Accelerating depreciation is the primary method investors can use to recapture their investments quickly. Specifically, commercial real estate investors utilize an accounting tool called cost segregation (or cost segs). The purpose of this tool is to take advantage of significant tax benefits. This happens by preserving capital through accelerated depreciation. Through asset reclassification, investors can get easier write-downs whenever disposing of assets. In this article, we explain all of these terms in greater detail.
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Defining Depreciation
Investopedia defines depreciation as “an accounting method of allocating the cost of a tangible asset over its useful life. [it] is used to account for declines in value.” In general, companies, investors, and businesses depreciate long-term assets for tax and accounting purposes. For example, a business can deduct the cost of tangible assets, such as equipment used on the property, for tax purposes. Some examples of these tangible assets within a property include:
- Capital improvements such as remodel or renovation
- HVAC systems and furnaces
- Electrical system overhauls
- Window replacements
- Full roof replacement
- Landscaping improvements
Yet to receive the full benefits of tax breaks, you and your business must depreciate these assets according to IRS rules.
Cost Segregation for Accelerated Depreciation
Cost segregation offers a number of benefits for commercial real estate investors. In general, if you or your company plans to purchase, renovate, or construct a commercial property, you could benefit from a cost segregation study. But what is a cost segregation study? How does it accelerate depreciation? According to Accounting Today:
A cost segregation analysis allows a taxpayer to look at their real estate assets and identify the portions that, for federal tax purposes, can be treated as personal property. This allows a taxpayer to identify assets that are being depreciated as 39-year property, and accurately move them to five, seven or 15-year personal property.
In the end, cost segregation for accelerated depreciation lets investors reduce their tax burden in the first few years of owning a property. Kevin Mowatt, Northeast practice leader at the consulting firm RSM’s tangible property services group in New York City says,
“The best way to look at [cost segregations] is that they are an IRS-recognized tool that helps companies exploit the time value of money or TVM.”
Cost Segregation in Real Estate
In a recent video, Anderson Business Advisors talked about Cost Segregation in Real Estate and the Advantages of Accelerated Depreciation. This video highlights several issues. For starters, it states that non-residential income properties currently have a depreciation life of 39 years. Without being aware, many investors throw every part of the property into the same 39-year ‘bucket.’ Yet as covered in the video, some property components can be separated into smaller buckets. This allows investors to depreciate these assets in less than 39 years.
A cost segregation study allows for shorter depreciation periods for tangible components.
Consequently, you can reclassify certain components as tangible personal property or land improvements. This allows investors to depreciate these components faster than the real property that they’re tied to.
As stated above, a cost segregation study gives you shorter depreciation periods for tangible components – five, seven or 15 years instead of the standard 39-year depreciation period. This is a brief outline of cost segregation.
By using this tool, investors get a faster depreciation write-off which works to their advantage sooner rather than later. In the short term, this means greater tax savings in the first few years of ownership. In addition, cost segregation may allow an investor to free up additional cash flow by reducing their tax burden.
Commercial Real Estate Depreciation
In the past, cost segregations have produced financial benefits for investors. At the same time, the 2017 tax reforms have caused some investors to question the continued benefits or cost segregations. Before the TCJA passed, the IRS required commercial owners or investors to initiate depreciation recovery at the standard 39-year MACRS period. Yet at the same time, there also may be hidden assets with the real estate component which may have lower recovery periods (usually five, seven or 15 years).
Many assets within the real estate component itself have shorter recovery periods -benefiting owners with slightly more favorable commercial real estate depreciation.
Currently, the TCJA says that ‘used non-building assets’ with recovery periods of 20 years or less now qualify for a 100% bonus within the asset’s first year of service. But this is only if they were put into service after Sept. 27, 2017. And although qualifying assets placed in service before Sept. 28, 2017 won’t qualify for the new bonus provision, there could still be assets with short tax recovery periods.
What’s more, these might not receive the 100% first year bonus provision. Instead, they would receive the normal MACRS depreciation rates over the five, seven and 15-year tax lives.
At the same time, there is good news. Now, as stated above, many assets within the real estate component itself have shorter recovery periods benefiting owners with slightly more favorable commercial real estate depreciation.
Section 179 and Bonus Depreciation
At the same time, the TCJA allows real estate owners and LLCs which create taxable income to qualify for “immediate expensing of certain capital improvements.” This happens one of two ways:
- The new 100% bonus depreciation rate
- Through expanded Section 179 expensing (now increased to a $1M maximum)
In contrast to depreciating assets over a number of years, Section 179 expensing lets you deduct qualified improvement properties. What’s more, the TCJA also permits Section 179 expensing for improvements to commercial properties like HVAC equipment, roofs, security systems, fire protection, and alarm systems.
Previously, the Section 179 expensing limit was $510,000 (for 2017). Now, for tax years from 2018 and beyond, the expensing limit increases to $1 million for qualifying properties. At the same time, this is may phase-out if qualified asset purchases for a certain tax year total more than $2.5 million (previously $2.03 million in 2017). Furthermore, there will be annual adjustments for inflation. For example, in tax year 2019 they will be $1.02 million and $2.55 million, respectively.
Impact of the Tax Cuts and Jobs Act on Depreciation / MACRS (Modified Accelerated Cost Recovery System)
The Tax Cuts and Jobs Act of late 2017 (TCJA) enacted a number of federal tax cuts and reforms. Notably, there are changes to the corporate AMT (alternative minimum tax), business interest, and carried interest. Yet depreciation rules remain mostly the same. At the same time significant changes were made to depreciation schedules. Specifically, the tax code changes established longer depreciation schedules:
- 40 years for nonresidential property
- 30 years for residential rental property
- 20 years for qualified interior improvements.
In the end, these longer depreciation schedules could possibly have a negative impact on ROI.
Depreciation on an Office Building
Over time, almost everything loses a certain amount of value. Regarding commercial real estate, Some of this value loss depends on current market conditions. For depreciation on an office building, part of this value loss is tied to the property’s aging components.
Be aware that not every firm employs professionals who have experience in engineering, construction, or architecture. Due to this, firms without the right personnel with these backgrounds often lack the necessary industry expertise. However, Lumicre does have a team of in-house compliance, technical, and engineering experts. So when you consult with our team, you can be sure to get the full picture of each and every commercial property.
Simply put, depreciation is the value loss on an asset.
Conclusion
For investors and building owners, commercial real estate depreciation is part of the game. Yet investors can take advantage of tax benefits by using cost segregation for accelerated depreciation. Accelerating depreciation is a great method for investors to recapture their investments quickly. Through asset reclassifications, investors take assets that are currently depreciated as 39-year property and change them to five, seven or 15-year personal property.
If you are a commercial real estate investor or a commercial real estate professional, you should be aware of any and all issues which may affect your assets and your clients. If you have additional questions about depreciation on an office building, cost segregation, or other issues, consult our team today. Let our team of commercial real estate professionals advise you on your existing assets. Or if you would like advice on purchasing new commercial assets, we can also help. We are a full-service firm offering a wide range of services, from leasing assistance to property management.
Further Reading
IRS Publication 946 (2018), How To Depreciate Property
IRS: Depreciation – Frequently Asked Questions