It’s tax time again and with a newly elected president and Congress, Americans are wondering what tax policy may look like in the near future. The consensus in Washington, D.C., and among tax professionals is that rates will likely come down. Both President Trump and the House have published preliminary tax reform plans that would reduce tax rates for most businesses and individuals.
Whenever tax rate increases are anticipated, many articles offering tax planning ideas to soften the blow of higher taxes are written. However, there also are plenty of tax planning opportunities during years when lower rates are expected. For commercial real estate owners, several strategies are available to time deductions in higher rate years.
Savvy building owners and their tax advisors are loading up tax deductions into 2016 while rates are still high and those deductions are more valuable. A $1,000 deduction for a taxpayer paying 39.6 percent federal income tax may reduce tax by $396. However, that same $1,000 deduction taken in a year when the taxpayer is paying 25 percent federal income tax may reduce tax by $250. In this case, that $1,000 deduction was worth $146 more during the year with the higher tax rate.
If you have commercial real estate holdings, pay a high federal tax rate and believe rates will decline, consider these deduction timing strategies.
Real Estate Cost Segregation
During a cost segregation study, engineers specifically trained in tax depreciation methods identify assets embedded in a building’s construction or acquisition costs that can be depreciated for tax through five, seven or 15 years rather than the standard 39 years. The costs associated with these assets are then reclassified, allowing the building owner to accelerate depreciation of the property for tax purposes.
Cost segregation also can be retroactively applied. With current IRS rules, you can complete a cost segregation study on a building that was placed in service during a prior year and “catch up” the additional depreciation deductions in the current year. Amended tax returns aren’t required to take the catch-up deductions and you take those deductions using the current year’s rates by filing an accounting method change with the IRS.
Any new construction, existing building purchase or renovation more than $1 million that took place in the last 15 years may qualify for cost segregation.
The Deduction for Energy Efficient Commercial Property
The Energy Policy Act of 2005 allows commercial property owners a deduction (179D) of up to $1.80 per square foot on any facility where energy-efficient building systems have been installed. Examples might include the construction of a new building, interior improvements to an existing building or upgrades to a building’s lighting or heating, ventilation and air-conditioning systems. This deduction can be taken in the current year for any investments made since 2006. Like cost segregation, the taxpayer can catch up the energy efficiency deductions available from prior-year projects in the current year at the current year’s tax rate.
Any new building, building expansion or building upgrade that includes more than 30,000 square feet and took place since 2006 may be a good candidate for the 179D deduction.
Partial Disposition Deductions & Qualified Improvement Property
If renovations were completed last year, you may be able to deduct the tax basis of assets removed during the renovation. With recent rule changes for depreciating tangible property, building owners may be able to make a partial disposition election and deduct the remaining basis of the building components removed during the project.
An opportunity also exists in 2016 to take advantage of bonus depreciation for certain interior building improvement projects. If the costs qualify, you may be able to deduct up to 50 percent of the renovation cost in the first year.
Any commercial building renovation projects that took place during 2016 should be examined for partial disposition and qualified improvement property deductions.
Taxpayer A built a new building in 2012 for $5 million. An engineering-based cost segregation study wasn’t completed at the time of construction. A cost segregation study is completed in 2016 and shows an additional $800,000 depreciation deduction available for 2012 through 2016 that would otherwise be depreciated through 39 years. In addition, a 179D study shows the building’s energy-efficient features qualify for an $180,000 energy efficiency deduction. The result is an additional $960,000 deduction in 2016, but what’s the true value of that deduction?
The value is highly dependent on Taxpayer A’s federal tax rate. The tax rate might be the rate paid by the business in a C corporation structure or the individual owners in an S corporation, partnership or other “pass-through” structure. Let’s assume Taxpayer A’s federal tax rate is 35 percent in 2016. Let’s also assume that in either 2017 or 2018 Taxpayer A believes its tax rate may be reduced to 25 percent. The same $960,000 deduction will reduce tax liability by $336,000 in 2016 but only by $240,000 when spread out through future years at the lower tax rate. The result is the present value benefit of taking those deductions earlier in the building’s life rather than through 39 years. There’s an additional $96,000 in tax savings due to the rate difference.
If you believe tax rates are going down, you may want to take advantage of higher rates while you can. When the circumstances are right, planning tools like these can have a powerful effect on your bottom line. Take a few minutes this tax season to think about your facility investments during the last 15 years and whether an opportunity exists to plan for lower tax rates.
Contact your BKD advisor if you have questions.