INSIGHT: Bonus Depreciation Tax Reform Changes Make Cost Segregation Studies Essential
With the recent passage of the bill known as the Tax Cuts and Jobs Act (2017 tax law), owners of commercial real estate now qualify for significant tax benefits, some of which are retroactive to the 2017 tax year.
Under the new tax regime, most owners who purchased either residential or non-residential property and closed on or after Sept. 28, 2017, can see significant tax benefits as a result of the bonus depreciation being applied to “used” property. For the first time since initial bonus depreciation provisions were passed in the Job Creation and Worker Assistance Act of 2002, owners and investors who acquire used property (property that has been used by previous owners) are now on an equal playing field as owners and investors who constructed or purchased “new” property. Under the new tax regime, qualifying assets that have a tax recovery period of 20 years or less, new and used, can now qualify for the 100-percent bonus depreciation provision in the assets’ first year of service (Note: While the term “bonus”is often misunderstood to mean an added benefit beyond the asset's depreciable tax base, it is a boost to accelerate the tax depreciation in the first year the asset is placed in service).
The original intent of the bonus depreciation provision was to stimulate job growth and investment back into the economy. When first enacted, bonus depreciation was applied at 30 percent in the asset's first year, but only to those that were new and had a tax recovery period of 20 years or less. Since most traditional assets, such as a brick and mortar building, would have a tax recovery period under the modified accelerated cost recovery system (MACRS), they would be classified as either a 39-year period for non-residential real property or a 27.5-year period for residential real property. Thus, those asset classifications would not qualify for this added incentive.
Prior to the passage of federal tax reform, owners or investors in used commercial property would have had to initiate depreciation recovery at the standard 39-year MACRS period, although there may have been hidden assets with the real estate component with lower recovery periods (usually at five, seven or 15 years). Now under the 2017 tax law, those used non-building assets that have recovery periods of 20 years or less qualify for the 100-percent bonus in the asset's first year of service (if in service after Sept. 27, 2017). While used qualifying assets placed in service before Sept. 28, 2017, would not qualify for the new bonus provision, there may still be assets with short tax recovery periods that will not receive the 100-percent first year bonus provision, but rather their normal MACRS depreciation rates over the five, seven and 15-year tax lives. The good news is there are many assets within the real estate component itself that can have shorter recovery periods.
In most cases where there are assets within a recently purchased used building, owners need to identify and reallocate the purchase price to take advantage of the lucrative bonus depreciation provisions. To do this, they should undertake a cost segregation study, which employs both engineering and tax professionals to assist in asset identifications. When only the lump sum cost of an asset, such as a parcel of real estate, is available at purchase, cost estimating techniques may be required to categorize individual components of the property as land, land improvements, buildings, equipment, or furniture and fixtures. Those assets traditionally allocated as land improvements, equipment, and furniture and fixtures placed in service after Sept. 27, 2017, would now qualify for the 100-percent first year bonus provision.
Take the following as an example: If a taxpayer acquires an existing shopping center on Sept. 27, 2017, under prior tax law, the taxpayer could allocate the purchase price via a cost segregation study to the various asset components. In this case, let's say the taxpayer allocated 20 percent of the purchase price to land (non-depreciable), 15 percent to land improvements (15-year recovery period), and 12 percent to equipment (five-year recovery period), and the balance to the building asset (39-year recovery period). Before the passage of the 2017 tax law, by employing a cost segregation study, the taxpayer's first-year depreciation deduction would be approximately $150,000. This is opposed to an approximately $30,000 depreciation deduction if an allocation was not completed, and the taxpayer left the entire asset in the standard 39-year tax recovery period.
Now, using the same situation as above, if the closing date was instead Sept. 28, 2017, the land improvement and equipment assets identified in the cost segregation study would now be eligible for a 100-percent depreciation deduction. In calculating the depreciation under the new tax regime, the first-year depreciation would be approximately $1.1 million, nearly one million dollars more than what the taxpayer would be entitled to prior to the bill's passage.
While this implementation of bonus depreciation can create a significant expense in the asset's first year, taxpayers must now consider if those deductions can be used to offset taxable income, to ensure there is sufficient taxable income to absorb the added deductions in the current year. The new tax law does allow for taxpayers to step down the deduction, using the prior tax provision for bonus at a 50-percent depreciation rate. Alternatively, they can also elect out of bonus entirely and just take the traditional MACRS depreciation on the allocated assets in their respective recovery periods (i.e. without first year bonus depreciation).
With the corporate and individual tax rates reduced by the 2017 tax law, taxpayers also need to consider if they should use the benefits on the added depreciation in 2017 or in future years. If the taxpayer can use the depreciation deductions in 2017, it makes more sense to accelerate those deductions with a cost segregation study while the tax rates are at their highest. As most real estate is held in pass-through entities (S corporations, limited liability companies, and partnerships), the income is taxed at the shareholders’, members’, or partners’ individual tax rates. Thus, if real estate is held in a pass-through entity and an individual is in the highest tax bracket, the benefit would be approximately 2.6 percent higher in 2017 than in 2018. For those companies that hold real estate in a C corporation, with the tax rate shifting from 35 percent to 21 percent, this one-time benefit can be as high as 14 percent in 2017.
Regardless of a taxpayer's structure, the new tax law provides a boon for any owner or investor of a used property. To maximize savings, it's critical to consider a cost segregation study to identify all qualifying assets. Savvy taxpayers will determine their ability to use the new bonus depreciation provisions and will assess when and how to implement them as a part of their overall tax strategy.