of $58,175, and an NPV of $35,769. So, while the benefit drops, the taxpayer still sees significant savings by completing the cost segregation study. The importance of cost segregation as bonus leverages down grows as it relates to renovations.
The TCJA, as fixed by the CARES Act, made qualified improvement property a bonus-eligible asset. However, without bonus, QIP is a 15-year asset depreciated using a straight-line methodology. If a taxpayer puts in $1 million in renovations that are all QIP when 100% bonus exists, they might not consider cost segregation.
However, if bonus phases out completely, the difference between five-year depreciation and 15-year depreciation grows. If cost segregation could move 50% of the $1 million to a five-year asset, a taxpayer with a 35% tax rate would save $110,810 over six years.
A more important metric for the viability of cost segregation studies deals with economic impacts. Since cost segregation creates a timing difference with deductions, tax rates and inflation, interest rates play a much more significant role in the applicability for many taxpayers. In recent years, inflationary pressures and increased interest rates have reaffirmed why maximizing timing differences is critical for businesses.
It is important to note that there are multiple bills in front of Congress that would extend bonus depreciation. While no one has a crystal ball to determine what the federal government will do, it does seem unlikely that bonus depreciation will fully phase out over the next few years. However, even if bonus depreciation does completely phase out, cost segregation will remain a valuable tax planning tool.
