Cost segregation studies should be in the back pocket of every commercial real estate investor. When optimized, they can increase cash flows, reduce tax liability, and uncover missed deductions. And thanks to the Tax Cuts and Jobs Act of 2017, the benefits are more favorable than ever before.
A cost segregation study is a strategic planning tool that commercial real estate owners and investors can use to improve their tax positions. These studies assess an entity’s real property assets and identify a portion of those costs that can be treated as personal property. By segregating personal property from the building itself, the studies will be able to reassign costs that would have been depreciated over a 39-year period to asset groups that will be depreciated at a much quicker pace, or perhaps even expensed immediately.
A force to be reckoned with
The tax reform package made two simple changes – both to bonus depreciation – that will make cost segregation studies more valuable.
Bonus depreciation allows individuals and businesses to immediately deduct a certain percentage of their asset costs the first year they are placed in service. The tax law made used property eligible for bonus treatment for the very first time, and it also increased the bonus percentage to 100 percent through tax year 2022. Prior to this law change, only new property was qualifying, and bonus depreciation was expected to be only 50 percent in 2019.
This means that performing a cost segregation study will now have a stronger impact. Any assets that are removed from the “real property” bucket and placed in the “personal property” bucket may now be eligible for bonus depreciation and can be immediately expensed in the first year.
Consider the following example: A taxpayer purchases a building worth $10 million. After performing a cost segregation study, they can reclassify 10 percent of those costs to be personal property. By assigning these assets a shorter depreciable life, they can apply bonus depreciation and write off $1 million of that $10 million purchase price in Year 1. A taxpayer with a 25 percent marginal tax rate would save $250,000 in taxes, or 2.5 percent of the purchase price, that first year.
Renovated properties may also benefit
A cost segregation study may also come in handy during a renovation, although the reason why is somewhat convoluted.
Back in 2015, well before the Tax Cuts and Jobs Act, a different tax law was passed: The Protecting Americans from Tax Hikes, or PATH, Act. This tax law removed the following three property classifications:
- Qualified leasehold improvement property;
- Qualified restaurant property; and,
- Qualified retail improvement property.
In their stead, it created an asset group called “qualified improvement property.” This new asset group included the same types of 15-year assets as the three groups it had replaced, but it was also written to include certain non-structural improvement assets. Once this law was passed, building improvements like plumbing, ventilation systems, and alarm systems were treated as 15-year assets. This was great news for renovators: They could now depreciate these assets over a shorter, 15-year period.
When the Tax Cuts and Jobs Act was passed two years later, Congress’ intent was to extend bonus depreciation to qualified improvement property. Unfortunately, the appropriate wording did not make it into the tax bill, and qualified improvement property took a major hit. Not only did it never become eligible for bonus depreciation, it reverted back to 39-year property. While we are still hoping for a technical correction, at the moment, qualified improvement property is no better off than real property.
While renovators may feel like they drew the short end of the stick, they can still benefit from a cost segregation study. The purpose of their study should be to identify which assets are not qualified improvement property so that they can depreciate those assets over a three-, five-, or seven-year period and qualify for bonus depreciation.
How to decide
All taxpayers in the commercial real estate industry – contractors, renovators, purchasers and investors – may benefit from a cost segregation study to determine which of their property qualifies for accelerated depreciation. To help with the study, they should engage qualified professionals with expertise in this area like veteran engineers, quality CPA firms, and others holding the Certified Cost Segregation Professional designation, to help them decide if the benefits will outweigh the costs.
