WEST PALM BEACH, FLA./ DECEMBER 05, 2018 (STL.News)
Background of Cost Segregation
Cost Segregation revolves around the ability of a taxpayer to optimize their depreciation deductions. The Internal Revenue Code (IRC) allows taxpayers to claim depreciation deductions that reflect the natural wear and tear of property used for business purposes. Further, the IRC requires that taxpayers utilize a specified depreciation schedule for each asset class placed in service. When individual assets items are purchased the property depreciation method is straightforward. However, when dealing with a building, multiple assets are combined to create a useful real property asset. In these situations, it is beneficial for a taxpayer to “segregate” the individual items through a Cost Segregation Analysis.
A Cost Segregation Analysis allows a taxpayer who owns real estate to reclassify certain assets as Section 1245 property with shorter useful lives for depreciation purposes, rather than the longer useful life for Section 1250 property. The Section 1245 property may then be depreciated over a shorter period of time–five, seven or fifteen years — and is also eligible for accelerated methods and bonus depreciation. Section 1250 property is depreciated at 39 years for nonresidential property and 27.5 for residential property.
In general, a taxpayer benefits from a reduced tax liability by maximizing depreciation deductions. Therefore, by using a Cost Segregation Analysis to reclassify certain property items as Section 1245 property a taxpayer creates faster depreciation deductions, thereby lowering the tax liability. The benefit of utilizing this technique is to take advantage of the immediate cash flow generated from the tax savings, particularly the tax savings attributable to the catch-up adjustment that is often available in the year the cost segregation study is completed for existing buildings. Basic time value of money principles makes this advantageous for the taxpayer. Additionally, the value of the cost basis of the Section 1250 property will be lowered.
The Benefits of Section 1245 Depreciation Methods
The Tax Cuts and Jobs Act (TCJA) made several changes to the treatment of depreciation methods available for Section 1245 property. The TCJA has updated Section 179 and Section 168(k), the IRC sections relied upon for determination of depreciation methods utilized for Section 1245 property.
The definition of Section 179 property has been expanded to include improvements made to nonresidential property. Specifically mentioned are roofs, HVAC, fire protection systems, alarm systems, and security systems. Further, the maximum deduction has been increased from $500,000 to $1 million, while the phase-out threshold has been increased from $2 million to $2.5 million.
Bonus depreciation (Section 168(k)) has been increased from 50 percent to 100 percent for qualified property acquired and placed in service after September 27, 2017, and before January 1, 2023. Taxpayers may still utilize bonus depreciation in excess of the maximum deduction with no limit. Note that the intent of Congress was to allow qualified improvement property the benefit of the 100 percent bonus depreciation; however, a drafting error currently excludes it.
The depreciation rules for improvement property also changed. Improvement property has been consolidated into qualified improvement property which is any improvement to a building’s interior. Excluded from qualified improvement property are improvements that are attributable to the enlargement of the building, any elevator or escalator or the internal structural framework of the building. Also, qualified property has been expanded to include used property, whereas only new property qualified before.
These new rule changes serve to make Cost Segregation Analysis even more attractive for a taxpayer. The updates to Section 179 expand the assets classes that may qualify while allowing for an even larger annual deduction. While the updates to Section 168(k) bonus depreciation provides for the opportunity to deduction the full cost of certain assets items.
Example of the Benefits of Cost Segregation
An office building is placed into service with a cost basis of $1 million. Without a Cost Segregation Analysis, the first year depreciation deduction on the building would be $25,641 ($1 million over 39 years). Generally, a Cost Segregation Analysis can reclassify up to 40% of the cost basis to shorter life Section 1245 property. For this example, the Cost Segregation Analysis reclassified $200,000 as five-year property and $200,000 as seven-year property. The first year depreciation deduction is now.
About Engineered Tax Services, Inc.
Engineered Tax Services, Inc. (ETS) is a licensed engineering firm that focuses on federal, state, and local tax benefits. Founder and CEO, Julio Gonzalez, is an expert in tax reform whose strong presence is helping define our current tax laws. Under Gonzalez’s guidance and true insight into how the industry is shaping, Engineered Tax Services is one of the largest, fastest growing, and most innovative engineering, energy, and specialty tax credit services firms in the country. Visit us at http://www.engineeredtaxservices.com.