Because of major changes initiated by the Tax Cuts and Jobs Act (TCJA), cost segregation studies (CSSs) are likely an important part of your tax strategy. If you're a property owner, commercial developer, or investor, you'll need to consider the finer details of TCJA changes when conducting your CSS in order to maximize your savings strategies. Here are the most important details you need to know.
How Can a Cost Segregation Study Complement Your Deductions?
Firstly, what is a CSS? A cost segregation study is the process of categorizing the costs of an overall building project (a standard of a 39-year recovery period) into shorter-lived classifications (15, 7, and 5 years for recovery) that allow for faster cost recovery and tax savings. Prior to the passage of the TCJA, a CSS example might have allocated the purchase price of commercial property into these periods of recovery:
- 20% to land (non-depreciable)
- 15% to land improvements (15-year recovery period)
- 12% to equipment (5-year recovery period)
- The balance to building asset (39-year recovery period)
When employing a CSS, this could result in a first-year depreciation deduction of perhaps $150,000 rather than $30,000 if the CSS had not been conducted and left all of the assets in the standard 39-year tax recovery period.
How Does TCJA Bonus Depreciation Help You?
The TCJA allows for 100% bonus depreciation for both new and used properties placed into service after Sept. 27, 2017, which can accelerate deductions as a result of a CSS. For closing dates of Sept. 28, 2017, and after, assets that were traditionally allocated as furniture and fixtures, equipment, and land improvements are now eligible for the 100% first-year bonus depreciation. Taking the example above, the land improvements and equipment identified by the CSS could be placed into this 100% bonus depreciation rather than the 15- and 5-year recovery periods, resulting in a $1.1 million first-year depreciation instead of $150,000. Special care should be taken when dealing with long-lived projects that may have started construction before September 27, 2017, and were placed in service after that date.
What are the Changes in Qualified Improvement Property?
Before the TCJA, there were separate Qualified Improvement Property (QIP) categories: Qualified Restaurant Property (QRP), Qualified Leasehold Improvement Property (QLIP) and Qualified Retail Improvement Property (QRIP). The TCJA eliminated these and left only the QIP. A technical error in the TCJA failed to reduce the class life for QIPs to 15 years, so the depreciation is 39 years with no qualification for the 100% bonus depreciation unless the assets. A cost segregation study would allow some of the QIP to be broken down into shorter-lived asset classes that could be bonus depreciation eligible.
How Do These TCJA Changes Affect Taxpayers?
Even with these changes, some taxpayers may not benefit from using CSS, though. Previously both personal property and real property qualified for like-kind exchange treatment. Under the TCJA, only real property qualifies. A taxpayer may choose not to do a CSS on a property if they know an exchange is imminent.
In addition, the TCJA also introduced an interest expense limitation. A deduction for interest expense is allowed equal to business interest income, 30% of the taxpayer’s adjusted taxable income for the year, and the taxpayer’s floor plan interest for the year. Adjusted taxable income is defined as earnings before interest, net operating loss, pass-through 199A deduction, depreciation, amortization, or depletion. After January 1, 2022, the definition is the same other than depreciation, amortization, or depletion are no longer added back to taxable income for the calculation.
Small businesses with a 3-year trailing period of annual gross receipts of $25 million or less are exempt from the interest expense limitation. Another exception to the limitation for real property businesses is electing to use Alternative Depreciation System (ADS) lives and methods. The ADS generally provides for longer lives and slower deductions than traditional tax depreciation methods. Additionally, ADS does not allow for bonus depreciation.
Electing ADS may negate the benefits of a CSS. If a technical corrections bill is passed, providing clarity for QIPs and bonus depreciation it will impact the way we think about CSS. With or without a corrections bill, CSS still provides a distinct opportunity for real property owners, but they need to be aware of the impact of the TCJA. If you have any questions, please contact us today.
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