While there are many uncertainties in the House Republicans’ current tax reform blueprint, perhaps the item garnering the most attention is the potential decrease in the corporate tax rate from 35 percent to 15 or 20 percent. However, one potential tax reform change that would have a dramatic effect on companies — especially those that are capital intensive, own property, etc. (thus those with depreciation) — is the ability to immediately expense all capital expenditures. This would bring an immediate benefit to capital-intensive companies, given the ability to reduce taxable income relative to the current rules in which assets are depreciated over statutory lives.
On the other hand, a decrease in the tax rate without any change in the depreciation rules would result in a reduction in the current benefit associated with accelerated depreciation under the Modified Accelerated Cost Recovery System (MACRS). With this potential reduced benefit in mind, businesses should consider a cost segregation study of their capital property sooner rather than later to maximize the benefit. The following provides a background of cost segregation, recent developments and thoughts on why it may make sense to conduct a cost segregation sooner rather than later.
Cost segregation studies (CSS) can broadly be defined as engineering-based studies that break down capital projects into components eligible for accelerated depreciation. If rates were to decline, accelerating depreciation deductions now will yield more value than under a projected 15 or 20 percent corporate tax rate (or reduced individual income tax rates). Aside from potential tax reform implications, there have been several other recent developments with major implications regarding depreciable lives and CSS. The implementation of qualified improvement property (QIP) and the Nielsen v Commissioner ruling are among those with the greatest impacts.
The benefits of CSS are driven by maximizing annual depreciation and thus improving cash flow. CSS make this possible by bifurcating depreciable basis between real property, which is depreciated over 39 years for non-residential buildings or 27.5 years for residential structures, and short-lived tangible personal property, with common depreciable lives of 5, 7 and 15 years.
Quite often, buildings are depreciated as one lump sum over the 39- or 27.5-year life, as this is the most conservative approach. Real property, or IRC Section 1250 property, can be likened to the base structure and other foundational components necessary for a building to operate. This includes essentials such as bathrooms, adequate lighting and general electrical outlets.
Tangible personal property, or IRC Section 1245 property, includes many of the detachable fixtures and alterations within a structure’s core components, such as plumbing and electrical, to service a particular industry. This can be as simple as increased electrical and networking systems for an accounting firm, or as drastic as heavy-duty electrical and mechanical connections for a mining company’s processing plant. In addition to the building’s interior, the generated benefit can further be supplemented by factoring in relevant land improvements, such as a parking lot and associated lighting.
For example, the reallocation on a $20-million newly constructed office building of an estimated $2.4 million in 5-year personal property and $2 million in 15-year land improvement property would yield more than a $1.1-million tax effected net-present value benefit over the life of the assets. This would provide a sizable net-present benefit relative to the costs associated with conducting the overall study and related efforts.
Consideration of obtaining CSS is far too often confined to “building.” Studies are applicable to most property acquisitions and new construction projects, regularly generating even more substantial results with industry-specific properties such as industrial or manufacturing plants, amusement parks, golf courses, etc. In addition to the tangible property assessed during the course of a study, a quality study should take into account indirect costs such as architectural and engineering fees incurred that are associated with personal property, as these costs are often attached to the project as a whole. Outside of studies focusing on structures, an analysis on fixed-asset ledgers can generate extensive results by reclassifying assets entirely.
The previous example of potential savings generated from a $20-million office building takes advantage of another acceleration allowance: bonus depreciation. Coupled with CSS, depreciation deductions can be frontloaded even further if the newly distinguished personal property qualifies for bonus depreciation. Originally introduced in September 2001, it allows for businesses to take an immediate first-year deduction for a portion of the asset’s basis. New assets qualified as personal property are eligible for bonus depreciation, alongside special asset categories such as qualified leasehold improvements (QLHI) and the recently implemented QIP.
