With the change in the tax law that became effective January 1, 2018, many taxpayers will benefit from lower income tax rates beginning in 2018. While individuals will see modest tax rate reductions on their personal returns, corporate income tax rates were slashed significantly to a flat rate of 21% from what was previously a high of approximately 35%.
While the expected tax savings should increase cash flow for business owners, it also means that the value of deductions will decline after 2017. The after-tax cost of a $100 expense based on a 35% tax rate is $65 [$100 x (1 – 35%)], but the after-tax cost of that same expense based on a 21% tax rate is $79 [$100 x (1 – 21%)]. Therefore, the same $100 expense could effectively cost owners 21.5% ($14 / $65) more in 2018 than 2017.
Regardless of the tax rate reductions, cost segregations are often beneficial to owners of real property. Coupled with the 2018 tax rate reduction, however, the tax benefits from accelerating deductions into 2017 through a cost segregation are “supersized.”
For those who do not know – or need a reminder – cost segregation is an IRS-approved method of reclassifying certain components and improvements of commercial or residential rental buildings as personal property, which can then be depreciated on an accelerated basis over shorter lives than if the assets were classified as part of the real property itself. For example, the tax lives of assets classified as personal property (five years or seven years) or land improvements (15 years) are significantly shorter than those classified as real property (39 years or 27.5 years). Accelerated depreciation methods are also permitted for personal property, but not for real property.
Reclassifying certain components of real property as personal property or land improvements accelerates tax deductions and increases cash flow in the near term. This accelerated deduction benefit is enhanced further when the real property has been depreciated for a number of years prior to the cost segregation being performed. That’s because the depreciation that could have been taken in prior years can be caught up and taken all at once.
For example, if a company had a cost segregation performed and it was determined that the depreciation catch-up adjustment in 2017 was $500,000, the tax savings would be $175,000 at a 35% tax rate ($500,000 x 35%). If the company didn’t have a cost segregation performed, or had the cost segregation performed after its 2017 tax return was filed, it would only generate $105,000 of tax savings ($105,000). This means that the permanent tax savings that would be realized by having a cost segregation performed (or lost if a cost segregation was not performed) is $70,000 ($175,000 – $105,000).
Prior to 2018, most cost segregations were performed simply to capitalize on the time value of money associated with receiving the tax deduction (and related cash flow benefit) earlier than would have been realized otherwise. The permanent tax savings that can be achieved from having a cost segregation performed prior to filing income tax returns for 2017 enhances this benefit significantly.
If you have purchased or constructed a building in the last five years, call us to see if a cost segregation study is right for you. Time is of the essence to take advantage of these deductions at the higher 2017 income tax rates.
For more information on cost segregation or other tax issues, please contact Denny Murphy at 440-449-6800 or email Denny.
