Cost Segregation in a Post-COVID-19 World
COVID-19 hit the world with a vengeance, and the commercial real estate industry took a hard hit. Both tenants and building owners struggled in the pandemic’s wake. While some sectors are beginning to recover, a still-fragile future leaves many investors searching for a plan to recoup from devastating losses as well as position themselves to weather more potential storms.
Some may have had to invest in unexpected building improvements or even had to repurpose a building just to survive the pandemic’s impacts, leaving them short on cash. It’s important to know that these investments can have tax advantages that accounting professionals can offer their clients. One such incentive is the IRS-approved, engineering-based tax strategy of cost segregation, which accelerates depreciation deductions on commercial real estate property to save tax dollars immediately.
Cost Segregation Overview
While commercial buildings generally must be depreciated over 39 years, the IRS has designated certain types of building components and land improvements that can instead be depreciated at five, seven or 15 years (such as flooring, accent lighting, decorative millwork and landscaping). Under the Tax Cuts and Jobs Act (TCJA) of 2017, an additional immediate 100-percent bonus depreciation incentive effectively cut that rate even further to just one year. Cost segregation studies identify which assets in and around a property qualify for these reduced depreciation schedules. Reclassifying qualified assets can save investors tens of thousands or even millions in income taxes. A study can be performed on new construction/acquisitions or even on previously owned property (up to 15 years) without amending tax returns.
The Payoff for Investors
Table 1 details the percentage of assets that can typically be reclassified and the resulting tax savings gained based on different property types.
A quality study can provide critically needed tax relief to many in a post-COVID-19 world. While cost segregation is not a new concept, the Coronavirus Aid, Relief and Economic Security (CARES) Act of 2020 set a 15-year depreciation schedule for qualified improvement property (QIP) made to the interior of non-residential buildings. Key benefits include the following:
- Taxpayers can apply 100-percent bonus depreciation, which effectively allows the full expensing of costs in the year incurred.
- The change is retroactive to 2018. A retroactive study does not require an amended tax return; taxpayers can simply submit Form 3115 to take the deduction in the current tax year.
- Potential tax losses created by large-depreciation deductions may be used to offset taxable income generated from other properties or carried forward to future years.
Not all improvement costs are eligible for the 15-year QIP classification. “Structural” costs such as exterior windows, exterior HVAC units, elevators and others must remain as 39-year property.
Vendor Qualifications and Study Components
Studies are typically initiated either directly from a property owner or their accountant. Approaches used to perform studies range from the IRS-preferred “fully engineered study” to a “rule of thumb” approach. Because of these variations, the American Society of Cost Segregation Professionals (ASCSP) was formed to help establish credentials, create/maintain quality standards and provide a code of ethics for the industry. Using an ASCSP-certified professional helps ensure the quality of the study and that elevated COVID safety procedures are followed.
As the commercial real estate industry continues to look for relief from COVID-19 effects, implementing cost segregation as a tax strategy may be a critical way for investors to regain significant lost ground, increase their cash flow to reinvest in upcoming projects or improvements and look forward to a brighter future.
Cost Recovery Solutions LLC works with accountants of commercial property owners to maximize depreciation deductions, reducing client income taxes and boosting their return on investment. Services include cost segregation studies, energy tax services and tangible asset appraisals/reviews. Learn more from the company's interactive capabilities brochure.
Robert Rahner, CFA, ASA, CCSP, is the managing director of Cost Recovery Solutions LLC.