So you are excited to take advantage of bonus depreciation, but did you know that most states don’t fully conform with the federal bonus depreciation rules? Many states don’t allow any bonus depreciation to be able to be taken. Some states allow partial bonus depreciation to be taken.
Bloomberg has a comprehensive list of which states allow for bonus depreciation and which ones don’t. As always with anything with tax, please consult your own tax advisor to understand how bonus depreciation can benefit you on both a Federal and possibly state level when it comes to reducing income tax liability.
Car washes and specifically, tunnel car washes, have a favorable status in the tax code. Many who buy these know this already, but if the building truly is a tunnel car wash everything there can be identified as 15 year class life. But even tunnel car wash owners can benefit significantly by doing a cost segregation study. Let’s get into it.
For simple math purposes, let’s use some round numbers. We also are assuming that this was not purchased as part of a 1031 exchange. If that was the case, the basis would be lowered or possibly eliminated. One’s CPA would need to tell us what the remaining basis is in the new building. But let’s move on…
In this example, a tunnel car wash sells for $3,500,000. The land value is estimated at $500,000 for this example. So we are left with a cost basis of $3,000,000. If the property was purchased and placed into service between Sept. 28, 2017 and Dec. 31, 2022, then the full $3,000,000 can be depreciated as 15 year class life property in year one. If you have not done this yet and would like to do it, your tax advisor would need to file an IRS Change of Accounting Form 3115. (We draft these for $750 with cost seg studies). If your car wash went into service in 2023, you could take 80% of the $3,000,000 right away in a depreciation expense – i.e. tax deduction / write off. If it’s in 2024, then bonus depreciation goes to 60% – so 60% of the $3,000,000. You can do this without hiring a firm like ours. Just make sure you truly do have a tunnel car wash and always get the advice of your own CPAs.
Why should owners of tunnel car washes consider paying for a cost segregation study when all the property is already able to be classified on a shorter class life schedule at 15 years? Because, it’s likely that 40-60% of that $3,000,000 could be classified as 5 year property. Why would you leave something as 15 year property when for a cost between $7-8k you can have an engineering-based cost segregation study clearly reclassify all your building components into their proper class lives. When bonus depreciation was 100%, this would not benefit you from an upfront depreciation tax deduction benefit, but it would help you when you go to sell. If bonus depreciation is anything less than 100% as it has been in 2023 and 2024, then you can benefit from doing a study both on the front end with more depreciation in the early years of ownership plus you can benefit when you go to sell.
Depreciation: in 2024, you can take 60% of property with a class life of 20 years or less. So using our example above, you have $3,000,000 and can take 60% or $1,800,000 in year one. The remaining 40% will be taken over the next 15 years as it’s 15 year class life.
But let’s say you study the property and it turns out 50% is 5 year and 50% is 15 year. That’s $1,500,000 for 5 year and $1,500,000 for 15 year. You use the 60% bonus depreciation and take $1,800,000 in depreciation expense. That leaves a total of $1.2MM but it’s actually $600,000 that is 5 year property and $600,000 that is 15 year property. That 5 year property gets depreciated over the next 5 years and then is fully depreciated given you a bigger tax deduction in the early years of ownership. The $600,000 of 15 year gets deducted over the next 15 years. So this is definitely a win. $600,000 depreciation deduction over 5 years at a 35% tax rate is a tax savings of $210,000. Now do you think it was worth spending $7-8k on a cost segregation study?
