If you own commercial or residential real estate that is being rented, you should consider a cost segregation study to minimize your tax bill.
Normally, if real estate is commercial, it is depreciated over 39 years, and if it is a residential rental, it is depreciated over 27 ½ years. On the other hand, tangible personal property such as furniture and fixtures, carpeting and window treatments are depreciated over a 5- or 7-year depreciable life, while land improvements such as sidewalks, paving or landscaping, are subject to a 15-year depreciable life.
The objective of a cost segregation study is to identify assets that are not structural in nature and classify these components as tangible personal property or land improvements that can be depreciated over these shorter lives and in some cases, immediately expensed in the year of purchase using bonus depreciation.
Bonus depreciation was originally added to the tax law to allow taxpayers to write off 50% of the cost of an asset in the year that it was purchased. One of the requirements under the old law, was that asset had to be brand new in order to be eligible for bonus depreciation. In the past, bonus depreciation could not be taken on a used asset.
Under the new tax law, called The Tax Cuts and Jobs Act (TCJA), which was passed in late 2017, bonus depreciation has been improved and expanded A taxpayer can now write off 100% of the actual cost of an asset, and the requirement that the asset had to be brand new was repealed. Therefore, used assets qualify. Unlike immediate expensing under Section 179, bonus depreciation is not limited to taxable income.
Assets qualifying for bonus depreciation must have a life shorter than 20 years. For restaurant properties, before the new tax law, leasehold improvements qualified as 15-year property, hence almost everything was eligible for bonus depreciation, as long as it was a brand-new asset. The new tax law contains a major glitch that, as of this writing, has not been corrected. Unfortunately, restaurant leasehold improvements are considered 39-year property and are not eligible for bonus depreciation. That is one of the reasons why it may make sense to consider a cost segregation study.
In 2014, the IRS finalized the Tangible Property Regulations, often referred to as “The Repair Regulations.” When improvements are made to a commercial property, a decision must be made to determine whether these improvements are repairs or De Minimis items that can be immediately expensed without putting them on the depreciation schedule, or if items must be capitalized. A cost-segregation study provides information that can be used to make these decisions. One of the advantages of treating an item as a repair or as a De Minimis expense is that upon a subsequent sale, these items will not be subject to depreciation recapture at ordinary income tax rates.
When a franchisee remodels a property, components being removed should be written down and removed from the fixed asset schedule in order to avoid depreciation recapture on ghost assets in the event of an asset sale. Sometimes, the initial acquisition of machinery and equipment, furniture and fixtures or leasehold improvements are not separately stated on the depreciation schedule but are lumped together in one number. A cost segregation study can calculate the value of items that were disposed and can provide information for a partial asset disposition.
Every type of commercial and leased residential property is eligible for the cost segregation tax strategy including office buildings, warehouses, self-storage facilities and especially restaurants, as well as apartments and owner-occupied properties. Newly constructed and recently acquired properties benefit significantly, as well as properties acquired in the past. There is no requirement that a cost segregation study be performed simultaneously with the purchase of a property. IRS allows a taxpayer to take the difference in depreciation on a tax return filed in the year that the cost segregation study was completed, even if the taxpayer owned the property for many years.
Owners must ensure that a cost segregation study meets IRS requirements, therefore it is recommended that a qualified cost segregation firm provide the engineering-based studies. The cost of a study depends on the complexity of the property, since all components of the building must be considered. Most reputable cost segregation specialists will provide an initial preliminary analysis to determine whether a cost-segregation study is beneficial.
Taking advantage of a cost-segregation study can result in a significant reduction in income taxes and increased cash flow that can be used to pay down debt, complete renovations or purchase additional units.
The benefits of 100% bonus depreciation won’t last long. IRS has instituted phaseouts after December 31, 2022 with a 20% reduction starting in 2023 and full phaseout for property placed in service after January 1, 2027. So, if you are considering cost segregation as a tax strategy, now is the time to set the wheels in motion. Please don’t hesitate to contact me with any questions at (602) 248-8223 or RobertDuskin@HaynieCPAs.com
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