Make the Most of Bonus Depreciation With Cost Segregation Studies
For years, larger businesses have relied on cost segregation studies to accelerate their depreciation deductions and, as a result, reduce taxes and boost cash flows. Others may have thought the studies were not worth the expense, especially for properties with a smaller tax basis.
The Tax Cuts and Jobs Act (TCJA) changed the landscape dramatically when it comes to the cost-benefit analysis. All owners, developers and investors building or acquiring new or used commercial or residential real estate should consider cost segregation studies.
What is a cost segregation study?
Real property often includes different classes of assets that come with different depreciation recovery periods – 3, 5, 7, 15, 27½ or 39 years. Taxpayers typically separate such property into individual components or asset groups that have the same recovery periods and placed-in-service dates to maximize their depreciation deductions. The process is relatively straightforward when you have the actual costs of each, but, if you have only lump-sum costs, you need to allocate costs to individual property components.
Cost segregation studies allow you to allocate some of the costs of buildings (Section 1250 property) to tangible personal property (Section 1245 property) and land improvements. Tangible personal property has shorter recovery periods (5 or 7 years under the tax code); the recovery period for land improvements is 15 years. Sec. 1250 real property, by contrast, has longer recovery periods (27½ years for residential property and 39 years for nonresidential property).
Taxpayers often order cost segregation studies when initially placing properties in service, but you can also have “look-back” studies. These let you retroactively claim the depreciation you could have claimed earlier.
First-year bonus depreciation under TCJA
Under pre-TCJA law, taxpayers could claim a first-year bonus depreciation deduction equal to 50% of the adjusted basis of new assets placed in service in 2017. The deduction was available for the cost of new computer systems, purchased software, vehicles, machinery, equipment, office furniture and the like. Used assets did not qualify for the deduction.
The TCJA extends and expands bonus depreciation. You can expense the entire cost of such property (both new and used, subject to certain conditions) in the year the property is placed in service. The amount of the allowable deduction will begin to phase-out in 2023, dropping off 20% each year for four years until it expires in 2027, absent congressional action. For certain types of property, though, the deadlines are a year later. That is, the deadline for placing the property in service is a year beyond the typical deadline. The phase-out for that property begins in 2024 and ends in 2028.
To qualify for 100% bonus depreciation, property generally must:
- Fall within the definition of “qualified property;”
- Be new (meaning the property’s original use begins with the business) or acquired used property;
- Be placed in service after September 27, 2017, and before January 1, 2023; and
- Be acquired by the taxpayer after September 27, 2017.
These changes compound the potential benefits of cost segregation studies. Property that you can remove from the building classification may now qualify for bonus depreciation, allowing you to immediately deduct its cost in the first year it is placed in service.
Note that bonus depreciation reduces taxable income, which could reduce certain other tax benefits — such as net operating losses or credits that are carried forward. In such cases, you may want to “elect out” of bonus depreciation. In that situation, you would take the traditional depreciation on the covered asset classes. For the tax year that included September 27, 2017, you can elect to apply the 50% bonus depreciation rate.
Also, bonus depreciation may be subject to “recapture” when you dispose of an asset, making a portion of it taxable at the applicable ordinary income tax rate. Your ORBA advisor can help you determine the best strategy to minimize your taxes on bonus depreciation and other property.
Sidebar: The “retail glitch” under TCJA corrected by the CARES Act
While the TCJA expanded bonus depreciation significantly, a critical type of property was excluded from that treatment – qualified improvement property (QIP). This problem has been referred to as the “retail glitch.”
Background on QIP under TCJA
Before the TCJA, qualified retail improvement property, qualified restaurant property and qualified leasehold improvement property were depreciated over 15 years under the modified accelerated cost recovery system (MACRS). The TCJA designated all of these property types as QIP, generally defined as any improvement to the interior of a nonresidential real property that is placed in service after the building was placed in service.
The TCJA’s legislative history made it clear that Congress intended QIP placed in service after 2017 to have a 15-year MACRS recovery period, which would qualify it for bonus depreciation; however, the 15-year recovery period did not appear in the statute.
The preamble to the final bonus depreciation regulations states that legislative action is required to address this problem. Congress had not acted, until the Coronavirus Aid, Relief, and Economic Security (CARES) Act passed on March 27, 2020.
CARES Act to the rescue
The CARES Act corrected the known “retail glitch” and QIP now has a 15-year recover period, thus allowing 100% of improvements to be deducted in the year incurred. This change was made as if included in the TCJA and is therefore effective for property acquired and placed in service after September 27, 2017. Your ORBA advisor can help you determine if amending 2017 and/or 2018 income tax returns is worthwhile.