Now what happens when you go to sell the property years down the road. Let’s say it’s 6 years later. Well, you have fully depreciated your 5 year property. Some of it maybe has even been replaced already which is also nice to have a cost segreagtion study which makes dispositions of property a lot easier for your CPA. It saves him time and you can come up with accurate information. That’s a win for you as the owner as it saves you money from an accounting standpoint and you get another write off. But now you go to sell and it will be between you and your CPA what kind of recapture tax you end up paying. Clearly on the depreciation of the 15 year assets, there is still life on those so you’ll have some recapture. But with the 5 year property, you might be able to pay little to no recapture tax on that $1.5MM in depreciation you’ve taken because those components may not have much value any longer. But let’s say your CPA wants to be more conservative and say that he puts a value of $500,000 on that $1,500,000 you’ve taken in depreciation. You pay recapture tax on the $500,000 and NOT the $1,500,000. Recapture tax is paid at your earned income tax rate. So if it’s 35%, this strategy may have just saved you $350,000 in recapture tax when you go to exit. You’ll still have capital gains tax to pay of course and as with all things dealing with tax, please consult your own tax advisor before proceeding.
To sum it up…it we are able to use 100% bonus depreciation, cost segregation doesn’t help very much on the front end of your ownership but it can save you potentially a small fortune on the back end. If we are running at less than 100% bonus depreciation, then cost segregation can help both on the front end with greater depreciation deductions earlier in the ownership life of the building and help with saving on recapture tax on the exit. If you hold long term, having done a cost seg will help when you go to replace parts of the car wash that are no longer working. You’ll be able to take dispositions a lot easier. Those are good and important tax deductions.
I work all over the U.S. If you’d like to discuss or get a quote, please let me know. There is no cost and no obligation.
Tenant Improvements, or TI’s as they are known typically are not studied. If it’s an interior improvement to a building most CPAs will just mark this cost as QIP or Qualified Improvement Property. It has a 15 year class life just like land improvements do. In the world where bonus depreciation was 100%, I could see why they would do this and not study the improvements. I still think there are benefits to studying the improvements even at 100% bonus but I’ll make mention of that in a minute.
But here we are today at 60% bonus depreciation. In 2023, bonus depreciation was 80%. Pretty much all hope has faded at this point that 100% bonus depreciation is coming back in 2024. Speculation is that the new government in 2025 will renew 100% bonus depreciation for 2025 and beyond but no one knows for sure at this point. All we have is 2024 and we sit at 60% bonus depreciation.
When I talk with CRE brokers about TI’s they will often tell me it absolutely makes sense that TI’s have a shorter class life at 15 years because pretty much once those improvements are made for a particular tenant, they are often worthless to the building owner when and if he has to place a new tenant in the space. Usually they have to tear it out or significantly modify the space for the new tenant. So the improvements have zero value essentially. When I talk with GCs who actually build out these TI’s they often say the 5 year class life property often has to be updated anyway in 5 years. It’s often worn out or maybe outdated. If that’s the case, why not identify and reclassify your TI’s so that you can clearly see what is 5 year property?
What is interesting is that if you actually study tenant improvements, the results will often come back with 30, 40, 50, 60% of the work effort being identified as 5 year property. The result usually is QIP…sometimes there ends up being some structural at 39 years. But lets say the 5 year is 50% of the overall improvement? That is significant in terms of depreciation, tax savings, diminished value and recapture tax. After seeing what I’m seeing on many TI projects, I’m really surprised owners don’t have these efforts cost segregated. The reason they don’t have them studied is their CPAs tell them they will just take 60% bonus and identify it all as 15 year. While that is an accepted practice, the owner is leaving depreciation on the table by not breaking out the 5 year. Some will say it’s not worth the cost of the study. To study most Tis is only a few thousand dollars. It absolutely is worth it for the owner to study it.
Given the space limitations here, I’ll do a follow up post at some point with some further details. But TI’s are not unlike the broader issue with commercial property…why would you buy a commercial property which is made up of 5, 15, and 39 year property but leave it all as 39 year property and depreciate it as such? There are on a few circumstance where that makes sense to do so.
Commercial real estate brokers and General Contractors have a real opportunity here to help their clients maximize their tenant improvements and get all the tax benefits they can out of improving their buildings.
I work all over the U.S. If you’d like to have a conversation, please don’t hesitate to reach out to me. You can also follow me on Twitter @costsegbuilding or visit my blog for more detailed information about cost segregation at www.costsegbuilding.com.
