Throughout 2018 we received guidance and commentary on how the Tax Cuts and Jobs Act (TCJA) will affect taxpayers. Over the coming weeks, the effects of this sweeping legislation will begin to take shape as preparation of 2018 tax returns gets underway. One significant change in 2018 will be the enhanced benefits of bonus depreciation and its effect on commercial or residential rental real estate owners.
Since 2001, bonus depreciation has been used to incentivize U.S. business investment. Over the years the rates and rules for bonus depreciation have changed several times (including a few years when it wasn’t available at all). In general, bonus depreciation allows a taxpayer—who invests in business property that typically would be capitalized and depreciated over the property’s useful life—to deduct all or a portion of the cost in the first year it’s placed in service. Prior to the TCJA’s passage, 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 Modified Accelerated Cost Recovery System (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. In addition, this benefit has been expanded for the first time 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 apply to certain longer production period property and certain aircraft). Learn more about these new bonus depreciation rules with our two-page overview. While these changes provide potential benefits for any business investing in new (or used) property, there’s 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 wouldn’t benefit from bonus depreciation. Buildings generally are 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 allows a building owner to identify portions of the building’s cost that can be allocated to shorter depreciable lives and, therefore, may be eligible for bonus depreciation.
During a cost segregation study, engineers 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. The ability to accelerate depreciation from 27.5 or 39 years to shorter lives is significant on its own. Thanks to the new bonus depreciation rules under the TCJA, any assets identified in a cost segregation study as qualifying for MACRS depreciation treatment of 20 years or less generally may be deducted in full in year one.
Cost segregation is an established tax planning tool 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 purchases a building in 2018 for $5 million; $1 million of the purchase price is allocated to land, and the remaining $4 million is allocated to the building and improvements. A cost segregation study is completed and results in the following allocations:
- Land (zero years recovery) – $1,000,000
- Five-year property – $1,000,000
- 15-year property – $500,000
- 39-year property – $2,500,000
The result for the owner is an increased 2018 depreciation deduction of $1,479,135. Assuming a 29.6 percent federal effective tax rate—37 percent marginal rate after the 20 percent qualified business income (QBI) deduction—and 8 percent 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’re not creating more deductions. Instead, you’re accelerating depreciation that would otherwise be spread out over 27.5 or 39 years. This timing difference can be an effective cash flow tool, but taxpayers should carefully consider their entire tax situation to assess whether they can benefit from the accelerated depreciation deduction. In particular, taxpayers should pay close attention to the effect of recent tax law changes. The following are two key provisions to consider:
- QBI deduction: New Internal Revenue Code Section 199A provides a 20 percent deduction of domestic QBI to individuals, trusts and estates for the 2018 to 2025 tax years. To learn more, see our flowchart and white paper.
- Loss limitations: The TCJA modified the net operating loss 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 to 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 a deep understanding of 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 an analysis performed upfront 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.