The new tax reform law, commonly referred to as the Tax Cuts and Jobs Act, reduces the income tax rate for C corporations and reduces the effective income tax rate on most pass-through business income through a new deduction on qualified business income.
This provides a unique opportunity for such companies to save on their 2017 taxes, if they act now. The reduction in effective tax rates creates an opening for these businesses to use strategic tax planning to accelerate available deductions into the current tax period, or defer income into a later period, to create a permanent cash benefit due to the lowering tax rates from one period to the next.
One of the opportunities available to accelerate deductions is cost segregation, which can help taxpayers reduce current taxable income at the current higher tax rates versus using the deductions in later years at a reduced rate.
Cost segregation is an IRS-approved tax deferral strategy that front-loads depreciation deductions into the early years of ownership to help increase cash flow. With tax reform’s reduction of income tax rates, this strategy provides taxpayers—real estate owners, investors, and tenants that are building, remodeling, expanding, or purchasing a facility—with a significant planning opportunity that can only be accomplished if implemented before a company’s effective tax rate is reduced in 2018.
Combining this depreciation acceleration strategy with the reduction in the effective tax rates makes the strategy even more valuable by generating permanent cash savings in addition to the tax deferral strategy.
The tax reform law lowers the tax rate on C corporations to 21% from the current top tax rate of 35%. For pass-through businesses, the law creates a new 20% pass-through deduction for eligible businesses that, when combined with the lowered individual tax rate, lowers the effective rate for pass-through business income to 29.6% from the current top individual rate of 39.6%.
For eligible businesses, these changes can result in a permanent cash savings on any accelerated deductions or deferred income of up to 14% for C corporations and 10% for eligible pass-through businesses, but only if they implement the planning strategy before the tax rates reduce.
Taxpayers can generally benefit from a cost segregation study if they own a facility with a depreciable basis of at least $1 million or leasehold improvements of greater than $300,000 and the facility or its improvements were put into service after 1987.
Qualifying fixed assets include the following:
- New construction
- Ground-up construction, remodeling, or expansion
- Leasehold improvements paid by the tenant or landlord
Qualifying tangible assets—such as removable flooring, equipment electrical, decorative items, signs, specialized plumbing and other specialty items—are prevalent across industries and often overlooked.
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How It Works
A cost segregation study can increase current year depreciation deductions by identifying items that can be reclassified to shorter depreciable lives.
A newly constructed commercial facility has a cost basis of $5 million. The facility’s property components and land improvements are classified under building and depreciated over the standard 39-year period.
Assume that $1 million in improvements can be reclassified to shorter depreciable lives, and that reclassification provides a benefit of accelerating $534,000 of depreciation into the current year. At 39.6%—the current top marginal tax rate for individuals—this represents a roughly $211,000 current year deferral of taxes to be paid.
With an effective rate of approximately 29.6% on qualified business income from a pass-through entity, letting those deductions roll into 2018 would result in a decreased deferral of roughly $158,000. The difference between these two numbers–roughly $53,000–is the permanent cash savings that is generated from the deferral strategy.
Using the same facts as above, but in the case of a C corporation with a tax rate of 35%, this represents an almost $187,000 current year deferral of taxes to be paid.
With the new corporate tax rate set at 21%, the value of the deferral in 2018 will decrease to a little over $112,000. The difference between these two numbers—almost $75,000—is the permanent cash savings achieved by pushing deductions into the 2017 tax period.
A cost segregation study can also:
- Help taxpayers identify provisions to recover the costs of depreciable property more quickly
- Accelerate depreciation of certain qualified real property
- Immediately deduct the cost of certain tangible personal property
Now is the time for businesses to review their fixed asset holdings to determine if they can benefit from the higher, 2017 tax rates. In addition to cost segregation, other strategies that could help taxpayers with tangible property reduce their tax burden include the following:
- Fixed asset reviews to correct recovery periods, depreciation methods, and property eligible for bonus depreciation
- Section 179D energy efficient building deductions
- Tangible property regulation opportunities
If companies can accelerate their tax deductions into periods prior to rates being lowered, there’s an opportunity to gain a permanent tax savings when filing their 2017 tax returns.
We’re Here to Help
If you have questions about how a cost segregation study can help your business plan for tax rate changes and decrease its tax liability, contact your Moss Adams professional. You can visit our cost segregation page or dedicated tax reform page to learn more.