By Jackie Matsumura and Doug Schultz
Depreciation expense is a deduction that reduces taxable income and thereby increases after-tax cash flow. Generally, the shorter the depreciation period, the greater the tax benefit derived. Factoring in the time value of money, larger deductions over a short period of time are far more beneficial than smaller deductions over a long period of time. This is true even though the total amount of deductions is the same under both short and long depreciation periods. Front-loading deductions puts after-tax dollars in your pocket that can then be invested in something else or used to retire debt. Plus, there is an opportunity to increase those tax savings with certain tax incentives available only through 2013, such as the availability of bonus depreciation.
Rules relating to bonus depreciation are among the tax benefits that were extended under the 2012 Tax Relief Act that was signed into law on January 2, 2013. In the absence of extending legislation, this tax break for assets used in business is scheduled to be completely eliminated. It may be beneficial to perform a cost segregation study to maximize those benefits this year.
Bonus depreciation applies to the following types of property (“qualified property”): tangible property with a depreciation period of not more than 20 years (machinery, equipment, other tangible personal property, and non-building land improvements); most computer software; and certain leasehold building improvements. The property must be new (not used), i.e., new construction or leasehold improvements. Bonus depreciation results in a deduction of 50% of the cost of an item of qualified property in the year placed in service and depreciation, under the regular depreciation rules, for the remaining cost of the item. Bonus depreciation has been available for several years; however, under current law, it will no longer be available for most property placed in service after Dec. 31, 2013.
Greater cash flow
Commercial rental property is generally depreciated for tax purposes over 39 years and residential rental property over 27.5 years. Furniture and fixtures are depreciated over five or seven years. Land improvements, such as landscaping and parking lots, are depreciated over 15 years. Leasehold improvement property is generally depreciable over 39 years; however, “qualified leasehold improvement property” is depreciable over 15 years. Unimproved land is not depreciated.
If one could take a portion of a building that would normally be depreciated over 39 years and instead depreciate it over five or seven years, there would be a substantial and immediate tax benefit. That is where cost segregation comes into play. A cost segregation study identifies certain portions of what typically would be considered part of a building, and breaks them into tangible personal property asset classes with shorter depreciable lives. The result is faster depreciation on a portion of a long-term asset. For new buildings or improvements, the benefits will be greater when bonus depreciation is applied.
Cost segregation studies can be performed on purchased buildings, newly constructed buildings and tenant improvements. Studies can be performed for buildings and improvements placed in service as far back as the mid-1980s. No amended returns are required to claim the additional depreciation. In 1999, the IRS announced that it would permit companies that have claimed less than the allowable depreciation in prior years to claim the omitted depreciation as a change in accounting method. In 2002, the IRS announced that all of the prior years’ depreciation that is allowable under a cost segregation approach might be claimed in the change year. The ability to claim several years’ worth of depreciation in a single year makes this a potentially lucrative tax benefit.
To take advantage of cost segregation allowances, you will generally need to hire an engineering or valuation firm specializing in cost segregation studies. Such firms make detailed inventories of individual assets to distinguish between items of personal property and items of real property. According to these firms, typically 20 to 40 percent of the costs can be reclassified.
Next, you will need a CPA to calculate the amount of additional depreciation and prepare Form 3115 (Application for Change in Method of Accounting), in order to claim the deduction on your tax return. A newly placed in service building or tenant improvement in the year of study would not require an Application for Change in Method of Accounting.
The study may not be beneficial to some owners. For example, if an owner is subject to the passive activity limitations of IRC Sec. 469, additional depreciation deductions may not be of immediate benefit. Losses disallowed under Sec. 469 are suspended and carried forward to a year in which there is passive income, or where the property is disposed of in a fully taxable transaction. Another consideration is depreciation recapture if the building is sold. If you are planning to sell your building within a short period of time, the benefits described could be reduced.
Examples of benefits from cost-segregation studies
New tenant improvements
A $6,000,000 leasehold improvement project (assuming not qualified leasehold) was completed during January 2013. Without a cost segregation study, the 2013 depreciation expense is $153,000. If a cost segregation study were performed and 20 percent of the construction costs were allocated into five-year property and 10 percent of the construction costs were allocated into seven-year property, the total depreciation expense, without taking into account the bonus depreciation provisions, would then be $433,000. However, since bonus depreciation is available in 2013, the 2013 depreciation expense would be $1,170,000. This would be an additional $1,016,000 of depreciation expense in the first year alone. In a 39.6 percent tax bracket, the 2013 cash savings would be approximately $402,000. The benefits would be even greater if the leasehold improvements were qualified leasehold improvements that have shorter depreciable lives.
Existing office building
Say an office building was purchased in 2007 for $30 million. Of that, $20 million was allocated to depreciable building improvements with a depreciable period of 39 years. The annual depreciation deduction was calculated to be $513,000. Therefore, between the years 2007 and 2012, $3,078,000 of depreciation expense was taken. A cost segregation study was performed for tax year 2013, and 20 percent of the depreciable cost was reclassified into 5-year property and 10 percent into 15-year property. The result would be a catch-up depreciation adjustment of approximately $4,000,000 against 2013 taxable income. In a 39.6 percent tax bracket, this depreciation adjustment would translate into a possible cash savings of $1,584,000.
A cost-segregation study can be of enormous benefit in increasing cash flow to building owners. Such a study will identify the personal property components of a building, including land improvements, and thereby, allow you to claim faster depreciation. Owners who plan to build or remodel a building, or make significant tenant improvements in 2013, stand to realize substantial savings as a result of performing a cost segregation study. Others who have owned their buildings for several years or who have made improvements in the past will likely benefit from this study as well.
Jackie Matsumura (firstname.lastname@example.org) and Doug Schultz are partners in the tax practice of accounting and tax consulting firm Burr Pilger Mayer (BPM), which has an office in Santa Rosa 707-524-6523.
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