Accelerated Depreciation and Cost Segregation Studies

Depreciation is an annual income tax deduction in which the IRS allows a taxpayer to write off a portion of the property’s cost each year and can be a powerful tax savings tool. Depreciation is based on the purchase price, or cost basis, of the property. The cost basis is then divided by the useful life of the property to determine the deduction allowed each year. For buildings, the lives are 27.5 years for residential real estate and 39 years for commercial real estate. Because of the long depreciable life of a building, accelerated depreciation strategies should be considered.

It is important to note that accelerating depreciation does not mean you receive extra depreciation; it simply means that you are speeding up the benefits to today rather than waiting to receive them. One way to do this is through a cost segregation study.

What is a Cost Segregation Study?

A cost segregation study is a tax strategy designed to accelerate depreciation expense. Cost segregation studies can fit into a few different categories. We will focus on acquired property, new construction and building renovations. These cost segregation studies combine accounting and engineering techniques to identify building costs that are properly allocable to tangible personal property rather than real property. This could potentially allow you to accelerate depreciation deductions, thus reducing taxes and boosting cash flow.

This is achieved by reclassifying some of the components of a building from an asset with a long depreciable life into assets with shorter depreciable lives. Examples include flooring, appliances, specialty plumbing & electrical, cabinets, roofing, HVAC units, and land improvements such as parking lots. Once these components are broken out, an accelerated tax deduction is achieved because those components can be written off over a shorter time period.

Because of the detailed reporting that the IRS requires in order to take the accelerated depreciation adjustment, it is recommended the cost segregation study be completed by a firm that specializes in the field. As with all business decisions, there is a cost/benefit analysis that should be considered to determine whether the tax savings resulting from the cost segregation study outweigh the costs to get the study done. For example, if your business is projecting a loss in one year but anticipates revenue in future years, it may be advantageous to wait until the business is generating income.

A cost segregation study can be completed at any time on property you own. It does not need to be done in the year you first purchase the property or place it in service. Also, unlike most tax strategies, the cost segregation study does not need to be implemented before the end of the tax year, although it does need to be completed before the tax return is filed. This allows the taxpayer to determine whether the cost segregation study might benefit them depending on their tax liability for the year.

How Can I Benefit from a Cost Segregation Study?

It is reasonable to be concerned that taking more depreciation now will lead to higher taxes later when the property is sold. Although it is true that a cost segregation decreases the investor’s tax basis, which thereby increases the future capital gains on the property, it can still be beneficial to have a cost segregation study done. Many taxpayers prefer deferring taxes into the future in order to have cash available that they can put into their business today.

IRS rules generally allow businesses to depreciate commercial buildings over 39 years (27½ years for residential properties). In most cases, a business will depreciate a building’s structural components such as walls, windows, HVAC systems, elevators, plumbing and wiring as well as the building.

Personal business property such as equipment, machinery, furniture and fixtures is also eligible for accelerated depreciation, but usually over five or seven years. Land improvements including fences, outdoor lighting and parking lots are depreciable over 15 years.

It is common for businesses to allocate all or most of a building’s acquisition or construction costs to real property and overlook the opportunities to allocate costs to shorter-lived personal property or land improvements. For instance, computers and furniture have obvious distinctions between real and personal property, but often the line between the two is less clear. Items that appear to be part of a building may be personal property, like a removable wall and floor coverings, removable partitions, awnings and canopies, window treatments, signs and decorative lighting.

In some cases where real property serves more of a business function than a structural purpose, it may qualify as personal property. This includes reinforced flooring to support heavy manufacturing equipment, electrical or plumbing installations required to operate specialized equipment or dedicated cooling systems for data processing rooms.

Although the relative costs and benefits of a cost segregation study depend on your facts and circumstances, it can be a valuable investment. Let’s say the business acquired a nonresidential commercial building for $5 million on January 1. If the entire purchase price is allocated to 39-year real property, the business is entitled to claim $123,050 (2.461% of $5 million) in depreciation deductions the first year. A cost segregation study may reveal that you can allocate $1 million in costs to five-year property eligible for accelerated depreciation. Reallocating the purchase price increases your first-year depreciation deductions to $298,440 ($4 million × 2.461%, plus $1 million × 20%).

A cost segregation study can assist you in making partial asset disposition elections and deducting removal costs under the tangible property regulations.

Section 179 and Bonus Depreciation

There are more ways than a cost segregation study to accelerate depreciation, such as the Section 179 deduction. The Tax Cost and Jobs Act (TCJA) enhanced certain depreciation-related tax breaks which may also enhance the benefits of a cost segregation study. Among other things, the TCJA permanently increased limits on Section 179 expensing. Section 179 allows you to immediately deduct the entire cost of qualifying equipment or other fixed assets up to specified thresholds.

