With Bonus Depreciation Being Phased Out In 2023, Is Cost Segregation Tax Deferral Strategy Still Worth It?
Proactive fixed asset work can help increase current-year depreciation deductions, free up your time to focus on your business and provide peace of mind through reduced exposure.
Recently Dave Mcguire, a partner at Mcquire Sponsel published an article in Accounting Today, about the topic of “is cost segregation still valuable as bonus depreciation is being phased out?”
What’s the Challenge of Bonus Depreciation in 2023?
The Tax Cuts and Jobs Act (TCJA) of 2017 expanded bonus depreciation to additional assets and allowed for 100% bonus depreciation. While the qualification for bonus eligibility does not change, the amount eligible starts leveraging down in 2023 by 20% per year. This means that bonus depreciation is 80% for 2023, 60% for 2024, and so on until it completely phases out.
Accounting firm Moss Adams wrote an article stating that “capital projects with estimated completion dates close to year-end could benefit from additional planning. Completing those projects by year’s end could help reduce current year tax burden through a better bonus depreciation rate.”
For example, for companies scheduled to construct or remodel buildings by the end of 2023, keeping that timeline could allow for a higher bonus depreciation deduction before further phasedown in bonus depreciation rates.
For cost segregation professionals, this leads to the question, what happens to cost segregation if bonus depreciation phases out?
Bonus Depreciation Background
To have a better grasp of how bonus depreciation affects cost segregation and depreciation decisions, it is important to fully understand bonus depreciation. Under Section 168(k) of the Tax Code, bonus depreciation allows businesses to immediately deduct a percentage of an eligible asset when it is placed in service. In recent years, Sec. 168(k) has become a relatively consistent part of the code. However, this has not always been the case.
The Accounting Today mentions that in 2002, Congress first added Bonus depreciation to the Tax Code as part of the Federal Job Creation and Worker Assistance Act being passed. At that time, businesses could deduct up to 30% of eligible assets. Bonus depreciation then received multiple extensions and revisions before the Tax Cuts and Jobs Act in 2017. To be eligible, assets need to have a life of less than 20 years and to have not been used by the taxpayer prior to the acquisition. Prior to 2017, the asset also had to have the original use begin with the taxpayer. While bonus seems like a universal part of the Tax Code, it is a relatively new provision.
What is Cost Segregation?
Cost segregation studies and other fixed asset services can help taxpayers increase current-year deductions. Performing studies on assets placed in service between late 2017 and the end of 2022 allowed access to 100% bonus depreciation. Property owners that build remodel, expand, or purchase a facility often overlook cost segregation provisions that could help defer federal and state income taxes—and avoid paying taxes sooner than required.
Cost segregation is a tax deferral strategy for building owners and tenants paying for leaseholder improvements aimed at increasing cash flow by reducing current tax liability through accelerated depreciation deductions.
This strategy involves an engineering study that identifies short-life property from a larger building or improvement asset. Cost segregation studies can be done on acquired or newly constructed buildings as well as improvements to existing buildings. It’s based on the concept of accelerated depreciation which allows taxpayers to take advantage of larger deductions in the near-term rather than spread out over the 27.5 or 39-year timeframe allowed by straight-line depreciation.
This is done by segregating qualified components of a building from 39-year life to 5, 7, or 15-year life. Shorter depreciation life equals, larger deductions, equals lower taxable income, and more cash in a building owner’s pocket. Plant Moran explains the details pretty well:
What’s the Challenge of Cost Segregation?
The Moss Adam’s article suggests finding a cost segregation provider to perform a study in line with the tax authority, as IRS guidance changes frequently with new laws and court cases. A cost segregation provider who is up to date with these changes can help you optimize depreciation under the current tax law.
Cost segregation studies can be done on projects placed in service in prior years without having to amend prior tax returns. The look-back deduction can be taken in the current year, which makes a cost segregation valuable for buildings you may have placed in service while in a loss position.
Is Cost Segregation still Worth it even with Bonus Depreciation being Phased Out?
The Accounting Today articles make the argument that yes it will be affected but it still has its benefits. Stating that while the immediate deduction will be lowered, the taxpayer will still end up saving money with a cost segregation study.
Cost segregation studies are often viewed over three metrics:
- First-year cash flow savings;
- Five-year cash flow savings; and,
- The Net Present Value over the life of the asset.
Mr. Mcguire said “Obviously, the first-year cash flow will take the biggest hit since the goal of a cost segregation study is to move as much as possible into shorter bonus-eligible assets.”
A Cost Segregation Scenario Example
Mr. Mcguire lays out a scenario where $200,000 is moved from a 39-year asset to a five-year asset through a cost segregation study. Assuming a 35% tax rate and a 7% discount rate.
With 100% bonus depreciation, the taxpayer saves $69,028 in the first year, and $61,746 over five years, and has an NPV over the life of the asset of $42,731.
These numbers drop to $57,828, $61,031 and $41,338, respectively, when the bonus is 80%. If the bonus falls to zero, the first-year savings is $13,028, with a five-year savings of $58,175, and an NPV of $35,769.
So, while the benefit drops, the taxpayer still sees a decent savings by completing the cost segregation study. The importance of cost segregation as bonus leverages down grows as it relates to renovations.
Worth noting
The TCJA, as fixed by the CARES Act, made qualified improvement property a bonus-eligible asset. However, without bonus, QIP is a 15-year asset depreciated using a straight-line methodology. If a taxpayer puts in $1 million in renovations that are all QIP when 100% bonus exists, they might not consider cost segregation.
Even if the bonus phases out completely, the difference between five-year depreciation and 15-year depreciation grows. If cost segregation could move 50% of the $1 million to a five-year asset, a taxpayer with a 35% tax rate would save $110,810 over six years.
Conclusion
According to a study by the American Institute of Certified Public Accountants (AICPA), cost segregation can save businesses an average of 10% on their taxes. The study also found that cost segregation can help businesses recover their investment in fixed assets more quickly.
One final takeaway from the Accounting Today articles author is that there are currently multiple bills in front of Congress that would extend bonus depreciation, and while no one knows what the Government will do, its hard to imagine that they would let bonus depreciation fully phase out over the next couple of years.
Ultimately, the decision of whether or not to pursue cost segregation is a complex one that should be made on a case-by-case basis. However, the potential benefits of cost segregation can be significant, even with bonus depreciation being phased out. If you have questions about bonus depreciation, cost segregation, fixed asset tax analysis, feel free to reach out to Huckbee CPA for a free consultation.
