Tax Benefits of Cost-Segregation in Commercial Real Estate – NEW DEPRECiATION RULES

 

Under United States tax laws and accounting rules, cost segregation is the process of identifying personal property assets that are grouped with real property assets and separating out personal assets for tax reporting purposes. According to the American Society of Cost Segregation Professionals, cost segregation is “the process of identifying property components that are considered “personal property” or “land improvements” under the federal tax code.”

A cost segregation study identifies and reclassifies personal property assets to shorten the depreciation time for taxation purposes, which reduces current income tax obligations. Personal property assets include a building’s non-structural elements, exterior land improvements, and indirect construction costs. The primary goal of a cost segregation study is to identify all construction-related costs that can be depreciated over a shorter tax life (typically 5, 7, and 15 years) than the building (39 years for non-residential real property). Personal property assets found in a cost segregation study generally include items that are affixed to the building but do not relate to the overall operation and maintenance of the building.

Land Improvements generally include items located outside a building that is affixed to the land and do not relate to the overall operation and maintenance of a building. Reducing tax lives results in accelerated depreciation deductions, a reduced tax liability, and increased cash flow.

Property asset classification
Analysis of capital expenditures is used to determine appropriate asset classifications. Cost segregation identifies building costs that would typically be depreciated over a 27.5 or 39-year period and reclassifies them to permit a shorter, accelerated method of depreciation for certain building costs. Costs for non-structural elements, such as wall coverings, carpet, accent lighting, portions of the electrical system, and exterior site improvements such as sidewalks and landscaping, can often be depreciated over five, seven, or 15 years, rather than over 27.5 or 39 years.

Example list of Reclassification Percentages
Average reclassification percentage recaptured with 5,7, and 15-year property with an Engineering-Based Cost Segregation Study.

PROPERTY TYPE RECLASSIFICATION %

Apartment Building (20-40%)
Assisted Living Facility (22-45%)
Auto-Car Dealership (29-35%)
Bank (30-45%)
Conference Center (25-35%)
Fitness Center (22-45%)
Golf Course (28-60%)
Grocery Store (20-45%)
Hospital (28-40%)
Hotels (20-40%)
Leasehold Improvements (20-80%)
Manufacturing (20-40%)
Medical Office/Clinic (22-35%)
Mixed-Use (20-40%)
Office Building (20-30%)
Research Facility (22-45%)
Resort (25-45%)
Restaurant (20-80%)
Retail Strip Mall (18-40%)
Theme Park (16-22%)
Warehouse (20-30%)
Winery (18-45%)

Eligibility
Real property eligible for cost segregation includes buildings that have been purchased, constructed, expanded or remodeled since 1987. A formal engineering-based study is typically cost-effective for buildings purchased or remodeled at a cost greater than $750,000. A cost segregation study is most efficient for new buildings recently constructed, but it can also uncover retroactive tax deductions for older buildings which can generate significant short benefits due to “catch-up” depreciation.

Cost segregation study process.
A cost-segregation specialist can perform a non-intrusive yet detailed engineering study of a building’s walls, flooring, and ceilings; and its plumbing, electrical, lighting, telecommunications, heating, and cooling systems.

Usually, a construction engineer will analyze architectural drawings, mechanical and electrical plans, and other blueprints to segregate the structural and general building electrical and mechanical components from those linked to personal property. The study also allocates “soft costs,” such as architect and engineering fees, to all components of the building.

In general, a study by a construction engineer is more reliable than one conducted by someone with no engineering or construction background. However, the possession of specific construction knowledge is not the only criterion. Experience in cost estimating and allocation, as well as knowledge of the applicable law, are other important criteria. A quality study identifies the preparer and always references his/her credentials, experience, and expertise in the cost segregation area.

Tax Reform: New Depreciation Rules
Recent tax reform has brought on significant changes performing a cost segregation study.

Below you will find specific areas of cost segregation by property type that have been modified or changed.

