You may not be aware of it, but if you’re a property owner, some changes to current tax laws could put substantial money in your pocket, especially via cost segregation studies. With a little strategic planning, you can drastically reduce your tax liability and generate retroactive refunds for extra cash flow, freeing up capital for future investments and site improvements.
Depreciation: Value Fades Over Time
With depreciation, you calculate an asset’s reduction in value as time passes. You allocate the asset over a specific period when it’s expected to be useful. In the IRS’ view, commercial real estate has a useful period of 39 years, while land improvements (such as asphalt, parking, landscape, and security fences) are assigned a useful allocation of 15 years. Land is classified an asset that doesn’t devalue over time.
While straight-line depreciation takes your entire building and depreciates it evenly over 39 years, the modified accelerated cost-recovery systems (MACRS) methodology analyzes different parts of a building as individual assets, such as the roof, concrete, asphalt, carpet, appliances, doors, and signage, which may be depreciated over five, seven, 15, or 39 years.
How Cost Segregation Works
Cost segregation uses MACRS to accelerate the timetable for property depreciation deductions. To determine depreciation schedules, a cost seg study identifies and reclassifies personal property assets to shorten depreciation time. Engineering and tax professionals can help you identify real property assets and identify which portions of those costs you can treat as real property for accelerated depreciation.
According to MACRS:
- 39-year property includes windows, walls, doors, roofs, HVAC systems, plumbing, and electrical components;
- 15-year property includes exterior improvements such as fencing, exterior signage, asphalt, curbs, landscaping, and exterior lighting;
- Five-year property includes carpeting, appliances, specialty lighting, woodwork, unit partitions, individual unit locks, security, business-specific heating, and ventilation systems.
Let’s see from the table below how depreciation increases drastically when you apply cost segregation vs. straight-line depreciation. And if your tax bill is lower, you can carry forward any unused depreciation amounts until they’re exhausted.
Cost Segregation vs. Straight-line Depreciation
| California Self-Storage Property | Straight-Line Depreciation | Depreciation With Cost Segregation |
|---|---|---|
| 5-Year Property | $0 | $10,220.97 |
| 7-Year Property | $0 | $359,183.70 |
| 15-Year Property | $0 | $187,448.01 |
| 39-Year Property | $571,812 | $14,959.32 |
| Total Depreciation in First Year | $14,661 | $556,822.68* |
The Bonus Depreciation Bonanza
With bonus depreciation, you can take an immediate first-year deduction on a percentage of eligible business property. The 2018 Tax Cuts and Jobs Act, which increased first-year bonus depreciation to 100%, applies it to any long-term assets placed in service after September 27, 2017. The 100% bonus depreciation windfall lasts from September 27, 2017 until January 1, 2023. After that, first-year bonus depreciation will decline as follows:
- 80% for property placed in service after December 31, 2022 and before January 1, 2024.
- 60% for property placed in service after December 31, 2023 and before January 1, 2025.
- 40% for property placed in service after December 31, 2024 and before January1, 2026.
- 20% for property placed in service after December 31, 2025 and before January 1, 2027.1
Post-2027, bonus depreciation vanishes completely.
Think of it: you could get more than $300,000 in first-year deductions on a $1 million purchase!
The Green Power of the 179D Energy-Efficient Incentive
If you can reduce total annual energy and power costs by 50 percent compared to a sample building from 2007, because of the Energy-Efficient Commercial Buildings Tax Deduction (known as 179D), you can take deductions for new construction and retrofits for assets like HVAC, the building envelope, or lighting for climate-controlled units.
The maximum deduction is $1.80 per square foot. You’re allowed partial deductions of $0.60 per square foot/per system if you reduce energy consumption through the building envelope, HVAC, lighting, or interim lighting.
New Tax Laws: Help from the CARES Act
When Congress passed the CARES act in In March 2020 in response to the pandemic, it delivered tax relief to property owners with these measures:
- Bonus depreciation and net operating loss (NOL): You can now carry back a NOL from 2018, 2019, and 2020 to generate refunds and remove the taxable income limitation. The former NOL limit of 80 percent of taxable income is suspended, allowing NOLs to fully offset income in current taxable years. For this reason, you should definitely consider a cost segregation study, as well as 179 and 179D opportunities to generate an NOL and possible refunds.
- Excess business loss carryback: Now passthrough business owners and sole proprietors for taxable years beginning in 2018, 2019, and 2020 are exempted from the excess business-loss limitation (the $500,000 cap), so they can benefit from the modified NOL carryback rules.
- Alternative minimum tax (AMT) credits: CARES provides temporary relief from TCJA provisions that imposed limitations on using AMT credits. By accelerating the timetable, it allows companies to claim refundable credits to facilitate cash flow during the pandemic.
Take Advantage of the New Tax Laws
As you can see, the highly specialized world of real estate taxation can be confusing. The average CPA is probably not conversant with the tax strategies I’m outlining here. As a result, it can beneficial to consult engineering and tax professionals who are familiar with such arcane solutions as cost segregation, bonus depreciation, 179D energy incentives, and NOL carryforwards. However, you might be impressed by your tax savings.
