Cost Segregation and Benefits for Real Estate Investors
What We Learned: Operators owning property types which have a tax basis of at least $1 million, and that are subject to depreciation, can qualify for a cost segregation study (CSS).
By Derek Weaver, Senior ManagerAs discussed in December 2017, 280E continues to be a major problem for plant-touching businesses. However, there are several opportunities to minimize taxes and maximize cash flow for ancillary businesses that serve the cannabis industry. This week we will take a look at cost segregation and the benefits for real estate investors.
Cannabis businesses that own real estate of newly constructed or acquired buildings and improvements can substantially increase cash flow through the use of cost segregation.
Cost segregation studies (“CSS”) assign building costs to separate identifiable components with accelerated short-lived depreciable lives for tax purposes. The benefit comes from identifying/maximizing property costs that qualify for short tax lives (5, 7, and 15-years) versus longer-lived building property (39-years). This allows for larger depreciation deductions in years 1-5, resulting in deferment of taxes and freed up cash flow earlier in the life of the property.
Most property types with both a tax basis of at least $1 million and that are subject to depreciation can qualify for a CSS. It is also important to consider the hold period when determining if a CSS would be beneficial. In order to avoid potential depreciation recapture issues (where the tax payer essentially gives back the deductions at sale), the hold period for the property should be at least a couple years. Examples of components that might be considered 5-year personal property versus 39-year building property include task-specific lighting, dedicated electrical/mechanical/plumbing connections for manufacturing equipment, specialty mechanical systems used to climate-control grow facilities, removable floor covering, and low-voltage data wiring. Land improvements that are not considered buildings can be depreciated over 15 years versus 39 years. Cost segregation experts can identify and maximize eligible basis associated with non-building land improvements as part of the analysis (similar to identifying the 5-year personal property elements). Examples of 15-year land improvements include surface parking lots, certain landscaping, storm water management, sidewalks, and parking lot lighting.
Even if you failed to do a CSS at the time of acquisition, don’t worry- there’s still hope. A CSS can be performed on property placed into service in prior years. Meaning, if you acquired a grow facility or manufacturing facility two years ago and did not perform the analysis in the year of acquisition, current law allows us to retroactively perform the study and recognize in the current year the additional depreciation deductions that were missed because a study wasn’t performed initially. In addition to the one-time cumulative catch-up depreciation from prior years, the segregated components will then be depreciated over shorter lives going forward, or written off entirely in the year of the study.
The tax savings can be significant, typically ranging from 10 to 30 times the cost of a study. The internal revenue code, revenue procedures, case law, and the IRS cost segregation audit techniques dictate acceptable methodologies and techniques when performing these studies. Most tax preparers do not have the requisite engineering knowledge to allocate assets into appropriate tax lives. Therefore, it is imperative that tax-technical engineers perform properly documented analyzes to avoid issues with the IRS if the study is audited.
As tax reform looms it will be important to consider, among other things, how tax depreciation and cost segregation are impacted. The Senate’s version of the Tax Cuts and Jobs Act of 2017 allows for full deductions of new 5- and 15-year MACRS property. This means the entire basis of non-building related personal property and land improvements identified with a cost segregation study would be fully deductible in the year the assets were placed into service. This would almost double the immediate benefit of these studies. We will have more clarity around potential changes in tax depreciation rules resulting from tax reform once the House and Senate bills have been reconciled.
The IRS has challenged Section 179 and bonus depreciation deductions on 280E impacted tax returns. It is important that cannabis companies carefully consider 280E implications when analyzing the benefits of a cost segregation study and their organization structure. Given the multitude of challenges facing the industry it is imperative that business effectively manage their tax exposure and maximize investor value. CSS represent one potential strategy that should be considered. We will continue to explore other ideas in the weeks to come.