Whether you’re an owner-operator of a single hotel or manage a lodging portfolio, chances are your most significant investment is in your real estate. Historically, many in the lodging industry have used a powerful tax planning tool called cost segregation to accelerate tax deductions and recoup that investment faster. Now, thanks to the Tax Cuts and Jobs Act (TCJA), the tax benefits available through cost segregation and other deduction timing tactics are more significant.
During a cost segregation study, engineers specifically trained in tax depreciation methods identify assets embedded in a building’s construction, acquisition or improvement costs that can be depreciated for tax over 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.
Present-Value Tax Benefit
At its core, cost segregation is a timing play. You take more deductions sooner and end up taking fewer deductions for depreciation in later years. Moving some building construction, improvement or acquisition cost from a 39-year category to a shorter life category provides high time-value-of-money benefit by itself, but the TCJA has added an incentive that multiplies that benefit. For buildings that qualify and are acquired or constructed after September 27, 2017, 100 percent bonus depreciation may be available. When the other requirements are met, bonus depreciation applies to assets with a tax depreciation life less than 20 years so those assets carved out in a cost segregation study can now be 100 percent depreciated in year one. A significant change under the TCJA is that bonus depreciation may now be applied to both new and used property (previously only new property qualified), so whether you are improving an existing property, building a new building or acquiring an existing building, you may be able to take advantage of cost segregation with 100 percent bonus depreciation.
Benefits from Prior Years
For taxpayers with an existing real estate portfolio, cost segregation also can be applied retroactively. Under 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 are not required, and the current-year tax reduction can be significant.
Lodging: Ideal Properties for Cost Segregation
Whether the property is a budget motel or full-service resort, these buildings often are ideal candidates for cost segregation. Why? Because the buildings are built around your business process. These aren’t empty generic building shells. Some of the specific assets and systems reviewed in a lodging industry cost segregation study include:
- Portions of the electrical system that support decorative assets and business process machines
- Certain types of floor coverings
- Certain types of millwork
- Kitchen equipment hookups
- Land improvements including landscaping, parking and recreation-related assets
- Spa/fitness center-related assets
- Wall coverings
Example: Current-Year Purchase
Company A acquired an existing hotel in the current year for $10 million. $1 million is allocated to land and $9 million is allocated to building. The following cost segregation study allocates $1.5 million to five-year personal property and $1 million to 15-year land improvements. Assuming the owners have an effective tax rate of 29.6 percent, they can take advantage of the new bonus depreciation rules and will increase their depreciation deduction in the first year by $2,465,225, resulting in a $729,707 reduction in current-year tax liability.
Example: Prior-Year Construction
Company B built a new full-service hotel six years ago for $5 million and didn’t complete a cost segregation study. They completed a cost segregation study in the current year, allocating $1 million to five-year personal property and $500,000 to 15-year land improvements. Assuming the owners have an effective tax rate of 29.6 percent, they’ll catch up an additional $1,122,900 in depreciation deduction in 2018, resulting in a $332,378 reduction in current-year tax liability.
Cost segregation is a powerful tax planning tool for the lodging industry, but it doesn’t work for every property or every owner. Before incurring the cost of a study, consult with a cost segregation professional with a deep understanding of both construction engineering and tax. The advisor should be able to provide a detailed feasibility analysis that outlines the potential tax benefit and fees involved in a study. Having that analysis performed upfront will help give you the data needed to make an informed decision.
For more information or to request a no-fee cost segregation feasibility analysis, contact Jason or your trusted BKD advisor.
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