Cost Segregation Benefits from the Recent Tax Reform Act

Cost segregation, a technique used to reclassify building/improvement costs to personal property or land improvement property to shorter tax lives, has benefited taxpayers for decades in terms of increased cash flow and long term net present value benefits.

However, due to recent legislative changes, real property owners now have even more reason to engage in a cost segregation study (CSS).

The Tax Reform Act of 2017 (the Act) includes cost recovery provisions that open new tax planning and savings opportunities for taxpayers owning or operating real estate. Portions of this Act directly benefit cost segregation, including 100% bonus depreciation for qualifying property acquired and placed in service after September 27, 2017, and an expansion of the definition of qualifying property to include used property (i.e., there is no longer an original use requirement). 

Under the Act, taxpayers constructing or acquiring real estate–commercial or residential–can benefit from a substantial acceleration of tax deductions by reallocating purchase or construction costs to qualified property classifications through a CSS. As a result, a significant portion of the cost basis for the property can be deducted in the year placed in service.

100% Bonus Depreciation

The Act extends the bonus depreciation through 2026 for property with a recovery period of 20 years or less under MACRS and meeting the other requirements under Sec. 168(k)(2). Bonus depreciation is effective at a 100% rate for property acquired and placed in service after September 27, 2017 and before January 1, 2023, phasing down bonus to 80% for qualified property placed in service before January 1, 2024, 60% for qualified property placed in service before January 1, 2025, 40% for qualified property placed in service before January 1, 2026 and 20% for qualified property placed in service before January 1, 2027. Similar to prior law, a taxpayer can elect out of bonus depreciation for any class of property on an annual basis. For the first taxable year ending after September 27, 2017, the taxpayer can elect to apply a 50% bonus rate instead of the 100% rate. 

Used Property Now Eligible

The Act also amends Sec. 168(k)(2) to extend bonus depreciation to used property, so long as it is the first use by the acquiring taxpayer and the property is acquired from an unrelated party. The legislative changes provide taxpayers with additional incentive to perform a CSS to assign property to the appropriate recovery class. Under prior law, taxpayers would benefit from a shorter recovery period, but not from bonus depreciation as the taxpayer did not meet the original use requirement. In contrast, under new law, used property is bonus-eligible. Thus, property classified to shorter lives can generally be expensed at the time placed in service. As bonus depreciation only applies to property placed in service in the United States, this will be particularly relevant for U.S.-based real property acquisitions, including both commercial and residential property.

Qualified Improvement Property May Be Eligible

The Act further amends Sec. 168 to remove references to qualified leasehold improvements, qualified retail improvement property and qualified restaurant property, categorizing them all, as well as property that was defined as qualified improvement property under the PATH Act, as qualified improvement property (QIP), for property placed in service after December 31, 2017. It appears Congress’ intent was to amend Sec. 168(e)(3) to assign a 15-year recovery period (20 years alternative depreciation system) to the newly compressed class of QIP. However, there may be a technical glitch in the statute as it does not actually appear to provide a 15-year recovery period for QIP. Since Congress did not amend Sec. 168 to provide a 15-year recovery period for QIP in the new legislation and because the amended Sec. 168(k)(2) allows bonus depreciation for any property with a recovery period of 20 years or shorter, it is unclear under the current law whether QIP qualifies for the new 100% bonus depreciation and a 15-year recovery period, or whether a 39-year recovery period applies, with no bonus depreciation. 

Case Study

Pre-Reform Law:

Company ABC acquires an office campus for $10,000,000 on January 15, 2017. Prior to the Act, the Company allocated $8,300,000 to building/improvements and $1,700,000 to land based on internal estimates. As a result, the Company could take $62,000 in first-year depreciation (as all property is classified as a 39-year asset). With a CSS, however, Company ABC is able to allocate $2,000,000 to shorter-lived property, accelerating first-year depreciation by an additional $325,000. Since the property is acquired and not newly constructed, the Company is not eligible for bonus depreciation.

Post Reform Law:

Assume the same costs above, except the Company acquires the property on January 15, 2018. Without a CSS, Company ABC can continue to take $62,000 in first-year depreciation. However, with a CSS, Company ABC is now eligible for 100% bonus depreciation on all qualifying CSS-reclassified assets. As a result, it can claim 100% of the reclassified asset basis of $2,000,000 as first-year depreciation.

The Takeaway

The Act benefits property owners not only by allowing 100% bonus depreciation for qualifying reclassified property, but also by extending bonus depreciation to qualifying used property. Taxpayers planning on building or acquiring commercial or residential real property should consult with their professional advisor to ensure they are maximizing their tax benefits under the new legislation.