Rediscovering the Value of Cost Segregation Studies After Tax Reform

December 16, 2019

By Terri S. Johnson, CRE, Managing Partner of Capstan Tax Strategies and Michael Torhan

The 2017 Tax Cuts and Jobs Act (“TCJA”) was the most sweeping tax reform initiative since 1986, and it is having a tremendous impact on all industries. Let’s take a closer look at the magnitude of these changes on commercial real estate.   

Bonus Depreciation

Bonus depreciation was introduced by Congress in 2001 in an attempt to stimulate the economy following the September 11 attacks. Bonus depreciation is a tax incentive that permits owners of qualified property (i.e., new property with a 20-year or less recovery period) to immediately deduct a percentage of the asset’s purchase price. The TCJA made two very significant changes to the bonus depreciation rules:

  • Bonus depreciation is now set at 100% for qualified property acquired and placed in service after September 27, 2017 and placed in service by December 31, 2022. After 2022, bonus depreciation rates gradually decline, as illustrated below.
  • Qualified property now includes both new and used property with a 20-year or less recovery period (i.e., new construction, renovations, acquisitions of new property, and acquisitions of used property that is new to you). This is a major change as bonus depreciation previously applied to new property only.

Let’s examine the factors that determine if a taxpayer can take 100% bonus depreciation. 

Acquisitions

Eligibility for bonus depreciation under the TCJA is contingent on a written binding contract (“WBC”) signed after September 27, 2017. If a WBC—as determined under state law—was in effect before that date, the property is not eligible. The acquisition date of property that a taxpayer acquires pursuant to a WBC is the later of (1) the date on which the contract was entered into; (2) the date on which the contract is enforceable under state law; (3) if the contract has one or more cancellation periods, the date on which all cancellation periods end; or (4) if the contract has one or more contingency clauses, the date on which all conditions subject to such clauses are satisfied.

For example, imagine that you signed a WBC for an acquisition on September 1, 2017, but you didn’t close on the property until October 30, 2017. The closing date is irrelevant. The WBC date is the deciding factor, and since it was signed prior to September 28, 2017 (ignoring the other relevant dates mentioned above), your property falls under the PATH Act rules (pre-TCJA legislation). Under the PATH Act, there was no provision for bonus depreciation on acquisitions of used property, and this property would be ineligible for bonus depreciation. If in this case there was a cancellation date of October 1, 2017, the effective date of the WBC would be after September 27, 2017. Therefore, it is important to review all pertinent dates when deciding if an acquisition qualifies for 100% bonus depreciation.

Case Study

Consider the acquisition of an existing manufacturing facility by new owners. The WBC was signed after September 27, 2017, and the depreciable basis was $10.8M. 

Using a cost segregation study, the client accelerated 30% of the depreciable basis to seven-year Modified Accelerated Cost Recovery System (“MACRS”) class life and 12% to 15-year MACRS class life. 

First-Year Projected Tax Savings
Due to Depreciation Deduction

10-Year Net Present Value
of Depreciation Deductions

$1,488,872

$1,203,504

 

What if the WBC had been signed before September 28, 2017? PATH Act rules would be in effect, and acquisitions like this one would be ineligible for bonus depreciation. How does that impact results? 

First-Year Projected Tax Savings
Due to Depreciation Deduction

10-Year Net Present Value
of Depreciation Deductions

$35,508

$896,499

New Construction

When determining bonus depreciation eligibility for new construction and renovation projects relating to qualifying property, the question isn’t when a contract was executed, but rather when substantial construction was initiated.

Although there is no bright-line definition in the tax code, substantial construction generally refers to the time when physical work of a significant nature begins. This doesn’t include designing, planning or zoning work; it’s when the shovel breaks ground. The IRS provides “Safe Harbor” provisions for several areas of tax law. Safe Harbors afford protection from liability or penalty in specific situations, or, if certain conditions are met, often serve as a “good faith” benchmark. The Safe Harbor provision regarding new construction provides that, “Physical work of a significant nature will not be considered to begin before the taxpayer incurs (in the case of an accrual basis taxpayer) or pays (in the case of a cash basis taxpayer) more than 10% of the total cost of the property."  

