You and your clients may be thinking that the proposed tax reforms will impact the utilization of cost segregation. Will the proposed changes to the tax law make cost segregation obsolete?
In recent years, the IRS and U.S. Treasury have created complexities when determining the proper tax treatment of expenditures related to commercial buildings. This is the result of the interaction of the federal cost recovery rules, the tangible property regulations, and the classification of improvements to commercial buildings as “qualified improvement property” and/or “qualified real property.” As a result of these changes, cost segregation has become more important than ever!
The capitalization or expensing of costs in the current year impacts the treatment of similar costs in future years under the tangible property regulations. Therefore, it is important to make the right decisions when capitalizing or expensing costs. Cost segregation is an important tool used to make these decisions.
If and when tax reform does occur, there will likely be many states that do not conform to the federal rules, or may transition over a period of years. As a result, cost segregation will continue to fulfill an important role in those states.
In addition, as we have written before, there are many compelling reasons to perform cost segregation. Many of those reasons are discussed below.
2015 PATH Act
The Protecting Americans from Tax Hikes (PATH) Act of 2015 had a significant impact on the importance of using cost segregation specialists to compare the tax benefit of renovating an existing building vs. building construction. Since building construction doesn’t qualify for bonus depreciation, renovating existing buildings can generate significant tax savings, creating a source of funds to finance the project.
Other important uses of cost segregation include:
- Bonus Depreciation and Section 179 Expense. A cost segregation study identifies “qualified property” for bonus depreciation and year-of-purchase expensing.
- Accelerated Tax Deductions. A cost segregation study creates accelerated tax deductions by accelerating the period over which the cost of assets are recovered for tax purposes. Assets identified in a cost segregation study are reclassified from a 39-year cost recovery period to a 5-year, 7-year, or 15-year cost recovery period.
- Tax Deferred Exchanges. The IRC Section 1031 exchange provision is a valuable strategy to defer the recognition of gain on the sale of buildings. Cost segregation used in connection with a tax deferred exchange can generate tax savings in addition to tax deferral.
- Estate Tax Planning. A cost segregation study can be used to generate tax savings for both the decedent and the heirs of real estate by segregating costs for both parties before and after the date of death.
- Partial Disposition of Building Property. Cost segregation is generally necessary to determine the adjusted tax basis of the portion of building property that was partially disposed of in connection with the partial disposition election.
- Improvement vs. Repair Analysis. Cost segregation is generally necessary to determine whether expenditures improve or repair the building structure or any building system, and to determine the appropriate unit of property.
- Tenant Improvement Costs Analysis. Cost segregation is often necessary to segregate the cost of tenant improvements between building property and tangible personal property, and to determine which expenditures are capital improvements or repairs.
Other uses of cost segregation include tax planning in the year of a building’s sale, to qualify for the small taxpayer safe harbor election, and for federal and state income tax planning.
In summary, cost segregation is more important than ever, especially for buildings placed in service in years preceding any federal or state tax reform that reduces tax rates.