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Depreciation Deductions and Cost Segregation for Tax Planning

As we get into the thick of tax season, many businesses and individuals are thinking of reducing their tax burden for the upcoming year. Having the right tax planning strategy in place helps lower your tax liability and reduces your costs. While many strategies are available, depreciation deductions are an excellent option for property owners.

These deductions can be used independently or combined with cost segregation to maximize tax-saving opportunities. Working with experts who understand depreciation deductions and offer cost segregation services ensures you are not missing out on any real estate tax savings.

What is Depreciation?

Depreciation allows taxpayers to recover a portion of their purchased property’s cost over a specific period. The cost is recovered through a deduction on the taxpayer’s income taxes. The amount of the depreciation deduction depends on several factors, including property type and the value of the property.

Depreciation Eligibility

Individuals and business entities are eligible for the depreciation deduction if their  property:

  • Is used for business or income-generating purposes by the taxpayer
  • Is owned by the taxpayer, which can include property that is leased or secured by a mortgage or other loan
  • Has a determinable use of life, meaning that it will decay, wear out, or become obsolete in a predictable number of years
  • Is expected to have at least a one-year lifespan

Land is not used to determine the value and cannot be included in depreciation deductions, though some land improvements may qualify. Properties used and disposed of within the same tax year, including inventory, are ineligible for this deduction.

Intangible property is ineligible for depreciation but may be eligible for amortization instead. Properties that have term interest held by someone other than the taxpayer are also ineligible for depreciation.

Depreciation Deduction Methods

Taxpayers who qualify for depreciation deductions have several methods to choose from. You may have to select a deduction based on the type of property you own. Businesses and individuals may be able to use a separate expense deduction along with the depreciation deduction for even greater tax savings.

Straight-Line Depreciation

Under this form of depreciation, the property will depreciate at the same rate during the entirety of the recovery period. It is the simplest way to determine the loss of an asset’s value over time. For example, a property valued at $150,000 with a 15-year recovery period will depreciate by $10,000 each year using this method.

Straight-line depreciation is the default method for properties with 27.5, 39, and 31.5-year depreciation periods. It is also an option for taxpayers with properties with a 3, 5, 7, 10, or 15-year depreciation period.

150% Declining Balance

This depreciation method allows the property to be depreciated at 150% of the allowed amount based on straight-line depreciation for the first year. This will enable taxpayers to benefit from more significant deductions early in their ownership. Using this depreciation method in the previous example would allow for a $15,000 deduction instead of a $10,000 deduction in the first year.

The 150% declining balance method is standard for a property with a 15 or 20-year recovery period. It can be used for a property with a 3-to-10-year recovery period. This method cannot be used for property or other assets with a recovery period longer than 20 years.

200% Declining Balance

The 200% declining balance depreciation method is similar because it uses the straight-line depreciation amount to determine the declining balance. In this method, 200% of this amount is used for the first year. Using the same information as above, a taxpayer would expect a $20,000 deduction for the first year using this depreciation method.

This method is standard for assets with shorter recovery periods of 3 to 10 years. Properties with a recovery period greater than 10 years are ineligible for this depreciation method.

Bonus Depreciation

This method allows taxpayers who own property with a depreciable life of 20 years or less to take an increased depreciation deduction in the first year. The bonus depreciation amount was increased from 50% to 100% through the Tax Cuts and Jobs Act and will remain in effect until December 31, 2022. At that time, the bonus depreciation percentage will be reduced and phased out gradually until it expires after December 31, 2026.

Section 179 Expensing

This section of the U.S. tax code allows taxpayers to deduct business equipment and expenses related to depreciable assets. This includes office equipment, technology, software, and vehicles. Section 179 helps businesses lower their current year tax liability in place of capitalizing the asset and depreciating it over time.

This expensing method is used for the year assets are placed into service. Businesses can take a maximum Section 179 deduction of $1,050,000 in 2021 and $1,080,000 in 2022. The limitation is adjusted annually for inflation. The annual Section 179 limitation phases down dollar-for-dollar when the total property purchased exceeds $2.62 million in 2021 and $2.70 million in 2022. The phase-out threshold is adjusted annually for inflation. Costs that exceed the annual limitation cannot be expensed under Section 179 and may be eligible for bonus depreciation.

Use Cost Segregation to Maximize Depreciation

Cost segregation allows taxpayers to identify assets in a building with shorter recovery periods and take eligible depreciation amounts. It is a helpful way to get more significant deductions in the property’s earlier years.

Rental properties and commercial buildings will have a longer recovery period than other tangible properties. The depreciable life is 27.5 years for residential rental property and 39 years for commercial property.

Tangible properties such as fencing, fixtures, cabinets, and flooring have shorter lifespans and shorter recovery periods. This shorter recovery period means they depreciate faster, resulting in larger deductions during the earlier years.

Cost segregation allows you to separate the components of the property that depreciate faster. This helps reduce your tax liability and increase your cash flow. It also allows the use of bonus depreciation and Section 179 expensing for property components that may not otherwise qualify for these deductions.

However, integrating cost segregation into tax planning does come with a few downsides. Before you decide to use this method, consider:

  • Cost segregation accelerates depreciation deductions that would otherwise be taken in the future
  • Taxpayers are responsible for a cost segregation study, which may include hiring consultants
  • Cost segregation can complicate your tax return, including filing additional forms that notify the IRS you are changing depreciation methods

Get Expert Tax Planning Assistance

Combining depreciation deductions and cost segregation helps businesses lower their tax liability and improve cash flow. While many companies and individuals take advantage of tax savings offered through building depreciation, few receive all the real estate tax savings they are eligible to receive.

Many businesses only depreciate the total building cost and fail to use cost segregation and depreciation for qualified components of their property. Working with tax and business advisors can help.

Winds has an experienced team of tax professionals and can assist with cost segregation studies to find all eligible tax savings for your business. Contact us today for expert assistance in this area.

Realize Maximum Real Estate Tax Savings

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