As with acquisitions, September 27, 2017, is the make-or-break date. If construction began before September 28, 2017, the following pre-existing PATH Act phase-down rules apply:

Placed in Service by 12/31/17

50% bonus depreciation

Placed in Service by 12/31/18

40% bonus depreciation

Placed in Service by 12/31/19

30% bonus depreciation

Also applies to new spend on renovations post-acquisition

For projects in which substantial construction began after September 27, 2017, the TCJA rules apply—enabling owners to take 100% bonus depreciation. These parameters also apply to renovations being performed on new-to-you acquisitions.

The nuances within the TCJA make it even more worthwhile for property owners to explore the use of a cost segregation analysis. These engineering-based studies have long helped owners ensure that they have the documentation and support needed to accelerate properties into the five-, seven-, and 15-year asset categories in order to capture bonus depreciation.

Prior to the TCJA, a cost segregation study on a smaller property might not have provided a sufficient ROI. With acquisitions eligible for 100% bonus depreciation under the TCJA, smaller-basis properties are becoming good candidates for cost segregation.

Consider a case study of a small office building, acquired with a depreciable basis of $1.5M. Engineers are able to move 13% of the basis to five-year depreciation and 10% to a 15-year timeline. Under the TCJA, first-year cash flow is significantly increased:

 

Pre-TCJA

Post-TCJA

First-Year Projected Tax Savings Due to Depreciation Deduction

$13,151

$116,432

10-Year Net Present Value of Depreciation Deductions

$67,147

$93,675

 

The above discussion of crucial dates is summarized in the following table:

Year

Placed-in-Service Dates

Post-TCJA Bonus Depreciation

2017

1/1/2017 – 12/31/2017

Acquisition of used property

WBC signed before 9/28/17: None

WBC signed after 9/27/17: 100%

 

 

New Construction/Renovation

Construction begun before 9/28/17: 50%

Construction begun after 9/27/17: 100%

2018

1/1/2018 – 12/31/2018

Acquisition of used property

WBC signed before 9/28/17: None

WBC signed after 9/27/17: 100%

   
New Construction/Renovation

Construction begun before 9/28/17: 40%

Construction begun after 9/27/17: 100%

2019

1/1/2019 – 12/31/2019

Acquisition of used property

WBC signed before 9/28/17: None

WBC signed after 9/27/17: 100%

 

 


New Construction/Renovation

Construction begun before 9/28/17: 30%

Construction begun after 9/27/17: 100%

2020

1/1/2020 – 12/31/2020

--

100%

2021

1/1/2021 – 12/31/2021

--

100%

2022

1/1/2022 – 12/31/2022

--

100%

2023

1/1/2023 – 12/31/2023

--

80%

2024

1/1/2024 – 12/31/2024

--

60%

2025

1/1/2025 – 12/31/2025

--

40%

2026

1/1/2026 – 12/31/2026

--

20%

Bonus Depreciation: Points to Consider

One asset category that should have qualified for 100% bonus depreciation is Qualified Improvement Property (“QIP”). QIP is defined as any improvement to an interior portion of a building that is nonresidential real property if the improvement is placed in service after the date the building was first placed in service by any taxpayer. Under the TCJA, QIP replaced Qualified Leasehold Improvement Property, Qualified Restaurant Improvement Property, and Qualified Retail Improvement Property. Items not eligible to be treated as QIP include building enlargements, any elevator or escalator, and the building’s internal structural framework. 

The TCJA, however, contains an unfortunate drafting error. The QIP recovery period was intended to be 15 years and, as such, it would be eligible for bonus depreciation—since assets with a class life of 20 years or less are eligible for bonus depreciation. In the drafting process, QIP classification was erroneously left unchanged, and so QIP remains a 39-year asset as it had been under the PATH Act. Until Congress passes a technical correction bill, QIP is ineligible for bonus depreciation, and it remains firmly among 39-year assets unless accelerated to five-, seven- or 15-year class lives through a cost segregation study.