Under Section 179 expensing, taxpayers can take a current deduction for the cost of qualified new or used business property placed in service in the tax year, up to certain limits. This applies to tangible personal property, such as machinery or equipment, purchased for use in a trade or business, and improvements to the interior portion of a nonresidential building after the building is placed in service. Additional items include roofs, HVAC, fire protection systems, and alarm or security systems for nonresidential real property. Taxpayers can deduct the full cost of these assets up to $1,080,000 for qualifying property placed in service in 2022. However, the section 179 deduction begins to phase out on a dollar-for-dollar basis after $2,700,000 of spending.

Another method to accelerate is through bonus depreciation. Currently, this allows a business to write off 100 percent of the purchase price of qualified depreciable property in the year of acquisition. Qualified depreciable property includes property with a recovery period of 20 years or less (meaning taxpayers cannot take bonus depreciation on buildings), qualified improvement property, livestock, computer software, and certain used property. The 100% bonus depreciation deduction is available for property acquired and placed in service after September 27, 2017 and before January 1, 2023. For tax years beginning January 1, 2023, the bonus depreciation deduction is being decreased from a 100% to 80% benefit. For each tax year beginning after December 31, 2023, the bonus depreciation benefit will decrease by an additional 20% each year until it reaches 0% for property placed in service after December 31, 2026, unless a law change is enacted.

The Section 179 deduction can be used alongside bonus depreciation to maximize the effectiveness of a cost segregation study. However, there are a few things to consider when determining which strategy will be most effective.

The Section 179 deduction is flexible and allows you to choose which purchases to elect it for, but there is a spending cap and the deduction cannot be larger than your annual business income. Bonus depreciation has no annual spending limit and can exceed your business income, but you must apply the same treatment to all assets of the same class.

Qualified Improvement Property

Qualified improvement property (QIP) is any improvement made to an interior portion of nonresidential real property if such improvement occurred at least 3 years after the building was first placed in service. The TCJA expanded 15-year-property treatment to apply to QIP. Previously, this tax break was limited to qualified leasehold-improvement, retail-improvement, and restaurant property.

QIP does not include expenditures attributable to enlargement of the building, any elevator or escalator, or the internal structural framework of the building. When a cost segregation study is completed, it is likely that a large portion of the reclassified components might be considered QIP. Under prior tax law, this was not eligible for bonus because its useful life exceeded the 20 year threshold.

As of April 2020, the IRS now states that QIP placed in service subsequent to December 31, 2017 has a recovery period of 15 years. This change allows for QIP to be eligible for bonus depreciation through the year 2026. The provision can be applied retroactively and may allow taxpayers to obtain tax refunds related to expenditures for renovation projects completed in 2018 and 2019.

Property and Sales Tax Considerations

Businesses can also use cost segregation studies to support the property tax or sales tax treatment of certain items. For example, a cost segregation study can be used to document the cost of a tax-exempt property. This would be helpful for manufacturers since many states exempt property used in manufacturing.

If your business decides to make changes based on a cost segregation study, please note that certain property may be treated differently for income tax and property tax purposes, and reporting mistakes can lead to double taxation. Suppose your state has a personal property tax and the business reclassifies certain building components as personal property for income tax purposes. If the business reports these items to the state as taxable personal property, but state law treats them as part of the real estate for real property tax purposes, they may be taxed twice: once as personal property and once as real property.

To avoid double taxation, be sure you have systems in place to track the costs of these items separately for income tax and property tax purposes.

Is a Cost Segregation Study Right for You?

Cost segregation studies may yield substantial benefits, but they’re not right for every business. Depreciation can result in significant tax savings when properly utilized. Cost segregation studies, bonus depreciation, and Section 179 expensing are all ways that your business can benefit from accelerated depreciation.

Please consult your tax advisor to discuss whether a cost segregation study would be worthwhile. They can perform an initial assessment to determine potential tax savings, depending on your situation.

Content provided by LBMC tax professional, Summer Brooks.

LBMC tax tips are provided as an informational and educational service for clients and friends of the firm. The communication is high-level and should not be considered as legal or tax advice to take any specific action. Individuals should consult with their personal tax or legal advisors before making any tax or legal-related decisions. In addition, the information and data presented are based on sources believed to be reliable, but we do not guarantee their accuracy or completeness. The information is current as of the date indicated and is subject to change without notice.