Cost Segregation Mitigates Longer Property Depreciation Under ADS

By Ashley Northcutt, CPA

Business interest expense limits may make it advantageous for entities to calculate the depreciation on buildings over an ADS life of 30 years versus MACRS life of 27.5 years to deduct interest expense fully. This change results in a longer depreciable life for certain properties, including commercial and residential. However, a cost segregation study can help accelerate depreciation on eligible assets.

The 2017 Tax Cuts and Jobs Act (“TCJA”) significantly changed the deductibility of business interest expense. In combination with legislation under the CARES Act, there are new considerations for business taxpayers who own commercial property, including residential real property and qualified improvement properties.

Under TCJA, three significant changes were:

  1. Predictable tax rates through 2026
  2. 100% bonus depreciation extended through 2022
  3. Acquired assets can now leverage bonus depreciation

An exemption in TCJA (IRC Sec. 163(j)(7)(B)) allows owners of real property, trade or business, to elect out of the IRC Sec. 163(j) limitation on deducting business interest expense. Doing so requires using an Alternative Depreciation System (ADS) for the full life of all nonresidential real property, residential rental property, and qualified improvement properties.
This exemption provides more flexibility for business taxpayers to deduct the full amount of business interest expense rather than simply deducting a percentage.
Formerly, ADS law required that buildings placed in service prior to January 1, 2018, use a 40-year depreciation life. However, changes to that law lessen that requirement to a 30-year life. In addition, under ADS, property owners cannot claim a bonus depreciation deduction, and ADS applies to both existing and newly acquired properties.

CARES Act Changes for 2019 and 2020
Enter the CARES Act, which retroactively changed TCJA IRC Sec. 163(j) for tax years 2019 and 2020. The main changes include:

– Deductible net business interest expense increases from 30% to 50% for 2019 and 2020 (partnerships have special rules). The 50% limit can be applied to either 2019 or 20120 ATI, and taxpayers can choose which year to apply it to, a change that offers flexibility with the interest limit.
– Qualified improvement property is classified as 15-year property under GDS and as a 20-year property under ADS. These properties also qualify for bonus depreciation.
– Taxpayers can withdraw previous elections under IRC Sec. 168, such as the election to depreciate assets under ADS and the option to elect out of bonus depreciation (IRC Sec. 168(k)(7)).
– Taxpayers can make an electing real property trade or business election by attaching an election statement to the taxpayer’s timely filed federal income tax return (including extensions).

The CARES Act also has special partnership rules. The ATI limitation increases to 50% for tax years beginning in 2020. For tax years beginning in 2019, a partnership’s ATI limitation remains at 30%, but 50% of excess business interest expense allocated to a partner can be deductible without limitation on the partner’s 2020 tax return.

How Cost Segregation Studies Accelerate Depreciation

Following these recent changes to federal tax law, owners of qualifying properties that elected out of the IRC Sec. 163(j) for the tax benefits may want to conduct a cost segregation study or look-back study. This study may identify opportunities to accelerate depreciation on qualified assets, even when the property is depreciated using ADS. Property owners may take bonus depreciation on any asset with a class life of 20 years or less, which includes land improvements, machinery, equipment, furniture, and fixtures. If the life of a building is over 20 years, bonus depreciation cannot be taken. A cost segregation study is completed by engineers who study the properties, with particular attention to the building, to identify which assets are more appropriately classified as land improvements, machinery, equipment, and furniture or fixtures. Once identified, these assets are reclassified to the appropriate 20-year life asset class, resulting in eligibility for bonus depreciation.

In general, however, cost segregation studies are beneficial throughout the real estate life cycle:

  • New construction or acquisition to maximize benefit over the long term
  • Acquisitions and/or rehab projects*
  • After changes in ownership (i.e., when the general partner buys out an investor, an asset purchase by a new owner or estate situation)
  • Buildings already in service (look-back study)

*There are special rules to consider regarding acquisitions and/or rehab projects, including appropriately timing a cost segregation study to correspond with the date the property is placed in service and whether or not the project involves historic tax credits. These situations make the importance of talking to a cost segregation specialist especially clear. Cost segregation specialists are uniquely qualified to help owners determine how this type of study might benefit their unique situation or portfolio concerning tax deductions and the necessity of meeting investor projections.
The IRS allows property owners to depreciate certain assets using shorter lives (5, 7, or 15-year depreciation). Through a cost segregation study, owners can carve out or segregate tangible property or land improvements with shorter lives and accelerate depreciation. Doing so leads to tax benefits for the owners and more cash flow for the property, which can, in turn, support operations and meet investor projections.

Accelerated Depreciation Project Example

Let’s look at an example of how this works in an actual tax situation. A multi-family LIHTC property was acquired and placed in service in March 2018. Subsequent renovations were placed in service in June 2018, June 2019, and June 2020.
The total depreciable basis is $69,074,774. This figure includes personal property and land improvements depreciated under the General Depreciation System (GDS) at five years and 15 years, respectively. It also includes real property depreciated under ADS at 30 years. The owner took the exemption under ADS to deduct additional business interest expense but extended depreciable life.

Following a cost segregation study, we were able to accelerate depreciation for 23.8% of the 15-year and 5-year assets combined and were also able to apply 100% bonus depreciation. The accelerated depreciation resulted in more than $4,000 in additional cash flow for the property in Year 1.

Without the study, only 76% of the property would have been eligible for depreciation as a whole, and it would not qualify for the 100% bonus depreciation. Can you send me this example? I want to reword only 76% of the property would have been eligible for depreciation to avoid confusion, but I need to see the example we are referencing.

[H2] Is a Cost Segregation Study Right for Me?
Business taxpayers that own real property should consider the value of a cost segregation study. Specifically, those owners who have elected out of the IRC Sec. 163(j) business interest expense deduction limitations and are now subject to the Alternative Depreciation System may find tremendous value in completing the study. Timing of the study is important to ensure that the results can be ready before the tax return’s due date for the year applied.

Tidwell Group and our partner Capstan know how to conduct cost segregation studies and look-back studies to benefit taxpayers and developers in light of the new TCJA and CARES Act rules.

Contact Ashley Northcutt, CPA to discuss your goals.

An Update on 45L following the PATH Act Release

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