Cost Segregation and Tax Planning in a New Era of Bonus Depreciation

Introduction

In the dynamic world of tax law, anticipating and adapting to changes is crucial. As we witness the phase-out of bonus depreciation—a provision significantly influencing tax planning and cost segregation strategies for numerous businesses—it's essential to comprehend its implications. This blog post aims to guide you through this pivotal shift and the strategic tax planning required in the emerging tax landscape. We'll delve into:

  • The concept and historical context of bonus depreciation
  • The details of its phase-out
  • The role and influence of cost segregation in the current tax environment
  • The impact of the bonus depreciation sunset on cost segregation
  • Strategic tax planning suggestions for businesses in this evolving scenario

Join us as we chart a course through these changes, offering insights and guidance on how to effectively manage your cost segregation and tax strategies amidst the bonus depreciation sunset.

Unraveling the Bonus Depreciation Phase-Out

Bonus depreciation, a cornerstone of many businesses' tax strategies, allows businesses to deduct a large portion of the cost of eligible assets in the year they are placed in service, reducing tax liability and enhancing cash flow. Initially introduced in the Job Creation and Worker Assistance Act of 2002, bonus depreciation has undergone several extensions and revisions.

The Tax Cuts and Jobs Act (TCJA) of 2017 was a major turning point, expanding bonus depreciation to additional assets and allowing for 100% depreciation of qualified assets. Businesses were able to deduct the full cost of eligible assets in the year they were placed in service, providing a significant boost for businesses investing in new assets.

This provision, however, was never intended to be permanent. According to the TCJA, the percentage of bonus depreciation started to decrease in 2023. The phase-out process is gradual, with the bonus depreciation decreasing by 20% each year until it is entirely phased out after 2026.

The phase-out of bonus depreciation signals a new chapter in the tax landscape. It suggests that businesses accustomed to leveraging bonus depreciation for their tax advantages will need to reassess their strategies and seek alternative avenues for tax savings.

The Evolving Role of Cost Segregation

Cost segregation, a strategic tax planning tool, enables businesses to accelerate depreciation deductions, thereby reducing tax liability and improving cash flow. It involves identifying and separating personal property assets and land improvements from real property assets, which allows businesses to depreciate these assets over a shorter tax life, leading to significant tax savings.

Cost segregation offers numerous benefits. It not only facilitates immediate tax savings but also provides a potential reduction in insurance costs, as personal property assets typically have lower insurance costs than real property. Furthermore, cost segregation can supply valuable information for property tax appeals and assist in precise calculations in case of casualty losses.

With the bonus depreciation in play, cost segregation studies have allowed businesses to maximize tax savings by identifying assets that qualify for this incentive. For instance, personal property assets and land improvements identified in such a study may be eligible for bonus depreciation, leading to substantial upfront deductions.

The Ripple Effect of Bonus Depreciation Sunset on Cost Segregation

The gradual phase-out of bonus depreciation is set to influence cost segregation practices considerably. As the bonus depreciation percentage decreases, the immediate tax savings from cost segregation studies may decrease correspondingly. A lower bonus amount will reduce the first year tax deduction and spread the rest out across the applicable asset timeline, potentially decelerating the pace of tax deductions for businesses.

Here is the timeline for applying bonus depreciation:

  • Sept. 28, 2017 – Dec. 31, 2022 100 percent
  • 2023 80 percent
  • 2024 60 percent
  • 2025 40 percent
  • 2026 20 percent
  • 2027 None
  • 2028 and thereafter none

These changes pose both challenges and opportunities for businesses. On one hand, the reduction in bonus depreciation may affect an investors cash flow and bottom line, especially those that heavily relied on it for tax reductions. On the other hand, it also prompts investors to revisit their investment strategies and make necessary adjustments.

Additionally, tax code changes occur almost every year and the H.R. 3936, Built it In America Act was introduced on June 8, 2023 and proposes and extension of 100% bonus depreciation until January 1, 2027 which could be passed later this year.

While the phase-out of bonus depreciation will undeniably alter the tax landscape, it does not nullify the benefits of cost segregation. Cost segregation will continue to be a valuable tool for businesses to accelerate depreciation deductions and manage their tax liabilities, albeit within a different context. It's crucial for businesses to adjust their strategies to successfully navigate these changes.

