When taxpayers purchase or construct a building, it is typically depreciated as a single asset over 27.5 or 39 years for income tax purposes. However, a process known as a cost segregation study can allocate the building’s costs among its numerous components, many of which can be depreciated over a shorter period of time such as five, seven, or fifteen years. This accelerates the depreciation deduction, reducing taxes in the near-term and as a result, increasing cash flow for the taxpayer.
How the Tax Cuts and Jobs Act of 2017 (TCJA) Impacted Cost Segregation Studies
The TCJA provides for new or used qualified property to be eligible for 100% expensing in the year of acquisition. Prior to TCJA, bonus depreciation was limited to 50% in the first year and used property was not eligible. With the increased deduction, a cost segregation study has the potential to be considerably more valuable than before since the shorter life assets identified in the study will now qualify for 100% expensing in the year of acquisition rather than the normal five, seven, or fifteen-year depreciation.
Other Benefits of a Cost Segregation Study
Buying or constructing an entire building is not the only instance when a cost segregation study may be beneficial; it may also be applied when a substantial improvement has been made to a building. Due to what appears to be an oversight, “Qualified Improvement Property,” (an improvement to an interior portion of a nonresidential building that meets a few specific requirements) is currently not eligible for bonus depreciation.
Without a technical correction enacted by Congress, this improvement property is depreciated over 39 years with no bonus depreciation eligibility. A cost segregation study could provide support for breaking down a substantial building improvement into smaller components of tangible personal property eligible for shorter depreciable lives and therefore, 100% bonus depreciation.
The Best Time to Consider a Cost Segregation Study
Under the TCJA, now is the time to consider a cost segregation study. One new aspect of the TCJA is the interest expense limitations under IRC §163(j). Under this change, business interest deduction is limited to 30% of income before interest income and interest expense. However, for tax years beginning before 2022, depreciation is also added back to income for purposes of IRC §163(j) limitation calculations. Therefore, for the next three years, the amount of depreciation expense, including 100% bonus depreciation, will not contribute to a taxpayer’s business interest expense being limited.
However, for taxable years beginning after 2021, the addback to income will no longer be available; depreciation deductions might potentially cause or further limit interest expense deductions. This creates additional incentives to accelerate depreciation deductions into earlier tax years.
There are several aspects of the TCJA that could lessen or defer your benefits. Taxpayers should consider their ability to utilize losses created by accelerated depreciation. This has always included tax basis, at-risk, and passive loss limitations; however, the TCJA introduced additional new hurdles. These include Excess Business Loss Limitations for net business losses of a taxpayer in excess of $500,000 (for married filing joint taxpayers; $250,000 for all others) and Net Operating Loss utilization limitations, which under the TCJA may now only be carried forward to future tax years (utilization is limited to 80% of taxable income). Also, with changing tax rates and expiration of provisions scheduled as part of the TCJA, accelerating tax depreciation may result in higher income in a future tax year that has higher effective tax rates. Careful planning is needed to maximize your tax benefits.
Tax planning is never a one-plan-fits-all situation, and as much as we advocate for cost segregation studies, we also recommend that your tax advisor be involved to analyze your specific facts and circumstances.
Tax Savings Through Cost Segregation
The TCJA provides the potential for cost segregation studies to be a more powerful tax savings tool than ever before. If you are considering a building acquisition, substantial improvement, or new construction, please contact your Sikich tax advisor to evaluate your situation and assess the potential tax benefits of a cost segregation study.