Consider a commercial property that was purchased by a corporation for $20 million dollars on January 1, 2018. The corporation paid $10,000 to a qualified construction engineer for a cost segregation study. The construction engineer determined the following components made up the total value of the commercial property:
Personal property (15%): $3,000,000
Land improvements (15%): $3,000,000
Building (60%): $12,000,000
Land (10%): $2,000,000
Using this study, the corporation could depreciate $6,000,000 in 2018 from the property if they elect the bonus depreciation option. The building’s actual value would depreciate normally over 39 years. The residual land value would not be entitled to depreciation. Corporate income tax rates were set at a flat 21% for 2018. Therefore, the total tax savings under this method would be $1,260,000. If the corporation did not have a cost segregation study performed, they would only be able to deduct normal depreciation from the property for 2018 – $512,821 ($20,000,000 / 39 years). Their tax savings from the building’s purchase would be $107,692 – much less than if the corporation had invested in the cost of the segregation study.
Elements of my purchased property qualify for the 100% bonus depreciation deduction. Should I take the deduction now, or depreciate the value over the normal 5 to 7-year period?
You should discuss your method of depreciation with your CPA. They will be able to advise you of the best strategy to meet your cash flow and tax needs. While the use of bonus depreciation will significantly reduce tax payments for the first year, they will generally increase in following years because the depreciation allowance will be limited to items not included in the bonus depreciation calculation. However, taking the bonus depreciation during the first year can be tremendously helpful for property owners who need to free up cash immediately for other investments or to meet operating cash flow needs.
Did the 2017 Tax Cuts and Jobs Act impact depreciation for personal property and land improvements?
Yes! The 2017 Tax Cuts and Jobs Act significantly impacted depreciation for personal property and land improvements. Property acquired after September 27, 2017 that has undergone a qualified cost segregation study can qualify for 100% bonus depreciation. This means that personal property and land improvements can be fully depreciated and included as a tax deduction the year that the property is purchased. This results in a significant cost savings for the property owner during the first year of property ownership. However, bonus depreciation is only available through 2022, at which time it will begin to decrease in 20% increments.
The 2017 Tax Cuts and Jobs Act also expanded the definition of property that can be depreciated under the bonus depreciation rules to include used property that has not previously been operated by the new owner and is not acquired from a related party. Therefore, property that is newly acquired but was previously owned or constructed is still entitled to bonus depreciation if a proper cost segregation study is performed.
Typical land improvements include parking lots, driveways, sidewalks, landscaping and security lighting. These can be depreciated over fifteen years. However, the 2017 Tax Cuts and Jobs Act re-introduced bonus depreciation, which also allows the owner to depreciate the value of land improvements 100% at the time of the property’s purchase.
Typical personal property that can be separated from real property includes flooring and carpet, moldings, cabinets, furniture, accent lighting, window treatments, shutters, any communication or data lines, and ceiling fans. Personal property can be depreciated five to seven years. However, the 2017 Tax Cuts and Jobs Act re-introduced bonus depreciation, which allows the owner to depreciate the value of personal property 100% at the time it is purchased.
By separating the value of the property into specific categories with reduced years required for depreciation, the property owner will realize an increase in cash flow that can be used for investments or operations. Tax payments can be significantly reduced depending on the value of personal and land improvement property that is identified within the property. It is estimated that 15-45% of the total value of a property can be reclassified to personal or land improvement components from a cost segregation study.
Cost segregation studies have been completed for decades and have provided extensive tax savings and increased cash flow to real estate investors. An engineered cost segregation study is used to accelerate depreciation deductions by shorting the useful life of components of real estate.
A formal cost segregation study requires the real estate investor to hire a cost segregation professional with an engineering background. This is required because extensive experience is required to analyze, determine and apply the various tax laws to the building components.
The greatest tax savings are realized by performing an engineered cost segregation study that can identify not only the obvious assets eligible for cost segregation but can also take advantage of the ability of experienced engineers and construction cost estimating experts to identify hidden or ancillary assets for cost segregation.
The IRS specifically states:
…Internal Revenue Service Audit Technique Guideline
If a real estate investor acquires a small property it just does not make sense to hire an experienced cost segregation firm. However since each property has unique characteristics, the property owner is relied upon heavily to make sure that they take adequate pictures, accounting, and make sure that our allocations are consistent with theirs. Our reports should not be used on larger commercial properties as a result of more complex engineering and structural components.
Engineered cost segregation studies provide a quantified, qualified and verifiable analysis and segregation for the depreciation of assets classified as real estate into the much shorter class lives of 5, 7 and 15 years that are provided for items of personal property. This tax savings strategy can result is significant tax deductions at a minimal cost.
So herein lies the problem. Because of the extensive requirements, many cost segregation reports will cost thousands of dollars and it is not unusual to see reports exceed $10,000.
The result is that it just did not make sense for owners of small rental properties to get a report done. So cost segregation studies were typically reserved for large commercial projects. But not anymore.
Thanks to tax reform, the useful lives of certain real estate components have been shortened. In fact, some components even allow for immediate expensing.