Catch-Up Opportunities for Depreciation

Editor: Michael D. Koppel, CPA, PFS

Selecting the proper class life for assets placed in service may allow a business to increase its cashflow by accelerating depreciation and thus deferring federal and state income taxes. Often little thought is given to assigning the proper class life to an asset when it is placed in service. In many cases, the ability to classify an asset as one with a shorter life eligible for accelerated depreciation is not recognized until years after the asset has been placed in service. All is not lost, however, because it is possible to retroactively “catch up” on depreciation not previously claimed.

This can be accomplished by switching to the proper class life and taking advantage of revenue procedures that allow taxpayers to deduct in one year the cumulative difference between the depreciation taken on an asset previously placed in service and the amount of depreciation that would have been taken using the proper method. This catch-up frequently results from a cost segregation study performed in connection with a property that was acquired a few years earlier. As a result of these procedures, it is possible to significantly increase cashflow from the tax savings generated by the deductions made available with this approach.

Cost Segregation

Cost segregation is the process of determining the proper classification of an investment in a facility between structural and nonstructural property. The various cost components are identified, separated, and reclassified into tangible personal property and other items eligible for shorter depreciable tax lives than the lives applicable to real property. By reallocating a significant portion of the costs from longer recovery periods (27.5 or 39 years) to shorter recovery periods (5, 7, or 15 years), the depreciation expense is accelerated, providing increased cashflow and tax savings in the early years of the asset’s life.

Although in many cases the total depreciation is exactly the same, the benefit of cost segregation comes from the time value of money. Put another way, a tax deduction today is worth significantly more than a tax deduction in the future.

Ideally, a cost segregation study should be performed for the year the real estate is first placed into service. However, the IRS allows taxpayers to deduct catch-up depreciation on the difference between the depreciation taken to date and the depreciation that could have been taken using cost segregation techniques. Cost segregation may apply retroactively to any property placed in service since 1987, although the cost versus the benefit of doing such a study must be considered.

Recent Changes

The Job Creation and Worker Assistance Act of 2002, P.L. 107-147, gave businesses a first-year 30% depreciation bonus for qualifying assets acquired between September 11, 2001, and September 10, 2004 (Sec. 168(k)(1)). The Jobs and Growth Tax Relief Reconciliation Act of 2003, P.L. 108-27, boosted this bonus depreciation significantly to 50% for assets placed in service between May 6, 2003, and December 31, 2004 (Sec. 168(k)(4)). This bonus is in addition to regular first-year depreciation. Under this law, at least 50% of all segregated costs of qualifying property can be deducted as depreciation in the year the asset is placed in service. These can be significant factors in calculating the catch-up depreciation benefit.

Certain revenue procedures (Rev. Procs. 2002-19 and 2002-9, as amplified by Rev. Proc. 2002-54) make it easier for taxpayers who claimed less than the allowable depreciation in prior years to take catch-up depreciation within a single tax year. The IRS views this as a change in accounting method and stated in Rev. Proc. 2002-19 that in the case of a negative adjustment (i.e., where additional deductions may be claimed), the adjustment may be taken in the current year.

The Service has claimed that under the modified accelerated cost recovery system (MACRS), the recovery period determines the period over which the basis of depreciable property is recovered. Therefore, the IRS considers changes to MACRS depreciation allocations as a result of cost segregation to be a change in recovery period and, consequently, to qualify as a change in accounting method to which the automatic change provisions of Rev. Proc. 2002-19 apply (i.e., recovery of prior years’ depreciation adjustments over a one-year period) (Regs. Sec. 1.446-1T(e)(2)(ii)(d)).

The identification of costs eligible for segregation must be determined on an item-by-item basis, and it is essential that studies be done only by individuals with a strong understanding of the applicable tax law, regulations, cases, revenue rulings, and current legislation. Cost segregation studies are not for everyone (e.g., tax-exempt organizations), so it is important to understand the taxpayer’s goals and situation before undertaking a study or suggesting making a change for catch-up depreciation.

Conclusion

Federal tax law creates the potential for accelerating substantial deductions in one year, depending on the cost, size, and nature of the property and the time period involved. Therefore, any time a significant investment in real property has been made or is going to occur, cost segregation should be considered.

If you would like additional information about these items, contact Mr. Koppel at (781) 407-0300 or mkoppel@gggcpas.com.