MACRS vs. ADS

MACRS is the IRS-approved method used by businesses that wish to accelerate depreciation on business equipment. MACRS provides an asset classification system delineating the number of years of depreciation associated with each type of asset.

Within MACRS are two depreciation systems: the General Depreciation System (“GDS”) and the Alternative Depreciation System (“ADS”). Entities required to use ADS are not able to take advantage of bonus depreciation.

Business Interest Expense Limitation

Another area that requires some extra planning is the new business interest expense limitation under the TCJA. Effective January 1, 2018, this provision subjects companies to a limitation on deductible interest expense. The deductible amount is capped at 30% of adjusted taxable income after certain adjustments. There is some good news for smaller firms. If a firm’s three-year average annual gross receipts are $25 million or less, it is generally exempt from the deduction limitation and may depreciate property using MACRS class lives as usual. The $25 million exception does not apply to certain taxpayers considered to be tax shelters, a discussion of which is beyond the scope of this article.

You may also be able to elect out of the limitation if you fall into one of these categories: real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing or brokerage trade or business.  If you elect out, you must depreciate your real property using ADS (“Alternative Depreciation System”) as follows:

  • Residential real property assets are 30-year straight line (40-year life applies to assets placed in service prior to 2018).
  • Nonresidential real property assets are 40-year straight line.
  • QIP is 40-year straight line.

Electing out also means being precluded from taking bonus depreciation on the above assets. Some of the nuances surrounding the business interest expense limitation and bonus depreciation warrant a careful discussion with your business/financial advisor. 

Section 179 Expensing Expanded Under TCJA

Section 179 is an entity-level election for trades or businesses that permits the full purchase price of business equipment to be written off in the year of purchase. On the books since 1958, it has long encouraged businesses to invest in themselves.   

The TCJA expanded the scope of Section 179-eligible assets to include the following improvements to nonresidential building systems placed in service after the building was placed in service: Qualified Improvement Property, roofs, HVAC, fire protection and alarm systems, and security systems. This opened up a new expensing strategy for commercial real estate owners, and the TCJA sweetened the deal by boosting the dollar limitation of the election from $510K to $1M. New and acquired assets are eligible for expensing under Section 179. 

Classic Tax Strategies Still in Play

Older tax strategies are still very much in play and serve as an excellent complement to the new legislation.

Before turning to bonus depreciation or Section 179 expensing, the taxpayer must confirm that the asset requires capitalization. The Tangible Property Regulations guide in this decision, introducing the Betterment, Adaptation, and/or Restoration criteria. If the improvement is judged to fall into one of those categories that require capitalization, taxpayers may also consider the applicability of the De Minimis Safe Harbor, Safe Harbor for Small Taxpayers, or the Routine Maintenance Safe Harbor. Any of these three safe harbors will allow the improvement to be expensed rather than capitalized. If one must capitalize, the ability to elect a Partial Asset Disposition (“PAD”) is still important post-renovation, permitting the remaining depreciable basis of disposed assets to be written-off entirely.  A quality cost segregation study remains the key to fully leverage fixed assets, providing the precise and comprehensive data required to support these tax strategies.  The TCJA continues to broaden the scope and utility of the traditional cost segregation study. 

Benefits of Cost Segregation

The following list includes some of the key benefits of cost segregation studies which take into consideration the tax law changes under the TCJA:

  • Accelerates depreciation, taking advantage of the time value of money (increasing losses in earlier years which offsets income).
  • Strategically minimizes tax liability while increasing cash flow.
  • Defines and documents shorter-lived assets eligible for 100% bonus depreciation under the TCJA.
  • Provides data to support expensing decisions under the Tangible Property Regulations.
  • Identifies and segregates assets eligible for the PAD election in a renovation.
  • Defines and documents assets eligible for expensing under Section 179.
About Michael Torhan

Michael Torhan is a Tax Partner in the Real Estate Services Group. He provides tax compliance and consulting services to clients in the real estate, hospitality, and financial services sectors.