Over the last few months while traveling to CPA firms around the country we seem to see similar questions. One of the main questions relates to the necessity of Cost Segregation in the new tax environment. With the lowered tax rates, the potential for Qualified Improvement Property, and changes to bonus depreciation does cost segregation make sense?
The short answer is yes, however the specifics of the situation are critical to dissect to ensure that the cost segregation study is accurately utilized. Cost segregation studies can be fit into multiple categories. For the purposes of this discussion, we will look at purchased property, renovations, and ground up new construction.
For purchased property, the benefit and need for cost segregation is increased. Under the new tax law property no longer has to meet the “first use” test to qualify for bonus depreciation. This means that eligible assets acquired after September 27th, 2017, subject to binding contract limitations, are now eligible for bonus depreciation treatment. This bonus treatment supercharges the benefits associated with a cost segregation study on purchased assets. For example, if a taxpayer purchases a $10 million property and 20% of the property can be reclassified to shorter lives, that taxpayer can write off $2 million in the year of acquisition. For a taxpayer at a 30% tax rate, this would save them $600,000 or 6% of the purchase price in the first year.
Similarly, the changes to bonus depreciation increase the benefits to cost segregation on newly constructed property. Under the new tax rules, bonus depreciation is increased from 50% to 100% for 5-years. This increases the return on investment from cost segregation significantly.
Renovations become a little less clear. Under the new tax law, non-structural assets installed to the interior of a building after the building is originally placed in service are considered Qualified Improvement Property, or QIP. Under the design of the law, these assets were supposed to be considered bonus eligible. If that was the case QIP could be written off in the year placed in service. Unfortunately due to a drafting error in the law QIP was not included in the bonus rules, but is instead 39-year property not subject to bonus depreciation. This is widely considered an error and requires a technical correction to fix. Assuming this fix occurs will a cost segregation study be necessary on a renovation? The answer is very much subject to the extent of the renovation.
If QIP is fixed a renovation that is only to the interior of a building and does not touch any structural assets, then a cost segregation study may not be necessary. However, if the renovation includes exterior facades, HVAC systems, Elevators, Escalators, load bearing walls, etc, a cost segregation study may be necessary to break out the assets that are not QIP. Without an analysis to break apart the QIP from the remaining assets a taxpayer will not be able to maximize the bonus-eligible property. Additionally, if a renovation is combined with expansion, a study will be required to separate the assets included in the expansion from the assets in the original space. When a taxpayer completes a renovation a discussion should be had with a trusted professional to determine if a study is necessary to determine the amount of QIP.
There are other changes in the new tax law that may affect depreciation. These changes include the new rules associated with NOL carryovers, the election to opt out of the 30% interest limitation, as well as other changes. However, in most cases, cost segregation is still necessary and beneficial for taxpayers investing heavily in real estate.