Cost segregation has long been a valuable tax planning tool that allows taxpayers to take accelerated deductions for their real estate investments. But cost seg. can be more complex than you think, depending on who owns the asset, how the property reports revenue, the nature of repairs and improvements made, and the depreciation time frame desired.
Mistakes can be very costly in the long run. Take the time to get the facts right. You’ll be glad you did.
Rarely a week goes by when we don’t see a published article or broadcast clip with misleading observations and recommendations about depreciation of residential vs. nonresidential real estate. And, don’t get me started on the confusing treatment of qualified improvement property (QIP) and proper use of bonus depreciation.
There are five major issues and misconceptions I see time and time again. Let’s unpack them one at a time:
1. Treatment of residential versus non-residential real estate
We often see examples of investments in apartment complexes or other multifamily housing property being depreciated over 39 years.
Residential rental property should be depreciated over a 27.5-year (not 39 year) recovery period using the straight-line method and the mid-month convention. Only nonresidential real property should be depreciated over 39 years. Residential rental property includes buildings or structures for which 80 percent or more of the gross rental income is rental income from dwelling units. So, an apartment complex falls within the definition of residential real estate and should be depreciated over the shorter 27.5-year recovery period.
2. Qualified improvement property
The Tax Cut and Jobs Act of 2017 consolidated four special asset categories (see below) into a single category called QIP. Those categories are:
a) Qualified improvement property;
b) Qualified leasehold improvement property;
c) Qualified retail improvement property, and
d) Qualified restaurant improvement property.
As part of the Coronavirus Aid Relief and Economic Security Act (CARES Act), which was passed March 27, 2020, an important drafting error from the TCJA — assigning QIP a 15-year recovery period, thus making it eligible for 100 percent bonus depreciation — was finally corrected. It should be noted that QIP is still eligible for the section 179 expense election for taxpayers who incur eligible expenditures in their trade or business and who are not subject to the section 179 expense limitations. Prior to the Tax Cut and Jobs Act, section 179 expensing applied to tangible personal property. The TCJA was amended to define qualified real property to include QIP and some improvements to nonresidential real property, such as:
- Heating, ventilation and air-conditioning property;
- Fire protection and alarm systems; and,
- Security systems.It’s important to note that QIP includes any improvements made to a nonresidential building’s interior after the date that the property was first placed in service. However, improvements do not qualify if they are attributable to the following criteria:
- The enlargement of the building,
- Any elevator or escalator,
- The internal structural framework of the building, or
- Improvements made to the exterior of the building.We often read or hear about situations in which an investor improves an apartment complex. Since an apartment building is residential (not commercial) real estate, such improvements cannot be considered QIP. Again, QIP applies only to nonresidential buildings, so an apartment complex would not be eligible for QIP treatment.
3. Why the “revenue test” is more important than ever
Owners of mixed-use property and their advisors should evaluate their rent rolls to determine whether their properties truly meet the revenue test in order to take the 27.5 year recovery period.
This may sound counterintuitive — especially when commercial space is less than 20 percent of a building — but the test relates to the revenue, not distribution of leased space. With QIP being reinstated, having a mixed-use property with 39-year depreciation might actually be a blessing in disguise, especially if major interior capital improvements have been completed or planned. Why is a 39-year recovery period a blessing in disguise? Because property owners that have undertaken (or plan to undertake) major capital improvements to their mixed-use properties may benefit from 100 percent bonus depreciation related to QIP. It will still be important to identify structural elements contained in the construction projects that would need to stay at 39-year depreciation.
4. Expensing versus taking 100% bonus depreciation
The TCJA increased the bonus depreciation amount to 100 percent for qualified property that was acquired and placed in service after Sept. 27, 2017 and before Jan. 1, 2023. This generally applies to depreciable assets that have a recovery period of 20 years or less. Both new and used machinery, equipment, furniture and land improvements now generally qualify for bonus depreciation.
This allows for an immediate tax deduction. Expenditures for which a taxpayer has taken 100% bonus depreciation may be subject to “depreciation recapture.” In contrast, expenses for activities such as repair and maintenance are not subject to depreciation recapture.
Remember, depreciation recapture refers to the gain realized due to depreciation at the time of the sale of depreciable capital property. It must be reported as ordinary income for tax purposes. Recapture of section 1245 property is recaptured at the taxpayer’s ordinary rate and section 1250 is recaptured at a maximum 25% tax rate.
Depreciation recapture is assessed when the sales price triggers a gain due to depreciation. Thus, if taxpayers took 100% depreciation on an asset sold, they might be subject to depreciation recapture.
However, if the treatment of the original asset could be classified as a repair and maintenance during the normal course of business, the asset would have not been capitalized and thus would not be subject to depreciation recapture as it would have been classified as an expense in the year incurred.
Many times, “experts” will forget to clarify that personal property and land improvements — identified as a result of a cost segregation study — should not be “expensed,” as is the case for maintenance and repair. Instead, those expenses qualify for 100% bonus depreciation and may be potentially subject to depreciation recapture upon the sale of the property.
While some of you may understand the distinction between an expense and a depreciation deduction, the nuances between these two terms are significant. This important distinction often gets lost when reporters, analysts and conference organizers are working on tight deadlines.
5. Impact of section 163(j) election
For taxpayers wishing to avoid interest deduction limitations, under section 163(j)(7)(B), a real estate trade or business election must be taken. With that election, the building and its improvements must be assigned the Accelerated Depreciation System (ADS), not the Modified Accelerated Cost Recovery System (MACRS), tax treatment.
The change from MACRS to ADS recovery periods for commercial property goes from 39 to 40 years. It goes from 27.5 to 30 years for residential rental and from 15 to 20 years for QIP. Unfortunately, no ADS property is eligible for bonus depreciation.
Greg Bryant is the managing partner of Bedford Cost Segregation and a past president of the American Society of Cost Segregation Professionals.