Depreciation is an annual income tax deduction in which the IRS allows a taxpayer to write off a portion of the property’s cost each year and can be a powerful tax savings tool. Depreciation is based on the purchase price, or cost basis, of the property. The cost basis is then divided by the useful life of the property to determine the deduction allowed each year.  For buildings, the lives are 27.5 years for residential real estate and 39 years for commercial real estate. Because of the long depreciable life of a building, accelerated depreciation strategies should be considered.

It is important to note that accelerating depreciation does not mean you receive extra depreciation; it simply means that you are speeding up the benefits to today rather than waiting to receive them. One way to do this is through a cost segregation study.

What is a Cost Segregation Study?

A cost segregation study is a tax strategy designed to accelerate depreciation expense. This is achieved by reclassifying some of the components of a building from an asset with a long depreciable life into assets with shorter depreciable lives. Examples include flooring, appliances, specialty plumbing & electrical, cabinets, roofing, HVAC units, and land improvements such as parking lots. Once these components are broken out, an accelerated tax deduction is achieved because those components can be written off over a shorter time period.

Because of the detailed reporting that the IRS requires in order to take the accelerated depreciation adjustment, it is recommended the cost segregation study be completed by a firm that specializes in the field. As with all business decisions, there is a cost/benefit analysis that should be considered to determine whether the tax savings resulting from the cost segregation study outweigh the costs to get the study done.  For example, if your business is projecting a loss in one year but anticipates revenue in future years, it may be advantageous to wait until the business is generating income.

A cost segregation study can be completed at any time on property you own. It does not need to be done in the year you first purchase the property or place it in service. Also, unlike most tax strategies, the cost segregation study does not need to be implemented before the end of the tax year, although it does need to be completed before the tax return is filed. This allows the taxpayer to determine whether the cost segregation study might benefit them depending on their tax liability for the year.

Depreciation Recapture

It is reasonable to be concerned that taking more depreciation now will lead to higher taxes later when the property is sold. Although it is true that a cost segregation decreases the investor’s tax basis, which thereby increases the future capital gains on the property, it can still be beneficial to have a cost segregation done. Many taxpayers prefer deferring taxes into the future in order to have cash available that they can put into their business today.

Section 179 and Bonus Depreciation

There are more ways than a cost segregation study to accelerate depreciation, such as the section 179 deduction. This applies to tangible personal property, such as machinery or equipment, purchased for use in a trade or business, and improvements to the interior portion of a nonresidential building after the building is placed in service. Additional items include roofs, HVAC, fire protection systems, and alarm or security systems for nonresidential real property.  Taxpayers can deduct the full cost of these assets up to $1,050,000 for qualifying property placed in service in 2021. However, the section 179 deduction begins to phase out on a dollar-for-dollar basis after $2,620,000 of spending.

Another method to accelerate is though bonus depreciation. Currently, this allows a business to write off 100 percent of the purchase price of qualified depreciable property in the year of acquisition.  Qualified depreciation property includes property with a recovery period of 20 years or less (meaning taxpayers cannot take bonus depreciation on buildings), qualified improvement property,  computer software, and certain used property  The bonus depreciation deduction is available for property acquired and placed in service after September 27, 2017 and before January 1, 2023.

The section 179 deduction can be used alongside bonus depreciation to maximize the effectiveness of a cost segregation study. However, there are a few things to consider when determining which strategy will be most effective.

The section 179 deduction is flexible and allows you to choose which purchases to elect it for, but there is a spending cap and the deduction cannot be larger than your annual business income. Bonus depreciation has no annual spending limit and can exceed your business income, but you must apply the same treatment to all assets of the same class.

Qualified Improvement Property

“Qualified improvement property” (QIP) is any improvement made to an interior portion of nonresidential real property if such improvement occurred after the building was first placed in service.  QIP does not include expenditures attributable to enlargement of the building, any elevator or escalator, or the internal structural framework of the building.  When a cost segregation study is completed, it is likely that a large portion of the reclassified components might be considered QIP.  In prior tax law, this was not eligible for bonus because its useful life exceeded the 20 year threshold.

As of April 2020, the IRS now states that QIP placed in service subsequent to December 31, 2017 has a recovery period of 15 years.  This change allows for  QIP  to be eligible for 100 percent bonus depreciation through the year 2026. The provision can be applied retroactively and may allow taxpayers to obtain tax refunds related to expenditures for renovation projects completed in 2018 and 2019.

Conclusion

Depreciation can result in significant tax savings when properly utilized. Cost segregation studies, bonus depreciation, and Section 179 expensing are all ways that your business can benefit.  Before implementing any accelerated depreciation strategies, be sure to meet with your tax advisor to determine which strategy is best for your business.