Cost Segregation: The Calculation of Asset Recapture Regulations
Scott Roelofs, CFA ABV
The most popular reason for owners to avoid having a cost segregation study performed is the threat of recapture. This paper is designed to add perspective to this issue from a financial analyst point of view. To do this, let’s start with the design of the recapture tax. The recapture tax is designed to prevent taxpayers from deferring ordinary income just to pay capital gains tax. A taxpayer could defer 39.5% ordinary income tax and sell the property a year later, maxing out at 23.5% capital gains tax. The depreciation deduction was never intended to convert income tax to capital gains tax. This loophole was closed and since has affected the use of cost segregation.
Recapture is the IRS’s way of fixing the loophole described above. Here is an example to help understand how it works. A property purchased for $100,000 that took $50,000 of depreciation and then sold for $125,000 would have recapture of $50,000. The remaining $25,000 would be taxed at capital gains rates. The idea of recapture is a repayment of a benefit already received, but that isn’t the whole story. The issue for the property owner doesn’t come from a tax penalty. It comes from the surprise of losing a perceived benefit. When a taxpayer is expecting a $75,000 benefit and instead receives a benefit of $25,000, the perceived loss of $50,000 can tempt a taxpayer to avoid such strategies in the future.
There are several remedies to this issue, but communication and planning are the easiest ways to prepare for this repayment. Preparing a property owner means they understand that depreciation allows them to offset ordinary income in the current year, but a portion may have to be paid back in future years. This information may change the direction and decision making around the timing and pricing of the sale of the property.
Implicitly or explicitly all business decisions are made off a net present value (NPV) calculation. Many projects have a razor thin NPV and the unexpected loss of a tax benefit may be the difference between green lighting a project and scrapping it. The property owner must be made aware of future tax consequences. All is not lost, however. There are several strategies to protect the taxpayer which we will discuss below.
Value of Assets upon Sale
Unlike the sale of a single item, the sale of a cost segregated property does not identify the value of each asset. The recapture provision is heavily weighted to the gross sale price of the asset. The decision of that price is often left to the tax professional to decide what an appropriate value would be. Let this be a helpful guide along that path. A nominal value may be assigned to property that has been fully depreciated and a larger portion of the value may be assigned to the 1250 property. These terms “nominal value” and “larger portion” offer little help when dealing with real estate, sometimes worth millions of dollars. The remaining 1250 real property will also create challenges when valuing the sale price allocation. It may not be the easiest task for a tax professional to identify the value of a parking lot made of asphalt that is seven years old.
The guidance given by case law relies on the government assessment of value barring any such specific valuation experience. In the Los Angeles County case of Nielsen v. Commissioner, the government found that though a property owner can assess the value of the property they own, they do not have any specific ability to assess the individual components of that property. Given this case, it would be prudent to accept the government guidance in regard to the value of property. The prevailing guidance would be MACRS depreciation in this example. MACRS depreciation can then both be used for tax and valuation purposes. This would be a benefit to the taxpayer as the double declining nature of the property would allow for a significant reduction in the value of the assets. Assigning a reduced value is different than assigning a zero value. A zero-value asset raises issues that are often overlooked and can make cost segregation more of a necessity for property owners, not less. We will discuss this in the next section.
Disposal, Retirement, and Improvement
Here is a place that cost segregation can be more of an asset than a liability. It is the term “allowed or allowable” that prevents taxpayers from using loopholes to defer ordinary income and pay capital gains tax. In the case of disposal property, property allocated to retirement, and property deemed to be improved by the IRS code, the term “allowed or allowable” can have serious repercussions. If an HVAC unit goes bad and needs to be replaced, the proper treatment of the old HVAC unit allowed or allowable is to take an immediate deduction for the remaining value of the property. In this case, upon sale of the property, recapture would be triggered. The recapture would be calculated as the remaining value of the disposed unit, from the date the disposal was allowed. The difference here is that without proper disposal of the property the taxpayer would not have received the disposal deduction and would essentially have been double taxed. This goes for retired assets and assets deemed to be improvements.
Most of the time the reason GAAP isn’t followed is that there has never been a defined value for those assets. The responsibility to assign a value of, for example, a 4000 square foot, unseen unmeasured, and ageless roof, would fall to the tax professional. These are issues for a construction specialist trained in engineering, design, and cost structures. Cost Segregation takes the responsibility off the tax professional and gives the property owner the exact measurements of the roof, the material used in construction, and the costs associated with a roof of that age. Disposal, retirement, and improvements of property are accurately recorded easily and without excess expenses. From here we need to look closer at the details.
With proper planning, we would like to show the types of cases that would be subject to recapture, where it applies, and how it is likely a reduced return of the tax benefits the owner would have already received. The best place to start is to list the kind of property owner that would be subject to recapture and, in turn, would not be right for cost segregation. There are five elements necessary and all five must be triggered to cause recapture or at least be significant enough to be a deterrent. This investor is a person that purchases an investment property:
In the current year,
Has an outsized tax liability in the current year,
Utilizes the 179/Bonus depreciation associated with a cost segregation study,
Turns around and sells the property within a 10-year time frame
Does not perform a 1031 exchange to another property.
In the following paragraph we will dive into each of these elements and define why they must be present.
