The old saying is “money doesn’t grow on trees,” but could it be hidden in the walls? Since the landmark Hospital Corporation of America v. Commissioner court case in 1997, tens of thousands of owners of commercial and residential rental buildings have utilized cost segregation studies to significantly reduce taxable income by accelerating depreciation.
The resulting tax reduction can be $50,000 to $70,000 for every $1,000,000 in building cost basis. Rather than depreciating a building over 39- or 27.5-year lives, the 1997 ruling allows building owners to separate building components into shorter depreciation lives of 5, 7, and 15 years.
A few examples of 5-year property are cabinets, moldings, carpet, wall coverings, and specialty lighting. Fifteen-year property would include retaining walls, external signage, parking lots, landscaping, among many other components. While there is general awareness of cost segregation within the business community, many building owners are unaware of recent changes in the tax code that have made cost segregation more valuable than ever.
Previously, bonus depreciation was just 50 percent and only applicable to new construction. The Tax Cuts and Jobs Act (TCJA) of 2017 now allows 100% bonus depreciation for both new and existing buildings acquired after 9/27/17. Bonus depreciation applies to 5-, 7-, and 15-year components which is typically 20-35% of a building cost basis.
Under the TCJA, 5-, 7-, and 15-year building components can now be fully depreciated in the first year of ownership, rather than over 39- or 27.5-years. A new owner of a $1,000,000 building acquired in December 2018 can often obtain a $70,000 tax reduction in the first year of ownership, compared to about $10,000 in the first year under the old rules.
Two other valuable, and often overlooked, changes resulted from the IRS Tangible Property Regulations (TPR) issued in 2013. When a renovation of an existing building is undertaken, the TPRs now allow a cost segregation study to determine the value of the building components discarded during the course of the renovation which can then be taken as a loss, less what had previously been depreciated. The deduction must be taken in the same year the renovation was completed.
To be compliant with the Regulations, a building must be broken down into its nine building systems: Building structure including roofs, plumbing systems, electrical systems, escalators, elevators, fire protection and alarm systems, security systems, gas distribution systems, and any other system defined by the U.S. Treasury.
When a building repair occurs, the newly repaired component must be compared to all similar components within the building system. If the new component is repaired more than two years after the original date of occupancy, does not make the component materially better, and does not affect more than 33 percent of all the like components, it must be expensed. The Regulations also offer three Safe Harbors that can be utilized which also can help the building owner expense repairs if any of the above rules do not apply.
It is difficult to take advantage of this favorable ruling without a cost segregation study. Owners of commercial or residential rental property acquired or renovated in the last 15 years for at least $300,000 likely qualify for a cost segregation study. Today more than ever, being aware of and taking full advantage of cost segregation benefits is crucial for building owners wanting to maximize their property investment in the most tax-efficient manner.