January 2018 brought a complete change to the U.S. tax laws, but the basic tax principles are the same as they always have been: pay the IRS and States as little taxes as the laws allow. One of the most significant ways to defer taxes and reduce current tax liabilities is through what’s called a cost segregation study.
In simplest terms, a cost segregation study is a way to identify assets with a shorter tax life (5, 7, 15 years, etc…) rather than over a longer life such as 27.5 or 39 years. The benefits of doing such a study are vast: shorter depreciation lives, potential for bonus depreciation, time value of money on tax savings, proper documentation in case of IRS audit, and identification of specific assets for write off in the future. Cost segregations are not new to the tax law and are actually common practice, especially in the real estate industry. We have seen these studies for years and have always realized the benefits.
But now, there is a new benefit to a cost segregation study that most people don’t know about.
As part of the Tax Cuts and Jobs Act, there is a new law regarding potential limitation of interest expense under IRC 163(j). Certain businesses whose average gross receipts exceed $25 million over the preceding three years are now limited to the amount of interest expense they can deduct. If your business exceeds this threshold, your interest deduction cannot exceed 30% of Adjusted Taxable Income (ATI). The excess interest expense is then carried forward indefinitely. But what exactly qualifies as ATI? ATI is taxable income calculated without regard to things such as:
- Activity not allocable to a trade or business (charitable contributions, Capital Gains/Losses, etc.)
- Interest expense and interest income
- IRC 199A deduction
- Amortization and depreciation
These rules have given way to a new aspect of tax planning to help ensure taxpayers continue to reduce their taxable income, while at the same time, generating a higher ATI.
Using a CSS has been a useful tool in this planning process. Starting in the 2022 tax year, taxpayers will lose the ability to exclude depreciation and amortization from ATI. With the loss of the exclusion, there will be an extra incentive to accelerate as much depreciation as possible and conducting a CSS could do that by identifying shorter-lived assets within your property. This will allow you to “pull-in” any depreciation before the 2022 cut-off that otherwise would have been included in ATI. If you have discussed possibly doing a CSS, there may never be a better time than right now.
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