Throughout the last two years we received guidance and commentary on how the Tax Cuts and Jobs Act (TCJA) will affect taxpayers. For many taxpayers, the major impacts of this sweeping legislation finally began to take shape as preparation of 2018 tax returns got underway in 2019. One significant change in 2018 is the enhanced benefits of bonus depreciation and its impact on owners of commercial or residential rental real estate.
Since 2001, bonus depreciation has been used to incentivize US business investment. Over the years the rates and rules for bonus depreciation have changed several times (including a few years when it was not available at all). Generally, bonus depreciation allows a taxpayer that invests in business property that would generally be capitalized and depreciated over the useful life of that property to deduct all or a portion of the cost in the first year it is placed in service. Prior to the passage of the TCJA, bonus depreciation was set to phase down and generally expire on December 31, 2019 with 2018 rates scheduled to be 40 percent of the cost of property with a MACRS recovery period of 20 years or less. Historically bonus depreciation has been available for new assets only, which excluded the purchase of existing or “used” assets.
The TCJA made a few changes to the bonus depreciation rules. Taxpayers can now deduct 100 percent of the cost of bonus eligible property in the first year for property acquired and placed in service after September 27, 2017 and before January 1, 2023. Additionally that benefit for the first time has been expanded to include used property (with exceptions for property purchased from related parties). The applicable bonus depreciation percentage begins to phase down for property placed in service between 2023 and 2026 (alternative dates play to certain longer production period property and certain aircraft). Learn more about these changes with this two-page overview. While these changes provide potential benefits for any business investing in new (or used) property, there is an especially powerful planning opportunity for those placing real estate in service.
Benefits for Real Estate Investments
On its face, it may seem that an investment in a building would not benefit from bonus depreciation. Buildings are generally depreciated over a 27.5 or 39 year life and bonus depreciation only applies to assets with a recovery period of 20 years or less. However, cost segregation is an established tax planning tool that allows the owner of a building to identify portions of the building’s cost that can be allocated to shorter depreciable lives which may be eligible for bonus depreciation.
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 over five, seven or 15 years rather than the standard 27.5 or 39 years. Those assets are then reclassified, allowing the building owner to accelerate depreciation of the property for tax purposes. In a typical year accelerating depreciation from 27.5 or 39 years to shorter lives is powerful on its own. Thanks to the changes to the bonus depreciation rules under TCJA, any assets identified in a cost segregation study as qualifying for MACRS depreciation treatment of 20 years or less may generally be deducted in full in year one.
Cost segregation is available and should be considered when real property is placed in service. The following are good candidates for cost segregation:
- New buildings
- Improvements and expansions
- Purchased property
- Stepped-up basis at death or partnership transactions.
Taxpayer A purchased a building in 2018 for $5 million. $1 million of the purchase price was allocated to land and the remaining $4 million to the building and improvements. A cost segregation study is completed and results in the following allocations:
- Land (zero years recovery) - $1,000,000
- 5-year property - $1,000,000
- 15-year property - $500,000
- 39-year property - $2,500,000
The result for the ownership is an increased 2018 depreciation deduction of $1,479,135. Assuming a 29.6 percent federal effective tax rate (37 percent marginal rate after 20 percent qualified business income (QBI) deduction) and 8% discount rate, the owners would reduce federal income tax in 2018 by $437,824 resulting in a present value savings of $280,457.
Not for everyone
Sound too good to be true? It can be. When you complete a cost segregation study, you are not creating more deductions. Instead you are accelerating depreciation that would otherwise be spread out over 27.5 or 39 years. This timing difference can be a powerful cash-flow tool but careful consideration should be given to the taxpayer’s entire tax situation to ensure they can benefit from the accelerated depreciation deduction. In particular, close attention should be paid to the effect of recent changes to the tax law. These are two of the key provisions to consider:
- QBI deduction: New Internal Revenue Code §199A provides a 20 percent deduction of domestic QBI to individuals, trusts and estates for the 2018–2025 tax years. Learn more with our flowchart and whitepaper.
- Loss limitations: The TCJA modified the net operating loss (NOL) rules to limit the deduction to 80 percent of taxable income for losses arising in tax years beginning after December 31, 2017 and added a new limitation on excess business losses for the 2018–2025 tax years.
To avoid unintended tax consequences, involve your tax advisor when considering a cost segregation study.
Before incurring the cost of a study, consult a cost segregation professional with deep understanding of both construction engineering and tax. A cost segregation professional will provide a detailed feasibility analysis that outlines the potential tax benefit and fees involved in a study. Having that analysis performed up front will give you the data needed to make an informed decision. For more information about cost segregation or to request a feasibility analysis contact Jason or your trusted BKD advisor.