The old saying goes, “Money doesn’t grow on trees,” but could it be hidden in the walls?
Since the landmark Hospital Corp. of America v. Commissioner court case decision in 1997, tens of thousands of owners of commercial and residential rental buildings have taken advantage of cost segregation studies to significantly reduce taxable income by accelerating depreciation. The resulting tax reduction can be $50,000 to $70,000 for every $1 million in building cost basis owned. Rather than depreciating a building over 39- or 27½-year lives, the 1997 ruling allows building owners to separate building components into shorter depreciation lives of five, seven and 15 years. A few examples of five-year property are cabinets, moldings, carpet, wall coverings, specialty lighting and accent lighting. Fifteen-year property includes retaining walls, external signage, parking lots and landscaping, among many other components.
While there is general awareness of cost segregation within the business community, many building owners are not aware of recent changes in the tax code that have made cost segregation more valuable than ever. The most significant changes to depreciation as it relates to commercial real estate revolve around bonus depreciation. Except for a brief pause from 2005-2007, bonus depreciation has been in place since 2001 to encourage investment in capital assets.
The concept of bonus depreciation allows for a percentage of the cost of a capital asset to be deducted in the year the asset is placed in service, with the remaining basis deducted over its normal depreciable life. This percentage has ranged from 30 percent to 100 percent over that time and had an original use requirement.
The Tax Cuts and Jobs Act of 2017 brought back 100 percent bonus depreciation through 2022, meaning five-, seven-, and 15-year building components identified in a cost segregation study may be fully depreciated in the year the components are placed in service. These shorter depreciation lives can often amount to 20-35 percent of a building’s cost basis.
Another taxpayer friendly change was the removal of the original use requirement for buildings acquired and placed in service after Sept. 27, 2017. As a result, in both new construction of commercial real estate and in a new acquisition of an existing building, a cost segregation study can be performed to take advantage of this accelerated first-year depreciation of earlier life building components.
As an example of this much greater first year tax impact, the owner of a $1,000,000 existing building acquired in December 2018 can often obtain a $70,000 tax reduction in the first year of ownership, compared with about $10,000 in the first year under the old rules.
Two other valuable and often overlooked changes resulted from the IRS Tangible Property Regulations issued in 2013. When a renovation of an existing building is undertaken, the regulations now allow a cost segregation study to determine the value of the building components discarded during the course of the renovation, which can then be taken as a loss, less what had previously been depreciated. The deduction must be taken in the same tax year that the renovation was completed.
To be compliant with the regulations, a building must be broken down into its building systems: building structure including roofs, plumbing systems, electrical systems, escalators, elevators, fire protection and alarm systems, security systems, gas distribution systems and any other system defined by the U.S. Treasury.
When a building repair occurs, the newly repaired component must be compared with all similar components within the building system. If the new component is repaired more than two years after the original date of occupancy, does not make the component materially better and does not affect more than 33 percent of all the like components, it can be expensed rather than capitalized over 39 years. Regarding the determining of value of building systems, the U.S. Tax Code says that at least a “reasonable” method must be used, but it has specifically called cost segregation a “certain” method.
The regulations also offer three safe harbors that can be used, which also can help the building owner expense repairs if any of the above rules do not apply.
Owners of commercial or residential rental property acquired or improved in the past 15 years for at least $300,000 likely qualify for a cost segregation study. Today, more than ever before, being aware of and taking full advantage of cost segregation benefits is crucial for building owners wanting to maximize their property investment in the most tax-efficient manner.
Paul Correa is the Regional Director for Cost Segregation Services Inc., one of the nation’s largest and most experienced cost segregation study providers.