Practitioners and taxpayers alike continue to try and assimilate the many changes to the Internal Revenue Code that were enacted into law under the Tax Cuts and Jobs Act (TCJA) in December 2017.
Media coverage has included significant commentary about the major and direct changes included in that tax bill, including the significant lowering of the regular corporation tax rate, the “qualified business income” deduction equating to lower rates for certain “pass-through” business entities, and marginal rate decreases for individual tax brackets. However, the technical area for businesses that has not received as much attention to date is depreciation and the many new opportunities these changes bring for additional tax savings via cost segregation.
A cost segregation analysis allows taxpayers to look at their real estate assets and identify those portions of the overall capital investment that, for federal tax purposes, can be treated as personal property. This allows a taxpayer to identify assets that might otherwise be depreciated as 39-year property, and more accurately (and appropriately) move them to 5-year, 7-year or 15-year personal property. By accelerating depreciation deductions, the taxpayer reduces the tax burden in the early years of an investment and accelerates the cash flows associated with higher tax deductions for depreciation.
Though cost segregation analyses and studies have been a part of sophisticated tax strategy development and planning for many years, the new 100% bonus depreciation rules under the TCJA make such cost recovery period reclassifications more beneficial than ever.
First established in 2001 as a stimulus measure, and to aid the economy in overcoming the negative impact of the September 11th attacks, bonus depreciation permits a taxpayer to write off a substantial portion of an eligible asset in the year it is acquired and placed in service. Historically, the benefits of bonus depreciation were limited to new (original use) property and, primarily, for assets with a recovery period of less than 20 years (with some exceptions).
Prior to enactment of the TCJA in 2017, the bonus depreciation limitation was equal to 50% of the eligible asset in 2017 and 40% in 2018. Currently, under the tax reform provisions, bonus depreciation on qualifying assets is increased to 100% for assets acquired after September 27, 2017. Additionally, and importantly, Congress also saw fit to extend bonus depreciation eligibility to used (non-original use) property.
These changes in the tax law are significant for business taxpayers. As such, a cost segregation study performed on a property acquired after September 27, 2017 is now significantly more valuable. For used property, that value is even higher.
By way of example, assume a taxpayer acquires real property in January 2018, and that the portion of the cost allocated to the building is $2 million. A detailed cost segregation analysis determines that approximately $200,000 of the $2 million is related to 15-year land improvements, and $100,000 is related to five-year personal property.
Under the new law, all of this property is now eligible for bonus depreciation. thus, the taxpayer is able to deduct $300,000 of the building’s purchase price in 2018. If the taxpayer is at a 30% rate, this change will reduce cash outflows for income taxes by $90,000. (Note that the current marginal tax rate for regular corporations is 21%, so the federal tax savings for those businesses taxed as regular corporations would be $63,000.)
In addition, when looking to the tax advantages offered by the use of a cost segregation analysis and study, taxpayers must carefully consider the impact and benefits offered by those states in which they file business tax returns. Due to the huge economic impact generated by the federal allowance of the immediate expensing of qualifying capital asset acquisitions under the bonus depreciation rules, many states have elected to “decouple” from the federal rules and allow depreciation at some limited amount. In certain cases, some states (including Pennsylvania) have noted that there will be no tax depreciation, whatsoever, for capital asset expenditures for which taxpayers have elected to apply the federal bonus depreciation rules. Though not expected to stand, as of the date of this posting, Pennsylvania has not enacted legislation to remedy this issue.
Also, it is important to keep in mind that the application of a cost segregation strategy results in an acceleration of the economic benefits associated with lower tax liabilities due to higher depreciation deductions. Unquestionably, the taxpayer will always get the same total depreciation deductions. However, accelerating the tax benefit associated with a deduction that would have been taken in year 39 for a depreciable real property asset to the first year of acquisition is a material advantage, even when considering the time value of money.
Cost segregation analysis is an absolute necessity for consideration when acquiring real property assets. However, as with all good things within the Internal Revenue Code, application of this strategy is somewhat complex. Navigating that complexity is worth the effort, as immediate expensing of a portion of the cost under these rules can often change the economics of the acquisition and increase the return on investment.