Tax Magic: Commercial Real Estate: 199A & Cost Segregation Benefits
This time of year is quite busy for tax attorneys and CPAs. Right now, many clients are finalizing their 2017 returns while also asking their advisors to forecast how the recent tax law changes will impact them. For those focused on commercial real estate, there are certainly bright spots and opportunities for even better outcomes… with some planning.
Real estate businesses frequently operate as pass-throughs (i.e. LLCs or Partnerships) with no employees. Tax reform passed in 2017 provides a new deduction under Section 199A that property owners are going to appreciate. Without question, 199A is the most complex part of the new tax law. For our purposes, it is only important to note that 199A provides the ability to deduct up to 20% of qualified business income. This deduction is also subject to an asset-based cap: 2.5% of the taxpayer's share of the tax basis, immediately after acquisition, of qualified property.
In the simplest terms, owners of qualified nonresidential real property can claim the pass-through deduction for up to 2.5% of the property's acquisition price. Suppose, you purchased an office building 20 years ago for $3 million. You can now claim a $75,000 deduction against your rents received, in each of the next 19 years as long as your business continues to own the building (commercial real estate is depreciable over 39 years). 199A is your friend until it sunsets in 2026.
Cost Segregation Studies
One valuable tax planning opportunity is to obtain a cost segregation study. Essentially, cost-segregation is the process of identifying personal property assets that are mixed in with the real property assets. A cost segregation study carries out that process so that personal assets can be reported separately for tax depreciation purposes. Why bother?
Those non-building assets, i.e. the personal property, can often be depreciated over a shorter period of time (5, 7, or 15 years) compared to the building (39 years). Think: electrical; plumbing; HVAC; sidewalks; fixtures; landscaping; and etc. Segregating those costs permits you to accelerate depreciation and ultimately decrease your tax obligation in earlier years. The cost segregation study is the required tool to identify and reallocate the property's purchase price between the building's recovery period and the other assets with shorter recovery periods. This lets you max out depreciation in earlier years, pay less taxes, and keep more of your real estate income.
Those tax benefits apparently were not enough. Under the new tax law, 'bonus' 100% first-year depreciation is permitted for certain non-building assets, i.e. the personal property, placed in service after September 28, 2017. What about those owning property before that date? They can still take regular cost segregated depreciation benefits available to them.
A cost segregation study can swing a client's depreciation deduction significantly. For example, assume a shopping center was purchased before September 27, 2017. The owner could depreciate approximately $30,000 under the 39-year recovery period, or, they could instead depreciate up to $150,000 in the first year by employing cost segregated depreciation. If the center was purchased after September 27, 2017, the new tax law's bonus first-year depreciation would be approximately $1.1 million.
As you can see above, there is a huge opportunity for tax savings. Depreciation can swing a profitable business to a tax loss, and that means you keep more of your real income. In my experience, a cost segregation study works particularly well with strip malls and other small shopping centers, small and mid-size apartment buildings, an even warehouses. Of course, the property applications are universal, but these clients will see an immediate tax benefit without incurring a huge expense for the study.
Existing and prospective commercial property owners should connect with their tax team to discuss. Combining the pass-through income and potential bonus depreciation benefits under the new tax law with a cost segregation study is a tax planning opportunity that merits serious consideration.
Just FYI Travis Scales is a tax attorney focused on efficient wealth accumulation and preservation strategies.