As the new year begins, many people are starting to think about possible tax planning strategies to use in 2022 that could reduce their tax bill next year. While a plethora of strategies are available, there are two that are rarely used to their full potential: depreciation and cost segregation.
In short, depreciation is what allows a taxpayer to recoup the cost of purchased property over a set period of time. This recapture is done through an income tax deduction, and the total amount that can be deducted depends on various factors. This tax planning strategy is available to all types of business entities that purchase property during the year.
Capital cost allowance requirements
To qualify for capital cost allowance, the property must:
- Be owned by the taxpayer (“ownership” may include leased property or property secured by a loan/mortgage);
- Be used in the business or income-generating activities of the taxpayer;
- Have a determinable useful life (meaning it wears out, decays or becomes obsolete over a predictable number of years); and
- Should last over a year.
Certain types of goods are not eligible for depreciation:
- Land (although some land improvements may qualify);
- Assets put into service and disposed of during the same tax year (for example, inventory, technical manuals);
- Intangible assets (which may be amortized instead); and
- Term interest on property where the residual interest is held by a person related to the taxpayer (very technical).
With these eligibility requirements in mind, taxpayers can then determine the type of depreciation they will need to use.
When it comes to selecting a specific depreciation method, it’s not as simple as making a choice. Often taxpayers must use a certain method depending on the type of property they own. There are three typical methods, a special depreciation method and a special expense type:
- Linear depreciation: Under this method, the property depreciates at the same percentage each year during the payback period. For example, a property with a payback period of 15 years is purchased for $15,000. Each year, the capital cost allowance would be $1,000 using the straight-line method. This is the default method for 27.5, 31.5 and 39 year old assets, as well as some 15 year old assets. Taxpayers can also choose this method for properties that are three, five, seven and ten years old.
- 150% decreasing: Under this depreciation method, assets can be depreciated in the first year at 150% of the amount allowed in the first year on a straight-line basis. For example, the same property as above purchased for $15,000 would have a depreciation of $1,500 in the first year instead of $1,000 on a straight-line basis. This method can give much higher deductions in previous years and is the default method for property with 15 and 20 year payback periods. It cannot be used for assets with payback periods greater than 20 years. Taxpayers can again choose to depreciate assets over three, five, seven and ten years under this method.
- 200% decreasing: Similar to the method above, this results in a depreciation of the property equal to 200% of the amount allowed on a straight-line basis in the first year. The same $15,000 property would have $2,000 depreciation for the first year. This is the default method for assets with payback periods of three, five, seven and 10 years. Assets with payback periods greater than 10 years cannot use this method.
- Bonus amortization: Unlike the three methods above, which are quite typical, this is a special depreciation method. Under bonus depreciation, taxpayers are allowed to take increased depreciation allowance for assets with a useful life of 20 years or less. The Tax Cuts and Jobs Act 2017 increased this abatement amount to 100% of the purchase cost of the property in the year it becomes available. This increase will begin to phase out in 2023, with the deduction being phased out completely by 2027 unless the law changes.
- Article 179 being charged: Often discussed in tandem with depreciation, expense 179 is a special expense allowance. Section 179 is a permanent tax provision for increased expenditures of property purchases in the year the purchase is made. The expense deduction is capped at $1 million, adjusted annually for inflation. In addition, Section 179 spending is phased out on a dollar-for-dollar basis if total property purchases during the year exceed $2.5 million, again adjusted for inflation. No purchases that exceed the sum of the limitation and the phase-out floor may be expensed.
Maximize depreciation with cost separation
Cost segregation is a great way to get bigger deductions in the early years of a property. So what is cost segregation? It allows taxpayers to identify assets with shorter payback periods in a building and take appropriate depreciation amounts. Property such as a commercial building or rental property has a longer payback period than tangible property.
A residential rental property, for example, has a lifespan of 27.5 years. Meanwhile, non-residential real estate has a lifespan of 39 years. The lifespan of tangible assets, such as tiles, light fixtures, carpeting, cabinets and fences, is shorter. Since these tangible property components have a shorter payback period, they can be written off at an accelerated rate, resulting in larger deductions in previous years.
To get started, have experts assess the property and determine which parts are “structural components” and which parts could be considered “item 1245 property”. Any property deemed to be a Section 1245 property may then be assigned an appropriate asset class, as determined by the IRS, along with its corresponding payback period.
The point to remember here is that if you’ve recently purchased real estate, you can use cost segregation to separate components of the property that depreciate faster than the building as a whole, allowing you to increase costs. cash flow and reduce tax payable.
A summary of cost separation
How exactly does real estate depreciation work? Houses and commercial buildings are not fully expensed in the year they are purchased. Instead, they are depreciated over their useful life, which is typically 27.5 years for residential buildings and 39 years for commercial buildings. In practical terms, this means that on a $1 million commercial property, a taxpayer could only take $25,641 per year in depreciation ($1 million divided by 39 years).
If the taxpayer retains the property for the full 39 years, the full $1 million will eventually be amortized. However, due to the principle of the time value of money, it is more useful to take an expense or deduction today rather than later – and cost segregation can allow you to do this with real estate.
When you buy real estate, although you cannot depreciate the land, a cost segregation study can be done to identify other asset classes in the building. Taxpayers can use software or a consulting company for this study.
The study involves an assessment to separate personal property in the building into shorter lifespans (eg five, seven or 15 years). Essentially, shorter asset life classes can use accelerated depreciation, which allows for higher depreciation expenses in the early years and lower expenses later.
Remember that the cost segregation study will not increase the overall depreciation that can be taken for the building; it will simply accelerate capital cost allowance in the early years of ownership. This means that the capital cost allowance for subsequent years will be lower.
Benefits and considerations of cost separation
In summary, here are some pros and cons to keep in mind with cost separation:
- May increase global deductions in previous years to reduce taxable income;
- May allow additional depreciation or expense under Section 179 of property that would not otherwise qualify.
- Reduces depreciation deductions that can be taken in subsequent years;
- Taxpayers must pay for the cost segregation study (software or consultant);
- May increase the chances of an audit.
If you haven’t already put the building into use for a full year, you can take advantage of this tax planning strategy immediately provided you have ownership of the building and carry out a segregation study. costs. There may be more requirements if you have already started depreciating the property, including filing for a change in accounting method.
Depreciation and cost segregation are huge opportunities for tax savings in 2022, but many people are not taking full advantage of them. If you own a property or plan to invest this year, be sure to maximize your cost recovery through depreciation.