Everybody loves that “new building” smell, but renovating an existing building may generate more tax savings. Only a building cost recovery analysis can tell you which way to go.
When a business reaches a point where it needs more space, it’s usually a pretty exciting, often frenetic time for the owners and employees. Whether it’s additional offices for new employees, expanded manufacturing and storage facilities for the business’ products, or a combination of both, many businesses don’t even realize that more space is the answer until long after the need has become severe.
At such a crazy time, the last thing many owners might consider is the tax impact of choosing between renovating an existing building or constructing a new building. That can be an expensive mistake.
The PATH Act made some changes to depreciation rules providing businesses that make improvements to the interior portion of existing buildings with opportunities to recover costs quicker than by constructing a new building.
- The section 179 expensing election is available to expense up to $500,000 of “qualified real property,” a term that limits this immediate tax deduction to qualified leasehold improvement property, qualified restaurant property, and qualified retail improvement property. However, the section 179 expensing election is phased out completely when the costs of eligible property exceeds $2.51 million for the 2016 tax year. The expense limitation and phase-out are adjusted upward for inflation each year.
- The first year special depreciation allowance, aka “bonus depreciation,” is available for “qualified improvement property” placed in service on or after January 1, 2016. Qualified improvement property is an improvement to the interior of nonresidential real property that is placed in service after the date the building was placed in service. (Certain improvements such as enlargements, escalators/elevators, and internal structural framework are excluded.)
For example, a business with a $10 million budget can use the full budget on constructing a new building or spend $2.5 million to acquire an existing building and $7.5 million on renovations. Although cost segregation can accelerate building cost recovery by assigning property to the property 5-year, 7-year, and 15-year recovery periods, a significant portion of the $10 million construction cost will be assigned to a 39-year recovery period.
If the business acquires and renovates an existing building, in addition to cost segregation of the building acquisition and renovation costs, a portion of the $7.5 million renovation costs will be classified as qualified improvement property and qualified real property. As a result, cost recovery will occur more quickly by acquiring and renovating an existing building than constructing a new building up to a certain cost point. Therefore, it is important to perform a building cost recovery analysis before decisions are made regarding new building construction.
When to Start the Conversation
It is important to raise this issue when you learn that a client is expanding or taking on a new product or process that will require more space or adding employees. When you learn that a client is expanding and needs more space, it’s important to get this information on their radar before decisions are made. Even though construction lead times can be considerable, the decisions that make a difference for tax purposes often happen very early in the process. You don’t want to find out after the fact that a client didn’t perform a building cost recovery analysis before deciding to construct a new building.
Keep in mind that the 50% bonus depreciation is available for property placed in service by December 31, 2017. For qualified improvement property that is placed in service during calendar year 2018 and 2019, the bonus depreciation rates are 40% and 30% respectively. And bonus depreciation will be completely phased out by 2020 (2021 for certain property).
The threshold at which the recovery of costs for new building construction is faster than the recovery of costs to renovate an existing building is based in part, on the price paid for an existing building. The lower the purchase price, the more cost that can be assigned to qualified improvement property and qualified real property to accelerate building cost recovery and tax savings.
Obviously, the acceleration of building cost recovery and tax savings are not the only concern when making the decision, but they can provide a valuable incentive to either reduce construction costs or extend the capital budget.
Need Help with a Building Cost Recovery Analysis?
CSP360 has over 20 years of experience focused on cost segregation services and cost recovery rules. Our cost segregation database makes us the perfect resource to perform a building cost recovery analysis. Contact us to learn more.