However, bonus depreciation is nearing the end of its life, as it phases out through the end of 2019, whereby it will need to be extended further in order for taxpayers to continue taking advantage of this provision. Taxpayers will need to place eligible property in service sooner rather than later, as the accelerated deduction shifts from 50 percent for assets placed in service through the end of 2017, to 40 percent in 2018, to 30 percent in 2019 and then to zero (long production property is afforded an additional year).
Land Values: Nielsen v Commissioner
On May 8, 2017, the Tax Court reached a decision in the case of Nielsen v Commissioner, determining a county assessor’s allocation to land and improvement values was ultimately more reliable than the allocation supplied by the taxpayer. The taxpayer argued the county assessor’s data were “extraordinarily inaccurate,” but the Tax Court saw the county assessor’s values as bearing more authority over the taxpayer’s determined values.
This ruling ultimately strengthens the IRS’s position against taxpayers taking an aggressive depreciable basis allocation in an acquisition price. For tax capitalization purposes, when purchasing a property, taxpayers must identify land and improvement value in relation to the acquisition price. Particularly when assessing a cost segregation of an acquired property, the land value is often a disputed subject, and this determination sheds more light on a previously “gray area.” Companies must therefore focus on and provide support for their allocation of the purchase price to land as part of CSS.
Qualified Improvement Property
Qualified improvement property is a more recent implementation that has largely flown under the radar. Defined as any improvement to an interior portion of a building placed in service after the initial building by any taxpayer, the property is depreciated under a 39-year life. However, unlike 39-year real property, QIP is bonus eligible. QIP is similar to qualified leasehold improvements in that the improvements must be placed in service subsequent to the building as well as the defined rules of interior space (exceptions include escalators or elevators, enlargement of the building, or any structural components), although there are a few subtle differences. QIP is not subject to the requirement that the building must be placed in service three years before the improvements or that the expenditures must be bound by a lease. Finally, QIP must be placed in service after December 31, 2015. The creation of QIP alongside QLHI may make it substantially easier for taxpayers to qualify the majority of their capitalized basis into a bonus eligible category.
Alvarez & Marsal Taxand Says:
The shifting landscape of bonus depreciation, the implementation of QIP and the uncertainty attached to tax reform all exemplify the benefits of capital-intensive taxpayers having fixed-asset work and considering a cost segregation study performed sooner rather than later. While tax reform updates should be monitored for clarification of potential depreciation changes, the benefits of CSS should still be utilized in the present to reduce upfront income tax costs and improve taxpayer cash flows.
The information contained herein is of a general nature and based on authorities that are subject to change. Readers are reminded that they should not consider this publication to be a recommendation to undertake any tax position, nor consider the information contained herein to be complete. Before any item or treatment is reported or excluded from reporting on tax returns, financial statements or any other document, for any reason, readers should thoroughly evaluate their specific facts and circumstances, and obtain the advice and assistance of qualified tax advisers. The information reported in this publication may not continue to apply to a reader's situation as a result of changing laws and associated authoritative literature, and readers are reminded to consult with their tax or other professional advisers before determining if any information contained herein remains applicable to their facts and circumstances.
About Alvarez & Marsal Taxand
Alvarez & Marsal Taxand, an affiliate of Alvarez & Marsal (A&M), a leading global professional services firm, is an independent tax group made up of experienced tax professionals dedicated to providing customized tax advice to clients and investors across a broad range of industries. Its professionals extend A&M's commitment to offering clients a choice in advisers who are free from audit-based conflicts of interest and bring an unyielding commitment to delivering responsive client service. A&M Taxand has offices in major metropolitan markets throughout the United States and serves the United Kingdom from its base in London.
Alvarez & Marsal Taxand is a founder of Taxand, the world's largest independent tax organization, which provides high quality, integrated tax advice worldwide. Taxand professionals, including almost 400 partners and more than 2,000 advisers in 50 countries, grasp both the fine points of tax and the broader strategic implications, helping you mitigate risk, manage your tax burden and drive the performance of your business.