Strategic Tax Planning in the New Era

Strategic tax planning, which involves structuring business operations and transactions to minimize tax liabilities, becomes even more crucial as businesses adjust to the bonus depreciation sunset. As we step into this new era, businesses will need to adapt their tax strategies. Here are a few suggestions:

  1. Proactive Tax Planning: Get a cost benefit analysis performed on your properties or potential purchases to have a plan of depreciation and how those write-offs will carry over each year. Planning for depreciation changes can help determine the best property and the purchase amounts with the highest benefit.
  2. Explore other tax incentives: The phase-out of bonus depreciation narrows one avenue for tax savings, but other tax incentives are still available. For instance, Section 179 expensing allows businesses to deduct the full purchase price of qualifying equipment and/or software purchased during the tax year, providing substantial tax benefits even in the absence of bonus depreciation.
  3. Revisit asset management strategies: The impending phase-out of bonus depreciation necessitates a reevaluation of asset management strategies. Businesses may need to reconsider the timing of asset purchases and disposals, the classification of assets and the potential for asset revaluations.
  4. Seek professional advice: The bonus depreciation phase-out adds another layer of complexity to navigating tax law. Businesses are encouraged to seek professional advice to fully understand these changes and to develop effective tax strategies.

Looking Ahead: Navigating the Post-Bonus Depreciation Era

The landscape of cost segregation and tax planning is set to change significantly with the sunset of bonus depreciation. However, this does not mean the value of cost segregation diminishes. Instead, cost segregation will continue to be a powerful tool for businesses to manage their tax liabilities in a new context.

In the post-bonus-depreciation era, cost segregation will likely play a more nuanced role in tax planning. The focus may shift towards assets with shorter recovery periods that can still provide substantial tax savings. To illustrate this, let’s delve into a simplified case study of a single-family rental property:

Scenario 1: With Bonus Depreciation

Suppose you purchase a single-family rental property for $200,000 in 2022, with the land valued at $50,000 and the building at $150,000. Let's say you perform a cost segregation study on the property and determine that $30,000 of the building's cost can be classified as personal property with a five-year lifespan. With the 100% bonus depreciation in effect in 2022, you could immediately depreciate the entire $30,000, resulting in a substantial deduction in your taxable income for that year. The remaining $120,000 of the building's cost would be depreciated over 27.5 years as usual.

Scenario 2: Without Bonus Depreciation

In contrast, if you purchase the property in 2027 when bonus depreciation has phased out, the same cost segregation study would yield no immediate depreciation on the $30,000 identified as personal property. Instead, it would be depreciated over a five-year lifespan. As a result, your first-year depreciation deduction would be significantly lower than in the previous scenario. This would increase the threshold for a property’s purchase to ensure that the benefit outweighs the cost.

Comparative Impact

In Scenario 1, the immediate depreciation provided by the bonus depreciation rule would give you a sizable tax break in the year you purchase the property. This can lead to increased cash flow, which could be reinvested in the business, offsetting the initial investment cost.

However, in Scenario 2, without bonus depreciation, the tax savings would be spread out over the five-year lifespan of the personal property, making it less impactful on your cash flow in the first year. This change will significantly affect whether or not investors choose to undertake cost segregation studies for smaller properties. For large properties, the expense of a cost segregation study may still be justified by the amount of depreciation it uncovers, even without bonus depreciation.

The above scenario is simplified for illustrative purposes. In reality, the impact will depend on a number of factors including your income, the nature of the assets and other tax considerations. Always consult with a tax professional when making these types of decisions.

This case study demonstrates that while the phase-out of bonus depreciation will influence the decision to undertake a cost segregation study, it does not eliminate the potential benefits of this practice. As bonus depreciation phases out, property investors must adapt their strategies to optimize tax savings.

Moreover, investors will need to explore other tax incentives that can complement their cost segregation strategies. For instance, Section 179 expensing can offer significant tax benefits even in the absence of bonus depreciation. Other tax incentives, such as the Research and Development Tax Credit or the Energy-Efficient Commercial Buildings Deduction (Section 179D), may also come into play.

Conclusion

The sunset of bonus depreciation marks a substantial shift in the tax landscape, influencing how businesses approach cost segregation and tax strategies. Despite these changes, it's crucial to remember that this phase-out presents opportunities for businesses to rethink and adapt their strategies.

As we navigate this new era of tax planning, professional expertise and guidance become invaluable. At Engineered Tax Services, we are dedicated to helping businesses understand and adjust to these changes. Our team of experts specializes in cost segregation and strategic tax planning, providing solutions that align with your business goals.

Whether you're considering a cost segregation study, exploring other tax incentives or need advice on managing the complexities of the bonus depreciation phase-out, we're here to help. Our goal is to ensure that your business is well-positioned to optimize tax savings and thrive in this evolving tax landscape.

Contact Engineered Tax Services today for a consultation and let us help you strategize successful tax planning in the post-bonus depreciation era. Your success is our success, and we look forward to partnering with you on this journey.

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