Everyone is interested in saving on taxes. Not everyone knows how.
Many commercial property owners and tenants and residential income property owners who are constructing improvements are unaware of the substantial tax savings available to them through some of the recent and temporary legislation that has been passed in an effort to stimulate the nation's economy.
Today, a large portion of new construction is eligible for an additional 30 percent to 50 percent bonus depreciation deduction in the first year of service, yet many fail to capitalize on this tax savings opportunity.
By learning how the latest tax rules work, building owners and tenants in the process of construction can decrease their tax payments significantly.
Know the Rules, Increase Tax Deductions
The rules behind bonus depreciation are fairly complex. Much of the eligibility for additional tax deductions from bonus depreciation is based on when construction has started. The Internal Revenue Service recently defined the start of construction as beginning when a taxpayer has incurred or paid more than 10 percent of the total construction cost of the property.
With the recent changes, taxpayers can claim an additional 30 percent first-year depreciation deduction on certain assets where construction started between Sept. 11, 2001, and Dec. 31, 2004, or Dec. 31, 2005, for certain property with a longer recovery period.
Assets where construction started after May 5, 2003, benefit even more because they are eligible for a 50 percent first-year depreciation deduction.
In addition to these date-based criteria, additional eligibility rules must be met depending on whether a taxpayer is constructing from the ground up, remodeling a building or constructing a leasehold improvement.
Qualified New Construction and Remodels
For taxpayers constructing or remodeling buildings, constructed assets that have shorter depreciation periods, such as carpeting, certain electrical connections and landscaping, may qualify for bonus depreciation.
The mistake most taxpayers make is the failure to correctly classify building assets into shorter tax lives. As a result, they miss out on the significant tax savings and increased cash flow.
To overcome this problem, taxpayers should have an engineering-based cost segregation study performed to determine what portions of their properties can be reclassified.
Many taxpayers often incorrectly classify their entire building project as having a tax life of 39 years or 271/2 years in the case of residential income properties.
Cost segregation studies often reclassify a substantial portion of a building project into five-, seven- and 15-year property. By doing so, the assets become eligible for bonus depreciation. Additionally, by having shorter lives, these assets can be written off faster, further increasing the tax savings.
To illustrate the tax savings, $100,000 in 39-year property would provide a $1,282 tax deduction in the first year. If a cost segregation analysis were to reclassify this $100,000 into five-year property, the resulting tax savings would be twofold. By making the property eligible for bonus depreciation, up to 50 percent can be deducted in the first year, allowing for a deduction of $50,000. The shorter tax life allows for an additional first-year deduction of $10,000, bringing the grand total in first-year tax deductions to $60,000. That is a 4,580 percent increase in first-year tax deductions.
Qualified Leasehold Improvements
While the benefit to building owners are clearly substantial, landlords and tenants in the process of constructing interior leasehold improvements stand to reap even greater benefits from the new bonus depreciation rules.
Qualified leasehold property does not include improvements that increase a building's length, width or height. Qualified leasehold property also doesn't include any elevator or escalator, any structural component benefiting a common area or the internal structural framework of the building.
Additionally, the leasehold improvement would have to be completed more than three years after the original building's construction completion date.
As long as the above criteria are met, even qualified leasehold property with a tax life of 39 years may qualify for the first-year bonus depreciation deduction. Unlike new construction, a cost segregation study is not required to take advantage of bonus depreciation.
For example, if $100,000 of 39-year property were to qualify for the 50 percent first-year bonus depreciation, the resulting first-year tax deduction would be $50,641.
It's Not Too Late
Even if one does not claim the tax deductions available through a cost segregation study, the IRS has a procedure that allows one to claim previously missed benefits. Those missed deductions can be claimed on a current return only if a cost segregation study is performed.
While the tax laws continue to become more complex, a clearer understanding of them can obviously create huge returns, especially in today's real estate market. By taking advantage of the new bonus depreciation rules and by using cost segregation to further accelerate depreciation and create eligibility to meet these requirements, taxpayers in the process of construction will be able to further decrease their tax liabilities and increase their cash flow for the time being.
CJ Aberin is the Senior Manager at KBKG, Inc. Cost Segregation Specialists.
Author: CJ Aberin | Publication: Real Estate Journal