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The Tax Cuts and Jobs Act Gives Cost Segregation Studies New Life Michael F

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The Tax Cuts and Jobs Act Gives Cost Segregation Studies New Life Michael F The Tax Cuts and Jobs Act Gives Cost Segregation Studies New Life Michael F. Lynch, Nicholas C. Lynch, and David B. Casten* A cost segregation study allows taxpayers to recover certain costs ordinarily classifi ed as real property over shorter cost recovery periods applicable to personal property. By recovering costs faster for tax purposes, taxpayers can accelerate tax benefi ts and enhance cash fl ows. The Tax Cuts and Jobs Act of 2017 has increased the benefi ts of a cost segregation study. However, the IRS will scrutinize aggressive cost reclassifi cations. Those inter- ested in performing cost segregation studies should be knowledge- able about the advantages and pitfalls of this tax-saving, cash-fl ow generating tool under the new tax law. Introduction As a result of the Tax Cuts and Jobs Act (TCJA) of 2017,1 investors in resi- dential and non-residential real estate property have more reason than ever to engage in a cost segregation study. A cost segregation study is an engineering or cost exercise the goal of which is to identify assets that qualify for accel- erated deductions under the new tax law. The purpose of a cost segregation study is to identify costs commonly associated with land and buildings that may properly be classifi ed as other than real property for tax purposes. The deferred tax created by properly reclassifying portions of land and build- ing costs as land improvements or tangible personal property, which can be depreciated over much shorter periods for federal (and where applicable, state) income tax purposes, results in signifi cant cash fl ow savings. * Michael F. Lynch, J.D., C.P.A., is a Professor of Tax Accounting and the Director of Graduate Tax Studies at Bryant University in Smithfi eld, RI. He is also a practicing attorney in Providence, RI. Nicholas C. Lynch, Ph.D., is a Professor of Accountancy at California State University, Chico. Professor Lynch has a background in public accounting with a full service advisory fi rm. David B. Casten, J.D., LL.M., C.P.A., is a practicing attorney and C.P.A. in Providence, RI. He is a retired partner of KPMG LLP and an Adjunct Professor of Law at Boston University School of Law as well as a member of the accounting faculty at Bryant University in Smithfi eld, RI. The authors can be reached at [email protected], nclynch@ csuchico.edu, and [email protected], respectively. 1 P.L. 115-97, 131 Stat. 2054. 47 48 JOURNAL OF TAXATION OF INVESTMENTS Cost segregation studies indeed are increasing in use as more and more investors, attorneys, CPAs, and their clients become familiar with them. Tax- payers should take necessary steps to ensure that the study is performed prop- erly, which includes hiring a qualifi ed team of cost segregation professionals comprising experienced appraisers, engineers, architects, cost estimators, and tax professionals who follow Internal Revenue Service (IRS) guidelines. Cost segregation studies can be performed on any residential or non- residential depreciable property that is constructed, purchased, improved, or inherited. The study is easier to accomplish and more benefi cial if employed during the planning phase of construction. A cost segregation study enables taxpayers with current or planned investments in real estate to realize signifi - cant increases in cash fl ows and tax savings over multiple periods. The TCJA has greatly enhanced the depreciation deduction benefi ts of a cost segrega- tion study, further increasing its value. Cost segregation studies do have their risks, however. There are cases where the IRS and the courts have levied penalties against taxpayers for tak- ing an overly aggressive stance in the classifi cation or reclassifi cation of costs. Those seeking to perform a cost segregation study should be knowl- edgeable about the advantages and pitfalls of this tax-saving, cash fl ow gen- erating tool under the new tax law. This article reviews the concept of cost segregation and provides an in-depth analysis of the enhanced depreciation deductions available under the new tax law, including new bonus depreciation rules and the expanded use of Section 179.2 A detailed discussion of what the IRS expects from a quality cost segregation report follows. Finally, the article analyzes the pen- alties imposed on persons who ignore the IRS guidelines and prepare a cost segregation report that results in the understatement of tax liability, and then recommends how to avoid those penalties. Why Perform a Cost Segregation Study? Potential for Faster Depreciation. Cost segregation studies provide value by properly classifying property costs that would either not be depreciable if included in the cost of land or