Special Note:
Bonus Depreciation is only eligible on a qualified property with a Class Life of 20 years or less.

Purchases of Used Property
Properties acquired and placed in service after 9/27/2017 are allowed 100% bonus depreciation on used property with a class life of 20 years or less.

This runs through 12/31/2022 and scales down annually.

1/1/2023 – 12/31/2023 = 80%

1/1/2024 – 12/31/2024 = 60%

1/1/2025 – 12/31/2025 = 40%

1/1/2026 – 12/31/2026 = 20%

Note: If purchase contract was entered into prior to 9/28/2017, then 0% bonus depreciation applies and use closing date for Placed in Service date.

New Construction, Improvements and Purchases of New Property
Properties acquired and placed in service after 9/27/2017 – 12/31/2017 are allowed 100% bonus on used property.

This runs through 12/31/2022 and scales down from there.

1/1/2023 – 12/31/2023 = 80%

1/1/2024 – 12/31/2024 = 60%

1/1/2025 – 12/31/2025 = 40%

1/1/2026 – 12/31/2026 = 20%

Note: If New Construction, Improvement, or Purchase of New Property contract was signed prior to 9/28/2017, then generally 50% bonus applies and use the Certificate of Occupancy or closing statement for Placed in Service date.

Old bonus rules prior to 1/1/2012 are still applicable.

Qualified Leasehold and Retail Improvements
Properties acquired and placed in service after 9/27/2017 – 12/31/2017 is allowed 100% bonus on new property.

Note: If the Improvement contract was signed prior to 9/28/2017, then a 50% bonus applies and use the Certificate of Occupancy for Placed in Service.

Note: Note: 15-year recovery period if placed in service by 12/31/2017.

Note: QIP placed in service on or after 1/1/2018 is 39 years and is NOT BONUS eligible.

Qualified Restaurant Property
Properties acquired and placed in service after 9/27/2017 – 12/31/2017 is allowed 100% bonus on new and used property recovered at 5/15 years but not the “Restaurant Property”.

Note: If a purchase and contract were signed prior to 9/28/2017, then a 0% bonus applies and still use the closing date for Placed in Service date. If signed and closed from 9/28/2017 – 12/31/2017, then 100% bonus applies on the 5 & 15 years but not the “Restaurant Property” which is recovered at 39 years.

Note: If new construction, the same rules apply as listed in the note above, except prior to 9/28/2017, 5 & 15-year property are eligible for a 50% bonus.[3]

Tax benefits of cost segregation
In addition to providing lower taxes, cost segregation can benefit businesses in a number of ways:

Maximizing tax savings by adjusting the timing of deductions. When an asset’s life is shortened, depreciation expense is accelerated and tax payments are decreased during the early stages of a property’s life. This, in turn, releases cash for investment opportunities or current operating needs.

Creating an audit trail. Improper documentation of cost and asset classifications can lead to an unfavorable audit adjustment. A properly documented cost segregation helps resolve IRS inquiries at the earliest stages.

Playing Catch-Up: Retroactivity. Since 1996, taxpayers can capture immediate retroactive savings on property added since 1987. Previous rules, which provided a four-year catch-up period for retroactive savings, have been amended to allow taxpayers to take the entire amount of the adjustment in the year the cost segregation is completed. This opportunity to recapture unrecognized depreciation in one year presents an opportunity to perform retroactive cost segregation analyses on older properties to increase cash flow in the current year.

Additional tax benefits. Cost segregation can also reveal opportunities to reduce real estate tax liabilities and identify certain sales and use tax savings opportunities.

Estate Planning. Using cost segregation as an estate-planning strategy can create permanent tax benefits. Upon a death where someone owns real estate, this is done by applying cost segregation to the decedent’s pre-stepped-up tax basis to create a Section 481(a) adjustment.

Downsides to Cost Segregation Studies
Downsides to cost segregation studies include cost, the triggering of depreciation recapture, and understatement penalties for taxpayers that use cost segregation too aggressively.