1. Why does the property need to be purchased in the current year to trigger recapture?
First, a cost segregation study recategorizes 1250 property to 1245 property. Because of this, the term “allowed or allowable” comes into play. For property that was 1250 property and is now 5-year 1245 property, the “allowed or allowable” deduction is double declining or 200DB. The design of the double declining, or in the case of 15-year property 150 declining, is to accelerate the depreciation to the early years and slows in the later years. The reason the depreciation is declining at such a rapid pace is not arbitrary. The resale value of assets shorter than 20-years in length declines much faster than straight line in the early years and levels off towards the end. Think of the value that is lost the second you drive a new car off the lot.
To further the explanation let’s look at an example of a $100,000 5-year property purchased three years ago. This property has an allowed or allowable remaining life of only $28,800. The resale value of an asset that is deemed to be replaced every five years doesn’t hold much value in its third year. So, let’s say the asset is sold for $30,000. The amount that would be subject to recapture would be the difference between the sale price and $28,800. That works out to a recapture of $200 or $80 of tax. For this example, if a 179/Bonus election was made the full $30,000 recapture would be applied, but that is only if all $30,000 was used and we will discuss this later.
Another topic that causes confusion along these lines is the “catch-up” provision associated with cost segregation. When the cost segregation study changes the property, the calculation takes the amount already depreciated, in this case $7,692.30 ($100,000 / 39-yrs X 3-yrs) and reconciles with the amount that would have been depreciated under a cost segregation, $71,200. This gives the property owners a current deduction of $63,507.69. This doesn’t cause recapture; however, this does prevent the taxpayer from paying double taxation by catching them up to the amount that is allowed or allowable under the IRS code.
2. Why is it relevant that there is an outsized current tax liability?
When you get into the calculation of recapture you notice a nice provision that adds back any unused 179 depreciation. With this provision, it is conceivable that the unused 179 bonus would be caught by the double declining balance within a few years. Let’s use the example from before. Assume $100,000 5-year property is 179 bonused. In the first 3-years, $70,000 of the bonus is used. The calculation goes as follows: Depreciation allowed or allowable – 179 bonus + Unused 179 bonus or $71,200 - $100,000 + $30,000 = a positive $1,200. This positive number signifies that recapture is unlikely to be triggered in any significant way.
3. Cost Segregation without using 179 bonus doesn’t trigger a recapture?
The simple answer is not likely. Most calculations that involve recapture start with the amount of money that is bonus depreciated. The main way to get the depreciation schedule significantly ahead of the resale value of property is to select 100% bonus. Without bonus, the depreciation schedule of 5-year property is designed to match as closely as possible to the actual value of 5-year property.
Changing a 1250 property that is depreciated over 39-years to 1245 property that is depreciated over 5-years is not a bonus. Obviously to the property owner this may feel like one, but according to the definition laid out by the IRS it is not a bonus. The IRS codes are full of provisions that add tax liability for one person and subtract it from another. In this case, changing from the composite form of depreciation to the component form gives the taxpayer a current benefit, but not necessarily a bonus.
4. Is a sale necessary to trigger recapture?
There are several reasons why an asset is no longer part of the balance sheet. Retirement, disposal, and a sale are options for business owners. Only a sale can trigger recapture and only a sale over the amount depreciated can trigger recapture. As discussed previously, retirement and disposal can affect recapture. However, a sale is the only item that can trigger the recapture, and more specifically, a sale within a short time frame. As noted earlier, the value of the assets that are deemed to be 1245 property are not assets that hold their value. Therefore, it makes sense to follow the government guidance and assign a value to the asset that aligns with the MACRS depreciation schedule.
Another strategy that has alluded us until now is the actual decision of whether to sell the property. Throughout this entire paper we have assumed that the property will be sold, without giving proper recognition that the concept to sell is not a given. Many times, after helping property owners see how a cost segregation can help them, they decide it is better to hold on to their property.
5. Can you do a 1031 exchange after a cost segregation?
The like-to-like transfer of property gets slightly more complicated when dealing with a cost segregated property, though the benefits may be worth the hassle. We always say, “accelerated depreciation is best when repeated.” A property owner could defer taxes for a long time by performing a cost segregation, exchanging to larger, more expensive property and then performing another cost segregation on the new property.
This is also the technique used when processing a 1031 exchange. The 1031 is a like-to-like transfer of assets. A cost segregation takes one kind of property, 39-year, and transforms it into four types of property. In order to transfer property that has been allocated to 5-year, 7-year, 15-year, & 39-year, the new property must also have a cost segregation with equal or greater allocations of each property. If the property has been held for a decade or more, it may be advantageous to allocate a large percentage of the sale to the 1250 property and only 1031 that amount.
Before the complexity convinces property owners not to go down this path, we are going to list the annual depreciation deductions of following this strategy while adding $1,000,000 every seven years. These are large numbers in relation to the amount of income a total of $4,000,000 of property could generate.
Obviously, we had to make some assumptions, simplify the transaction costs, and not account for all variables. But the goal is not to make an argument that asset recapture is a positive cash flow strategy. The goal of this paper is to show just how few cases would be subject to a significant recapture tax. Even when they are, cost segregation is still a valuable tool to make sure all of the allowed or allowable deductions were taken.
For more information on cost segregation and asset recapture contact RCG Valuation.
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