Bonus Depreciations Phase Out: Effects on Cost Segregation

Bonus depreciation was originally introduced to the Internal Revenue Code with the Job Creation and Worker Assistance Act of 2002 at a 30% rate. Since 2002, there have been various bills to extend and change the percentage within a given year, ranging from 30% to 100%, with 50% being the most common from its inception.

Cost Segregation

The Tax Cuts and Jobs Act of 2017 extended bonus depreciation through 2026, while also increasing it to 100% in 2018 through 2022, before reducing it 20% each year beginning in 2023. For taxpayers who have capitalized on cost segregation studies in the past, the 100% bonus depreciation has been a welcome increase as it has enabled them to amplify the effect of the study. However, with bonus depreciation already phasing out this year, are cost segregations still going to be worth it?

The short answer is “yes.” However, the results will be realized over a handful of years rather than having the immediate impact of the past five years. Nonetheless, you will want to do a cost segregation study as the tax law still enables you to depreciate your assets over a shorter period rather than the typical 39 or 27.5 years.

Below is an example comparing accumulated depreciation of a $10 million property at 100%, 60%, and 20% bonus, having allocated 20% of a property’s basis to 5-year classifications and 10% to 15-year land improvements through means of a cost segregation analysis:

The most glaring difference is realized in year 1, as this is where bonus depreciation will have an immediate impact. Generally, most personal property bifurcated through a cost segregation will be recognized in the first 15 years, as most of the reclassified asset lives fall into either a 5-, 7- or 15-year class life. In terms of savings, the net present value (NPV) estimate using a 35% effective tax rate would amount to over half a million in savings with even minimal bonus depreciation.

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Bonus Depreciation on Land Improvements & QIP

The term “Qualified Improvement Property” (QIP) may sound familiar. Any taxpayer that has undertaken a renovation or buildout since September of 2017 has most likely utilized the classification as it holds a 15-year recovery period as opposed to real property at 39 years. What makes QIP especially advantageous, however, is its eligibility for bonus depreciation, which had been at 100% for the past five years.

Office and retail buildouts tend to benefit the most from QIP, and this should continue with many companies continuing to downsize or relocate office space due to flexible work arrangements brought about by Covid-19. There are a few defining criteria to qualify, such as that improvements need to be made after the building housing them is in service, even if it’s just one day after. Finally, QIP doesn’t apply to some improvements: the enlargement of the building, elevators, escalators, or structural framework.

While bonus depreciation remained at 100%, there was no material benefit to having a cost segregation study performed on the improvements as the full amount would effectively be expensed in the first year. Now that we are firmly in 2023, QIP doesn’t quite hold the same weight with respect to bonus depreciation as compared to 5- and 7-year property classifications. The difference will be minimal in 2023, as 80% of the basis would qualify for bonus depreciation. However, the impact could be material with larger capital projects. Let’s look at the short-term savings over the first five years for a $5 million improvement project, assuming 40% reallocated to 5-year property and using a 35% tax rate:

While bonus depreciation is scheduled to end in 2026, there’s still a chance Congress could extend it once again. Bonus depreciation aside, there are other factors that impact the viability of an analysis, such as inflation and, most notably, interest rates. The economic impact of rising interest rates has further emphasized the effectiveness of cost segregation studies to maximize timing differences and generate an influx of immediate cash flow.

If you have questions about bonus depreciation or would like to discuss a cost segregation study for your business, please contact your Anchin Relationship Partner.

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