In the closing months of 2021, Denver businesses and organizations are taking advantage of the few remaining COVID-19 tax programs still available. Looking ahead to 2022, it is likely there will be far fewer opportunities to receive the same depth of tax savings available during the pandemic. Despite the transition back to “business as usual”, there are tax-saving methods that are still available – especially for real estate companies through a cost segregation study. These studies have long been a reliable tax reduction strategy for industry companies and commercial real estate owners. Essentially, it is designed to accelerate deductions into the early years of property ownership creating a significant tax benefit. A study segregates various building assets into separate classifications and recovery periods for federal tax purposes. Although it may seem complex, companies have been relying on these studies for years to achieve significant savings. To help clients, prospects, and others, Hanson & Co has provided a summary of key cost segregation details below.
Cost Segregation Studies Defined
Depreciation, an annual tax deduction that helps to recoup the cost of certain property types, is routinely used in nearly every industry. In real estate, depreciation becomes even more valuable because of the frequency of new building construction, renovations, and property transfers. For an asset to be depreciable, it must meet four requirements from the IRS:
- Owned property
- Income-producing or used in the business
- Has a set useful life
- The expectation of lasting longer than one year
A cost segregation study separates personal property or land improvements from the building itself. What this does is allow the building owner to depreciate individual assets like a parking lot or plumbing and electrical, which each depreciate over a span of 15 years. This is compared to whole building depreciation, which is currently 39 years for commercial property (or 27.5 years for residential).
Cost segregation studies shorten those time periods. A shorter depreciation schedule means higher tax write-offs and better (and more immediate) cash flow.
The best time to conduct a cost segregation study is the year the property is acquired, placed into service, or renovated, though lookback studies are possible. In those cases, the taxpayer would need to submit the lookback study along with a change in accounting method application.
How Cost Segregation Studies Are Performed
Each cost segregation study is different, but the overall process remains the same. First, qualified tax advisors and engineers conduct a feasibility analysis. This is an estimate of how certain assets could be reclassified to achieve shorter depreciation. It will also include estimated fees. Next, analysts will request information depending on the nature of the real estate project.
For example, for new construction, documents like overall project costs, invoices, and drawings would be important. Appraisals and closing documents would be requested in the case of an acquisition.
Analysts will tour the property in person and review all documentation to separate the assets into categories like Personal Property, Land Improvements, Building Components, and Land. Finally, they will issue a report with asset reclassifications and other information.
Because of the specialized nature of cost segregation studies, it’s best if someone with a construction and real estate background performs the study. Working with an industry expert increases the reliability and accuracy of the final report.
Benefits of a Cost Segregation Study
As previously mentioned, cost segregation studies allow property owners to frontload depreciation for allowable assets. In turn, this can generate substantial cash flow in the years immediately following a large purchase, new build, or renovations.
Most of the time, a cost segregation study uncovers several assets that can be reclassified. In one study, it was found that medical offices, hotels, and apartment buildings each averaged at least 20 percent reclassified assets. Office buildings, retail centers, and warehouses all averaged between 16 and 18 percent. These numbers translate to potential first-year tax savings of $320,000 to $475,800, on average.
Then there’s the likelihood of uncovering assets that can apply to Section 179D energy efficiency deductions. Under Sec. 179D, building systems including the envelope, lighting, and HVAC are evaluated against certain energy efficiency standards. If met, the deduction can be worth up to $1.80 per square foot.
Another benefit is a listing of original costs for key property assets, which is helpful when the owner needs to replace something later.
Impact of COVID-19 on Cost Segregation Studies
COVID-19 did not directly result in any changes to the saving opportunities available through a cost segregation study. However, it did create an environment where cash flow is even more important. The pandemic also gave rise to several new pieces of legislation and tax law changes.
In the CARES Act, two key tax changes relative to real estate were:
- 100 percent bonus depreciation through 2022 and
- Qualified improvement property (QIP) eligible for 100 percent bonus depreciation and 15-year class life.
Thanks to the Tax Cuts and Jobs Act, bonus depreciation will continue to decline until 2026. Beginning January 1, 2023, bonus depreciation will decrease 20 percent each year until it phases out completely in 2027.
Importantly, the second provision is permanent and retroactive to January 1, 2018. The Tax Cuts and Jobs Act mistakenly classified QIP as a 39-year property, which made it ineligible for bonus depreciation. When the CARES Act fixed the error, interior improvements became eligible for bonus depreciation. Especially combined with 100 percent bonus depreciation in 2022, property owners may want to consider a lookback cost segregation study to recapture previously disallowed deductions.
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