Cost segregation studies have become a popular way for commercial property owners to realize immediate tax savings.
Whether its new construction, improvements or the owner has recently acquired the property, a cost segregation study has its benefits. However, it’s important to be aware of and plan for tax resulting from depreciation recapture prior to conducting a study. Depreciation recapture requires the building owner (usually the taxpayer) to repay accelerated deductions (including from a cost segregation study) when the property is sold at a gain. Since the tax is assessed only when the property is sold, it’s important for property owners to have a tax plan in place prior to the sale. To help clients, prospects and others understand the tax, JLK Rosenberger has provided a brief summary below.
What is the Tax Impact on Depreciation Recapture?
Depreciation recapture occurs when a taxpayer sells an asset for a gain after taking deductions for depreciation. Because the depreciation deductions offset ordinary income, any gain the taxpayer receives, up to the depreciation amount, must be included as ordinary income and not capital gain. In other words, taking the accelerated deprecation allows a building owner to take deductions against ordinary income usually in the current year. However, this also creates a situation that results in a lower capital gains tax when the building is sold, thus providing an additional benefit to the property owner. As a result, the tax was enacted to ensure that gains resulting from depreciation were correctly taxed.Unlike normal capital gains taxed at 15%, the recapture portion is taxed at 25%.
Recapture Tax Planning Strategies
- Partial Asset Dispositions – As we discussed in a prior post, the new regulations permit a taxpayer to recognize a partial disposition when components are removed from a building or it is simply demolished. Using this approach it’s possible to recognize losses on the remaining basis for the replaced items. Examples may include HVAC systems, new roofing, or even interior and exterior windows. Through partial dispositions, the property owner is shielded from related recapture on the disposed assets. So the partial asset disposition tool really offers two streams of value for the taxpayer.
- Repair v Capitalization Review – There has been much written about the new repair v capitalization rules when making repairs and enhancements to properties. It’s important to work with a CPA to ensure all costs have been properly classified – especially repair costs which are immediately deducted. Not only will this help the immediate tax situation, but it will ensure there is no artificial inflation of the tax related to depreciation recapture.
- Net Operating Loss – If the taxpayer has a net operating loss (NOL) from a prior year then it’s wise to use the losses against the gain to offset additional tax liability. If general business credits can be applied this is another way to reduce tax liability, although generally the reduction impact is less than with other strategies.
There is a popular myth that building owners can actually lose money when conducting a cost segregation study. The myth is based on the tax impact of depreciation recapture. While a cost segregation study is not for every property owner there are compelling benefits which should not be overlooked. If you are considering selling your commercial property or have questions about the capture tax, JLK Rosenberger wants to help. For additional information please call us at 949-860-9902, or click here to contact us. We look forward to speaking with you soon.