Is cost segregation worth it? Both large and small real estate owners have been asking themselves this question for decades. In this post, we offer one simple rule to follow to answer this very important question.
But first, let’s take a look at why cost segregation studies are becoming increasingly popular. Tax reform has made it more economical and given many owners (especially smaller owners) greater incentive.
Cost Segregation and the New Bonus Depreciation Tax Bill
The passage of Tax Cuts and Jobs Act (TCJA) bill provides significant tax benefits to owners of the commercial estate. These benefits can even be claimed for the 2017 tax year. The new tax law stipulates that owners who purchased a residential or non-residential property, closing on or after September 28, 2017, are eligible for tax benefits due to the bonus depreciation applied to the used property.
This is a tremendous advantage for owners and investors acquiring used property. Some of these privileges were only enjoyed by owners who constructed or bought new properties under the Job Creation and Worker Assistance Act of 2002. The new law also provides for 100% bonus depreciation in the first year. Assets must be qualifying, new or used, with a tax recovery period of 20 years or less.
Bonus depreciation provision was initially meant to stimulate growth and encourage an investment back to the economy. It originally provided for 30% bonus depreciation in the first year of use of an asset which was new and had a 20 year or less tax recovery period.
Assets like brick and mortar building classified as either 39-year depreciation period for non-residential real property and 27.5 years for residential property under Modified Accelerated Cost Recovery System (MACRS) would therefore not qualify for the bonus depreciation provision.
Cost Segregation Studies Make More Sense Today
Before the tax law was passed, used commercial property owners had to depreciate their properties using the 39-year MACRS period, not accounting for hidden assets within the real estate component which had lower recovery periods like five, seven or 15 year periods. These assets can now qualify for the 100% bonus in their first year of use if they have a 20-year or less recovery period and started service after September 27, 2017.
Those placed in service before September 28, 2017, would not qualify for the bonus but can use the MACRS depreciation rates, most assets within a real estate component qualify for MACRS short periods of depreciation.
Cost segregation is important for recently purchased used assets. Engineering and tax professionals identify and reallocate purchase price for the main purpose of taking advantage of the significant bonus depreciation provisions. We explain this in our dummies post.
Where an asset is generalized at a lump sum cost, for example, a parcel of real estate, professionals will use cost estimation techniques to categorize individual components of the property such as land, land improvements buildings, equipment, and furniture and fixtures. Assets placed in to use after September 27, 2017, can qualify for the 100% bonus provision.
Bonus depreciation is reported as an expense in asset’s first year of use. An owner should ensure that the significant deductions are directed towards offsetting taxable income. The new tax law has a provision that allows asset owners to step down the deduction by use of prior tax provision for a bonus at 50% depreciation rate.
However, asset owners can opt out of the bonus depreciation and use the traditional MACRS depreciation, conducting a cost segregation to take advantage of the short depreciation periods.
TCJA has reduced corporate and individual tax rates. An asset owner should, therefore, consider claiming the benefits in its first year of use or claiming it in future years. Cost segregation should be done and deductions claimed when tax rates are at their highest. Those holding assets as pass-through entities are taxed on individual levels;they can enjoy a benefit of up to 2.6% while those in C corporations can enjoy a 14% benefit.
Is Cost Segregation Worth It?
So at the end of the day – is cost segregation worth it? Every investor or used asset owner benefits from the new tax law regardless of their structure. Cost segregation study helps to maximize the tax savings under the bonus depreciation provision. Cost segregation will identify an asset according to its ability to use bonus depreciation provision and when best to implement the provisions for maximized benefits to the taxpayer.