We’re only a few weeks into this tax season, and it’s clear that it’s going to be a messy one. The IRS has given a lot of frustrating mixed messages this year, from asking millions of people to wait to file their income taxes (only to backtrack days later) to vague guidance on various rule changes for the 2022 tax year. It’s a confusing start to a tax year that’s undergoing a bunch of modifications that will greatly impact real estate transactions for years to come. Fortunately, we’re here to help.
In 2023, and over the next few years, one big issue that filers will have to contend with, at least for U.S. federal income tax purposes, is the gradual phase out of the bonus depreciation deduction, an expedited tax deduction that enables business entities in several states to immediately write off a significant portion of the cost of qualifying assets (which often include newly-acquired properties, newly constructed properties, and the cost to rehabilitate said properties).
Simply put, depreciation is a concept that allows a taxpayer to recover the cost of an asset (or “recognize a deduction,” as your CPA will phrase it) as the property declines in value of its useful life. Bonus depreciation is a special rule that allows a filer to accelerate the rate at which depreciation is recognized on qualified assets. It initially appeared in the tax code in 2002, when Congress passed a slew of initiatives intended to kickstart economic recovery after 9/11, and it became so popular that the deduction’s reach expanded over the years. By 2017, the bonus depreciation deduction rules allowed taxpayers to write off 100 percent of the cost of a qualified asset in the year in which it was placed in service. However, all good things must come to an end, and tax perks are no exception. Starting in the 2023 tax year, the bonus depreciation percentage goes down to 80 percent, and will continue to go down by 20 percent each subsequent year, until it finally dies out in 2027.
Any investor wants to reduce their current tax bill and delay tax payments as much as they can. So, knowing which assets are eligible for bonus depreciation is a useful tool for achieving tax deferral. Even as the bonus depreciation rate goes down over the next few years, it will still allow new owners of properties to reduce their current tax bills and use that cash in other ways. But the ability to take advantage of the bonus depreciation rules hinges upon whether an asset is a “qualified” asset for purposes of the bonus depreciation rules under IRC section 168(k).
Buckle up, because we’re about to get technical. Qualified assets, as laid out in Section 168(k) of the IRS Code include, among other things, property with a short useful life. These short-lived assets generally include personal property (that are not building components) and also include “land improvements.” It’s important to note that some of that qualified property could include parts of a building that are not “building components” under the tax rules. By identifying those parts of a building that are not building components or structural components, taxpayers can assign an appropriate amount of cost to that component and recognize accelerated depreciation for that cost. Personal property (including the parts of a building that are non-structural components) are generally referred to as “Section 1245 property.”
Live free or 1245 hard
Determining what exactly qualifies as Section 1245 property (and what is and is not a building or structural) can get a little bewildering. The IRS tax code defines a 1245 as either: personal property or other tangible property not including a building or its structural components generally used in a trade or business. Therefore, in order for something to be section 1245 property (and be eligible for bonus depreciation), it must be tangible personal property or (if it is “other tangible property”) must not be a building or a structural component of a building.
If you’re just itching to flip through the tax code, you can find the regulations that define “Tangible Personal Property” under Section 48. But don’t sweat it if you’re not—we did it for you. One part of that definition states that tangible personal property includes “all property (other than structural components of a building) which is contained in or attached to a building.” Those regulations go on to say that structural components include parts of a building such as walls, partitions, floors, and ceilings (as well as any permanent coverings thereof) windows and doors, HVAC components, electrical components, and plumbing components and other components that relate to the operation and maintenance of the building. Additionally, the rules (including case law that interprets the above rules) make clear that how permanently something is attached is important as to whether it is a structural component or not, and whether something relates to an item of equipment (and not the building itself) becomes important…there are dozens of cases interpreting the above rules that leave one’s head spinning.
While there are certain items that are clearly tangible personal property (like a refrigerator, for example), there are many other items that are less clear. Analyzing whether certain components are section 1245 property or not involves conducting what’s known as a cost segregation study. A cost segregation study is an exhaustive analysis that examines each element of a property, divides them into different categories (including a category for bonus eligible property), and enables filers to take advantage of accelerated depreciation for qualified property.
Thankfully, Richard Shevak, Principal in CohnReznick’s National Tax practice, was gracious enough to take the time to explain what qualifies for Section 1245 for one of these studies. “If something is readily removable from a building, then that component will likely lend itself to being a 1245,” he said. “For example, if we’re looking at an apartment building that was built or rehabilitated, we would typically treat kitchen cabinets as 1245 property because those cabinets do not meet the definition of a building component and they’re easily removable. ”
Shevak told me that other examples of 1245 properties include ornamental lighting fixtures, carpet, and decorative molding. But a more interesting example treads the “no building components” rule: electrical accessories. “What people are surprised about sometimes is the fact that we could take a portion of the electrical system and actually treat that as Section 1245 property,” Shevak explained. “You would obviously think that the electrical system in a building is a building component. But, there’s another rule that says if something supports – or is accessory to – a piece of equipment—let’s say a refrigerator—we could then allocate a portion of that electrical system that relates to the refrigerator. Same thing for the electrical, plumbing, and/or exhaust for a washer, dryer, microwave, garbage disposal, any appliances really.”
The tax man cometh
Here’s the thing, you could avoid this entire analysis and treat the total cost of a building as “section 1250 property” (building property). If you ignore the above analysis, you’d recognize tax depreciation deductions for the entire building slowly over time. If you do so, you’d miss out on the accelerated depreciation that might otherwise help to put cash back in your hands.
If you acquired, constructed, or rehabilitated a building in the 2022 fiscal year, and you believe some of the costs of that building qualify for the bonus depreciation, generally you’d be wise to perform the cost segregation analysis to determine how much of the cost of that building is eligible for bonus depreciation. But don’t sweat it if you haven’t carried out a cost segregation study yet. Cost segregation studies can be done in a later year.
A cost segregation study isn’t something that can be carried out overnight, expect a wait time of 30-60 days for the process to reach completion. So, maybe take the IRS’ earlier advice to hold off on filing your taxes and request an extension until October instead.
Filers who acquired their first real estate assets in 2022 may have a couple of questions about how to take advantage of the bonus depreciation deduction’s last call, including whether or not certain repairs fall under Section 1245 of the tax code. And whatever question that may be, it’ll always start with the same answer: consult a professional.