Article 12/01/2017

How Will Tax Reform Affect Cost Segregation Deductions?

Side of a building with a crane

Most Americans agree—tax reform is coming. While we don’t have a clear picture of what tax policy will be in 2018 as of this writing, the consensus in Washington, D.C., and among tax professionals is that rates for some likely will be lower in 2018. Both the House and Senate have released bills calling for lower tax rates. If you want to prepare for potentially lower 2018 rates, now may be the time to plan for tax rate arbitrage.

Savvy building owners and their tax advisors are loading up tax deductions into 2017 while rates are still high and those deductions are more valuable. For example, 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 the following 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 purposes over five, seven or 15 years, rather than the standard 39 years (27.5 years for residential rental property). 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. Under current tax law, 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, i.e., Form 3115. For new buildings placed in service in 2017, additional depreciation benefits may be available.

Any new construction, existing building purchase or renovation costing more than $1 million that occurred 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 under Internal Revenue Code Section 179D of up to $1.80 per square foot on any facility where energy-efficient building systems have been installed. Examples 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 this year, you may be able to deduct the remaining 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 2017 to take advantage of bonus depreciation for certain interior building improvement projects. If the costs qualify, you may be able to deduct 50 percent of the renovation cost in the first year as bonus depreciation and take regular depreciation on the remaining basis.

Any commercial building renovation projects that took place during 2017 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 2017 and shows an additional $800,000 depreciation deduction available for 2012 through 2017 that would otherwise be depreciated over
39 years. In addition, a §179D study shows the building’s energy-efficient features qualify for a $160,000 energy-efficiency deduction. The result is an additional $960,000 deduction in 2017, but what’s the true value of that deduction?

Assume Taxpayer A’s federal tax rate is 35 percent in 2017, and Taxpayer A believes its tax rate may be reduced to 25 percent in 2018. The same $960,000 deduction will reduce tax liability by $336,000 in 2017, but only by $240,000 when spread through future years at the lower tax rate and prior to any present-value effect of taking those deductions later in the building’s life. There’s an additional $96,000 in tax savings due to the rate difference. If the 20 percent corporate rate included in both House and Senate bills becomes law, that spread is even wider.

If you believe tax rates could decline, 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 during 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 Jason or your trusted BKD advisor with questions or for more information.