Cost segregation has long benefited taxpayers with increased cash flow and long-term net present value benefits by reclassifying building or improvement costs to property with shorter tax lives, such as personal property or land improvement property.
We discussed cost segregation benefits in light of tax reform in a prior issue of For the Record (see Cost Segregation Benefits from the Recent Tax Reform Act). In this tax reform update, we discuss how cost segregation continues to add value in light of recent changes to the regulations under Sec. 163(j) and the new interest expense limitation rules.
The Tax Cuts and Jobs Act (TCJA) includes cost recovery provisions that creates new tax planning and savings opportunities for taxpayers owning or operating real estate. Portions of the TCJA directly benefit cost segregation studies (CSS); including 100% bonus depreciation for qualifying property acquired and placed in service after September 27, 2017, as well as an expansion of the definition of qualifying property to include used property (i.e., there is no longer an original use requirement).
However, since the TCJA has passed, taxpayers and their advisors have been left with uncertainty on many topics that are expected to be addressed in future technical corrections or other administrative guidance. Qualified Improvement Property (QIP), for instance, was expected to have a 15-year recovery period (20 years under the alternative depreciation system (ADS)) and be eligible for bonus depreciation. However, QIP is currently a 39-year asset (40-year ADS) that is ineligible for bonus depreciation.
Other uncertainties surround Sec. 163(j), which relates to the deduction of business interest expense when a taxpayer is an electing trade or business. Despite these uncertainties, a CSS remains beneficial in light of changes made to Sec. 163(j) for real estate trades or businesses.
Section 163(j) Interest Expense Limitation
The TCJA amended Sec. 163(j) to apply new rules that limit the ability of taxpayers to deduct business interest expense for tax years beginning after 2017. The new limitation is generally applicable to all taxpayers with business interest expense. However Section 163(j) does however allow qualifying real estate trades or farming businesses to elect to be excluded from the limitation. If an election is made, electing taxpayers must use ADS tax lives for residential and commercial property, as well as QIP. The provision as amended also states that electing taxpayers are not eligible for bonus depreciation provided under Sec. 168(k). This ineligibility for bonus depreciation, however, does not apply to assets typically reclassified from a CSS, such as personal property or land improvements. An exception to this is specific to electing farming businesses, where property with an ADS recovery period of 10 years or more is not eligible for bonus depreciation. Thus, electing and non-electing taxpayers can continue to benefit from cost segregation. Since it is only real property that is affected by Sec. 163(j), shorter-lived property or land improvements are not required to use ADS and can still take bonus depreciation.
Qualified Improvement Property
Under the TCJA, QIP now captures all property formerly known as qualified leasehold improvements, qualified retail improvement property or qualified restaurant property (collectively, Qualified Property). QIP is essentially any improvement to the interior of a building. Prior to the TCJA, QIP and Qualified Property were eligible for bonus depreciation. However, Congress’ intent to amend Sec. 168(e)(3) to assign a 15-year recovery period (20-years ADS) to QIP was overlooked. Consequently, QIP currently does not qualify for the new 100% bonus depreciation or a 15-year recovery period. Electing taxpayers can still benefit from a 20-year ADS life for QIP, rather than a 40-year life, though they would not be eligible for bonus depreciation.
As currently enacted, property with an ADS class life of 20 years or less (e.g., personal property and land improvements) is eligible for bonus depreciation, regardless of whether a taxpayer is subject to amended Sec. 163(j) or elects to be excluded as a qualified real estate trade or business. This can provide a significant benefit for taxpayers constructing or acquiring commercial or residential real estate.
As a result, cost segregation remains beneficial for real estate trades or businesses electing to be excluded under amended Sec. 163(j), though proper planning should be considered for taxpayers whose renovation costs include QIP. Taxpayers should also consider the impact if a retroactive technical correction is made by Congress to treat QIP as 20-year ADS property.
Compliments of Andersen Tax, a member of the EACCNY