Over the past few weeks I’ve had many discussions with our CPA clients concerning the changes that may develop from the recent election. While tax policy for 2017 and beyond is still up in the air, most practitioners feel that a rate drop will most likely be in effect for the top marginal tax rates. This could create a limited window to generate permanent tax savings for taxpayers.
Traditionally, the two biggest complaints about cost segregation and other depreciation studies have been that they are merely timing issues and they may increase taxpayers’ exposure to 1245 recapture. Due to the potential difference in rates between 2016 and 2017 we have a limited window to address these two complaints.
Let’s take for example a developer that built a property with a $10 million basis in 2015 and plans to sell it in 2017 for the same $10 million. Traditionally, the taxpayer would not want to complete a cost segregation study as it would recognize 1245 property and thereby trigger 1245 recapture at an ordinary income rate. If we see a top marginal tax rate drop of 7 percent between 2016 and 2017 that concern may be mitigated.
If we assume that of the $10 million in basis, 20 percent or $2 million could have been considered 5-year personal property. This means that if a cost segregation study is performed in 2016, the taxpayer could see as much as $1.5 million in increased deductions in 2017 (assuming bonus depreciation and 5-year double declining balance calculations). If the taxpayer is at a 40 percent tax rate this would save them $600,000 on their 2016 tax return. If then the taxpayer sells the property in 2017 and their tax rate drops by 7 percent to 33 percent, the recapture would be calculated at the new rate. If 100 percent of the 1245 basis is subject to recapture, the taxpayer would pay a recapture penalty of $495,000. Effectively, this would create a permanent tax savings of $105,000. In reality, the savings could be even larger if it is assumed that some of the 1245 property has lost value in the two years since it was originally placed in service.
As the example demonstrates, we have a limited opportunity to create permanent savings by accelerating depreciation into tax years with higher tax rates. Since a depreciation study does not have to be completed until the tax return is filed (which includes extensions) tax preparers have the opportunity to see which changes the administration makes in the first couple of months. If rates drop as expected, taxpayers could then move forward with these studies to create large permanent tax savings.
This type of analysis would be true not only for traditional cost segregation studies but also 179D reviews and other depreciation related studies. If you have any questions please contact your McGuire Sponsel representative to discuss.