Cost segregation is not a new tax strategy, but the passage of the Tax Cuts and Jobs Act in December 2017 now make it a more valuable one. Essentially, cost segregation identifies parts of a building that can be depreciated more quickly and turns those components into bigger tax deductions that can generate more cash flow in the earlier years of a building’s lifespan. Tax reform’s changes to another fixed asset tax strategy – bonus depreciation – provides even more incentive for business owners to consider a cost segregation study in the near future. Let’s find out why.
What is bonus depreciation and how did tax reform change it?
Bonus depreciation is the amount of deductible depreciation taken in the first year, above and beyond what is normally available. Tax reform changed bonus depreciation in two major ways:
- Increased bonus depreciation from 50 to 100 percent for property acquired and placed in service after September 27, 2017 and before January 1, 2023 (before January 1, 2024 for longer production period property or certain aircraft property). The 100 percent bonus rate decreases by 20 percent annually after December 31, 2022.
- Expanded the eligible property to include certain used property as well as certain film television and live theatrical productions. Anti-abuse rules also prevent related parties from buying property from each other and taking the depreciation deduction.
In general, 100 percent bonus depreciation is applicable to depreciable business assets with a recovery period of 20 years or less. This means that items such as furniture, fixtures, equipment, machinery and computers can now be fully deducted in the first year for tax purposes if the criteria above are met.
What does bonus depreciation have to do with cost segregation?
Following the provisions described above, any personal property or land improvements identified and broken out from the building cost through a cost segregation study would now be eligible for 100 percent bonus depreciation in the current year. Since used property is now eligible, the personal property and land improvements identified at the time of a building’s purchase are also now eligible for bonus depreciation. Before tax reform, these assets were depreciated with shorter depreciable lives and accelerated methods, but not eligible for bonus depreciation.
As part of its translation of tax reform’s legislative provisions into regulatory guidance, the IRS recently published proposed regulations that give specific definitions and clarifications around the application of new bonus depreciation changes. Here are some highlights:
- Acquisition Date: Property must be acquired by a taxpayer after September 27, 2017 or acquired pursuant to a written binding contract entered into after September 27, 2017. This includes property that is manufactured, produced or constructed for the taxpayer by another person under a written binding contract.
- Written Binding Contract: The IRS defines this as a contract enforceable under state law that does not limit damages to a specified amount. This does not include an option to acquire or a supply agreement if not specific in what is to be purchased. Also, a binding contract to purchase components of a larger property does not then cause a binding contract to acquire the larger property.
- Self-Constructed Assets: If a taxpayer manufactures, constructs or produces property for its own use, then the written binding contract is not applicable. In this situation, the acquisition date is met when the taxpayer begins the manufacturing, construction or production of the property after September 27, 2017.
- Work “begins” when physical work of a significant nature begins and is based on facts and circumstances. This does not include the initial soft costs such as planning, designing, clearing the site, testing drilling or security financing.
- Optional Safe Harbor: Physical work of a significant nature begins at the time the taxpayer incurs (accrual method) or pays (cash method) more than 10 percent of the total cost of the property excluding soft costs and other preliminary activities.
- Qualified Improvement Property (QIP) placed in service after September 27, 2017 and before January 1, 2018 is eligible for the additional first-year depreciation. However, the proposed regulations did not provide any guidance on QIP placed in service after December 31, 2017. At this time, it is assumed that QIP is not eligible for bonus depreciation since it is an asset with a 39-year recovery period, unless a technical correction is issued.
Bonus depreciation is mandatory but the rules do allow a taxpayer to opt out of the additional first year deduction (entirely or by class life). To opt out, a taxpayer can make this election on his timely filed federal tax return. Taxpayers who already filed their 2017 tax returns without taking the mandatory bonus deduction or electing to opt out will need to file an amended return.
Since the recent guidelines are simply proposals and not yet final, RKL’s team of fixed asset tax strategists are watching closely for additional modifications. Using bonus depreciation requires strategic advance planning, so it’s important to discuss all tax implications of asset purchases with your RKL advisor. Contact us today to start the conversation.