Has your company invested in buildings this year to rent out or use for business purposes? Real estate investors have used cost segregation studies for many years to lower their tax bills. In a nutshell, these studies divide property into smaller parts, allowing for faster depreciation of certain parts of a building.
Thanks to liberalized depreciation rules included in the Tax Cuts and Jobs Act (TCJA), real estate investors who conduct cost segregation studies may be able to write off an even bigger portion of a building’s overall cost in the early years of ownership than they could under prior law. Here’s how you can put this strategy to work for you.
Cost segregation studies help recoup your investment in qualified property faster than you’d normally be able to under the usual tax rules. Generally, a commercial property must be depreciated over a lengthy 39-year period. (The depreciation period is 27.5 years for residential property.)
A cost segregation study identifies various building components that may be classified as personal property and land improvements that are subject to shorter write-off periods. For instance, some property may be classified as five-, seven- or 15-year property eligible for accelerated depreciation methods.
As a general rule, IRS regulations define “personal property” as tangible depreciable property other than buildings and their structural components.
Several U.S. Tax Court cases have held that parts of a commercial building may be treated as personal property if they relate to only the equipment used in a business located in the building, instead of normal operation of the building. This may include such components as:
- Specialized electrical equipment and systems
- Plumbing systems in restaurant kitchens
- Removable carpeting
The write-off periods for components often depend on the nature and use of the commercial property. The rules can be confusing. So, many taxpayers rely on outside tax experts to provide cost segregation studies that break down write-off periods for various building components.
Brave New World in Cost Segregation
The TCJA expands the benefits of cost segregation studies, starting in 2018. The two most relevant provisions relate to Section 179 expensing and bonus depreciation deductions.
Sec. 179 expensing. Under Internal Revenue Code Sec. 179, a business can currently deduct the cost of qualified property placed in service during the year, up to a specified limit. But the Sec. 179 deduction can’t exceed your business income for the year. In addition, the deduction is phased out on a dollar-for-dollar basis for acquisitions of property above an annual threshold.
For tax years beginning in 2018 and beyond, the TCJA permanently increases the annual Sec. 179 deduction limit and the amount is adjusted for inflation. For 2018, the inflation-adjusted deduction limit is $1 million (from $510,000 for 2017). The TCJA also increases the deduction phase-out threshold limit for 2018 to $2.5 million (from $2.03 million for 2017).
Also, more assets now qualify for the Sec. 179 deduction under the TCJA. Examples include property used predominately to furnish lodging and various nonstructural improvements to commercial property such as roofs, HVAC equipment, and fire and security systems. These changes are effective for assets placed in service in tax years beginning after 2017.
Bonus depreciation. A business must claim first-year bonus depreciation deductions for qualified property placed in service during the year unless it elects out by property class. Qualified property generally includes tangible assets with an applicable tax recovery period of 20 years or less and computer software. Special rules apply to vehicles.
There are no phase-out limits for bonus depreciation, which is helpful for larger companies. In some cases, both Sec. 179 and bonus depreciation may apply to the same property.
Previously, the bonus depreciation deduction was equal to 50% of the remaining cost of qualified new property, after any Section 179 deduction. The TCJA doubles the bonus depreciation percentage to 100%, albeit temporarily, while extending this tax break to used property. (Under prior law, bonus depreciation applied to only new property.) These changes are generally effective for qualified property placed in service after September 27, 2017, and before January 1, 2023.
Bonus depreciation is generally reduced after 2022, based on the following schedule:
- 80% for property placed in service in 2023
- 60% for property placed in 2024
- 40% for property placed in service in 2025
- 20% for property placed in service in 2026.
After 2026, bonus depreciation will no longer be allowed, unless Congress decides to extend it. (The preceding cutbacks are delayed by one year for certain property with longer production periods.)
As a result of enhanced Sec. 179 expensing and bonus depreciation provisions, real estate investors may use cost segregation studies to claim “bigger and better” depreciation deductions in the early years of ownership, rather than recovering the costs over the usual 39-year period.
Cost segregation can provide a sizable tax windfall for commercial building owners under the TCJA. However, your cost segregation study should adhere to the guidance outlined in an Audit Technique Guide (ATG). Overly aggressive cost allocations and inadequate documentation can lead to additional scrutiny from the IRS.
IRS Closely Studies Cost Segregation Studies
For years, the IRS has contested depreciation deductions that are based on overly aggressive cost segregation studies. Back in 2004, the IRS issued a 115-page Audit Techniques Guide (ATG) to help its agents assess the validity of cost segregation studies. The guide provides answers to the following questions:
- Why are cost segregation studies performed for federal income tax purposes?
- How are cost segregation studies prepared?
- What should IRS agents review when examining these studies?
- When do issues identified in the cost segregation study need further examination?
A team of service engineers and IRS agents developed the guide. It can also provide insight to real estate investors, tax professionals, engineers and contractors regarding whether cost allocations will be perceived as reasonable—or raise red flags with the IRS. However, the guide isn’t an official IRS pronouncement and can’t be cited as authoritative guidance in an IRS inquiry.
Today, cost segregation studies continue to be hot button with the IRS, and auditors remain vigilant in finding taxpayers that claim deductions based on overly aggressive studies. Under a 2017 Chief Counsel Advice, the IRS argued that it may also assess penalties against tax professionals who prepare aggressive cost segregation studies for aiding and abetting taxpayers in the improper preparation of their tax returns.
The Tax Cuts and Jobs Act expands the benefits of cost segregation studies. So, expect ongoing IRS scrutiny in the coming years.
Get It Right
If done correctly, cost segregation studies can dramatically lower your tax bill. But if your study is audited by the IRS and issues are unearthed, this strategy can backfire — potentially costing significant additional taxes, penalties and interest. Contact your tax advisor to discuss whether a cost segregation study is right for your situation and how to minimize the risk of attracting unwanted IRS attention.