As the new year begins, many people are beginning to think about possible tax planning strategies to use in 2022 that could reduce their tax bill next year. While a plethora of strategies are available, there are two that are seldom utilized to their full potential: depreciation and cost segregation.
As a quick summary, depreciation is what allows a taxpayer to recover the cost of purchased property over a set period of time. This recovery is through an income tax deduction, and the total amount that can be deducted depends on various factors. This tax planning strategy is available to all types of business entities that purchase property during the year.
To qualify for the depreciation deduction, the property must:
- Be owned by the taxpayer (“ownership” may include leased property or property secured by a loan/mortgage);
- Be used in the business or income-producing activities of the taxpayer;
- Have a determinable useful life (meaning that it wears out, decays or becomes obsolete over a predictable number of years); and,
- Be expected to last more than one year.
Certain types of property are ineligible for depreciation:
- Land (though certain land improvements can qualify);
- Property that is placed in service and disposed of in the same tax year (e.g., inventory, technical manuals);
- Intangible property (which can be amortized instead); and,
- Term interests in property for which the remainder interest is held by a person related to the taxpayer (very technical).
With those eligibility requirements in mind, taxpayers can then move on to determining which type of depreciation they will need to use.
When it comes to selecting a specific method of depreciation, it’s not as simple as making a choice. Often, taxpayers must use a certain method depending on which type of property they have. There are three typical methods, one special method of depreciation and one special type of expensing:
- Straight-line depreciation: Under this method, property depreciates at the same percentage each year in the recovery period. For example, a property with a 15-year recovery period is purchased for $15,000. Every year, the depreciation deduction would be $1,000 under the straight-line method. This is the default method for 27.5-, 31.5- and 39-year property, as well as some 15-year property. Taxpayers may elect this method for three-, five-, seven- and 10-year property as well.
- 150% declining balance: Under this method of depreciation, property may be depreciated for the first year at 150% of the amount allowed in the first year under the straight-line method. For example, the same property as above purchased for $15,000 would have a first-year depreciation of $1,500 instead of the $1,000 under the straight-line method. This method can give significantly higher deductions in earlier years and is the default method for property with recovery periods of 15 and 20 years. It cannot be used for assets with recovery periods longer than 20 years. Taxpayers can again elect to depreciate three-, five-, seven- and 10-year property under this method.
- 200% declining balance: Much like the method above, this gives property depreciation equal to 200% of the amount allowed under the straight-line method in the first year. The same $15,000 property would have $2,000 of depreciation for the first year. This is the default method for property with recovery periods of three, five, seven and 10 years. Assets with recovery periods longer than 10 years cannot use this method.
- Bonus depreciation: Unlike the three methods above, which are fairly typical, this is a special method of depreciation. Under bonus depreciation, taxpayers are allowed to take an increased depreciation deduction for assets with useful lives of 20 years or fewer. The Tax Cuts and Jobs Act in 2017 increased this allowance amount to 100% of the purchase cost of the property in the year it’s placed in service. This increase will begin phasing out in 2023, with the deduction being completely phased out by 2027 barring any changes in the law.
- Section 179 expensing: Often discussed in tandem with depreciation, 179 expensing is a special expensing allowance. Section 179 is a permanent tax provision for increased expensing of property purchases in the year in which the purchase is made. The expense deduction is capped at $1 million, as adjusted annually for inflation. In addition, Section 179 expensing phases out at a dollar-for-dollar amount if the total property purchases in the year exceed $2.5 million, again adjusted for inflation. No purchase exceeding the sum of the limitation and the phase-out floor can be expensed.
Maximizing depreciation with cost segregation
Cost segregation is a great way to get larger deductions in the early years of a property. So, what is cost segregation? It allows taxpayers to identify assets with shorter recovery periods within a building and to take the appropriate depreciation amounts. Property such as a commercial building or rental property has a longer recovery period than tangible property.
Residential rental property, for example, has a property life of 27.5 years. Meanwhile, nonresidential real property has a property life of 39 years. The life of tangible property, such as floor tiling, fixtures, carpeting, cabinets and fencing, is shorter. Since these tangible property components have a shorter recovery period, they can be depreciated at an accelerated pace, leading to larger deductions in earlier years.
To get started on this, have experts evaluate the property and break down which parts are “structural components” and which parts could be considered “Section 1245 property.” Any property that is considered Section 1245 property can then be given an appropriate asset class as determined by the IRS, along with its corresponding recovery period.
The takeaway here is that if you’ve recently purchased real estate, you can use cost segregation to separate out components of the property that depreciate faster than the building as a whole, allowing you to increase cash flow and reduce tax liability.
A summary of cost segregation
How exactly does real property depreciation work? Houses and commercial buildings are not fully expensed in the year they’re purchased. Instead, they are depreciated over their useful life, which is generally 27.5 years for residential and 39 years for commercial buildings. Practically speaking, this means that on a $1 million commercial property, a taxpayer would only be able to take $25,641 per year in depreciation ($1 million divided by 39 years).
If the taxpayer keeps the property for the full 39 years, the entire $1 million would eventually be depreciated. However, due to the principle of the time value of money, it is more valuable to take an expense or deduction today instead of later — and cost segregation may allow you to do that with real property.
When you purchase real property, while you can’t depreciate the land, a cost segregation study can be performed to identify other classes of assets within the building. Taxpayers can use either software or a consulting firm for this study.
The study involves an evaluation to separate out personal property items in the building into shorter class lives (such as five, seven or 15 years). In essence, the shorter asset life classes can use accelerated depreciation, which allows for higher depreciation expenses in the first few years and lower expenses later.
Remember, the cost segregation study will not increase the overall depreciation that can be taken for the building; it will just accelerate the depreciation deduction in the first years of ownership. This means the depreciation deduction in later years will be lower.
In summary, here are some pros and cons to keep in mind with cost segregation:
Benefits:
- Can increase overall deductions in earlier years to reduce taxable income; and,
- Can allow for bonus depreciation or Section 179 expensing of property that would not otherwise qualify.
Considerations:
- Reduces depreciation deductions that can be taken in later years;
- Taxpayers must pay for cost segregation study (software or consultant); and,
- Can increase chances of an audit.
If a building has not already been placed in service for a full year, the owner can take advantage of this tax planning strategy immediately so long as they have an ownership right in real property and complete a cost segregation study. There may be more requirements if they have already begun depreciating the property, including filing for a change in method of accounting.
Depreciation and cost segregation are tremendous tax-saving opportunities in 2022, but many people don’t take full advantage of them. Those with property or who are considering investing this year, should be sure to maximize their cost recovery through depreciation.