be depreciated over long periods of time (27.5 years for residential property and 39 years for non-residential property) if included in the cost of a building. These reclassifi ed costs, referred to as land improvements or non-structural building elements, are depreciated over much shorter time periods: three, fi ve, seven, 10, 15, or 20 years under the 2 All references to “Sections” are to the Internal Revenue Code of 1986 (the “Code”) as amended, unless otherwise indicated. COST SEGREGATION STUDIES 49 Modifi ed Accelerated Cost Recovery System (MACRS).3 The accelerated depreciation offered through MACRS results in lower taxable income and net present value cash fl ow savings, making cost segregation studies a desir- able value-creating tool.4 Liberalized Bonus Depreciation Rules. The value of a cost segregation study is made greater by the liberalized cost recovery provisions included in the TCJA. The new tax law allows 100 percent bonus depreciation for qualifying property with a recovery period of 20 years or less under MACRS, provided it is acquired and placed in service after September 27, 2017.5 The TCJA also expanded the defi nition of qualifying property to include used property.6 Bonus depreciation now applies to used property as long as it was never used by the taxpayer before acquiring it. Qualifi cation Requirements. In order to qualify, all of the following must apply: • Neither the taxpayer nor its predecessor used the property at any time before acquiring it; • The taxpayer did not acquire the property from a related party; • The taxpayer did not acquire the property from another member of a controlled group of corporations; • The taxpayer’s basis in the used property is not determined in whole or in part by reference to the adjusted basis of the property in the hands of the seller or transferor; • The taxpayer’s basis in the used property is not determined under the provision for computing the basis of property acquired from a dece- dent; and • The cost of the used property eligible for bonus depreciation does not include the basis of property determined by reference to the basis of other property held at any time by the taxpayer (for example, for 3 Although Congress disallowed the use of component depreciation with the onset of MACRS in 1986, the decision in Hospital Corp. of America v. Comm’r, 109 TC 21 (1997), provided the legal basis for using a cost segregation study to classify or reclassify building components that do not meet the defi nition of a “structural component” of a “building” as IRC § 1245 property. See also Whiteco Industries, Inc. v. Comm’r, 65 TC 664 (1975). 4 For a comprehensive analysis of the present value cash fl ow tax savings that result from a cost segregation study, see Nicholas Lynch & Charles Pryor, “Cost Segregation Stud- ies: A Tax Saving Tool All Practitioners Should Be Ready to Offer,” 27(4) J. Tax’n Invs. 27 (Summer 2010). 5 IRC §§ 168(k)(1)(A), 168(k)(2)(A), 168(k)(6)(A). 6 IRC §§ 168(k)(2)(A)(ii), 168(k)(2)(E)(ii). 50 JOURNAL OF TAXATION OF INVESTMENTS property “similar or related in service or use” acquired to replace property taken in an involuntary conversion7). This is the fi rst time since the bonus depreciation provisions were passed in the Job Creation and Worker Assistance Act of 20028 that owners who acquire used property have the same tax benefi t as owners who acquire new property. This is a game changer for the cost segregation industry. Prior to the TCJA, taxpayers purchasing used property may have been dissuaded by the cost of a study. Congress has created a window of opportunity under which taxpayers purchasing commercial or residential real estate may now benefi t from a cost segregation study, by using the bonus depreciation rules, just as much as those who purchase new property. A building itself does not qualify for this new tax incentive. Under MACRS, non-residential real estate is still depreciated over a 39-year period and residential real estate over 27.5 years using the straight-line method. But MACRS property to which IRC Section 168 applies with a recovery period of 20 years or less will generally qualify.9 Phase-Out of Bonus Depreciation. Prior to the TCJA, bonus depre- ciation was limited to 50 percent of the cost of the qualifi ed asset. The 100 percent deduction only applies to assets purchased before January 1, 2023. After 2022, the percentage is reduced as follows: • 80 percent for property placed in service in 2023; • 60 percent for property placed in service in 2024; • 40 percent for property placed in service in 2025; and • 20 percent for property placed in service in 2026. After 2026, bonus depreciation will no longer be allowed unless Congress decides to reinstate it.10 Option to Elect Out. Similar to the old law, a taxpayer can elect out of bonus depreciation for any class of property on an annual basis.11 The new 7 See IRC § 1033.
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