Tax optimization strategies are a great way for Commercial Real Estate (CRE) owners and developers to maintain cashflow during periods where access to capital is of great significance.
Most of these strategies possess a common thread: the use of “accelerated depreciation”, an accounting method that businesses can use to deduct a large portion of an asset’s cost in the early years of its useful life.
Check out this article to learn more about Accelerated Depreciation: What is Accelerated Depreciation and why is it a Tax Advantage?
In this article, we will cover four popular tax optimization strategies that many CRE owners and developers are able to deploy. These strategies can help them unlock access to cashflow, which can subsequently be reinvested into their businesses.
Strategy 1: Cost Segregation
This strategy is available to commercial building owners who have either purchased or made significant capital improvements to buildings. It allows these owners to accelerate the depreciation deductions for certain assets within those buildings.
Instead of using the straight-line depreciation method for a building (39 years for commercial and 27.5 years for residential), Cost Segregation allows the owner to reclassify non-structural components of the building into different asset pools. This accelerates the depreciation of each according to their asset class.
What is a Cost Segregation Study?
A cost segregation study is conducted by specialized professionals, such as engineers and tax experts. We first analyze the architectural/engineering drawings and specifications. Next, we define components for creating cost estimates based on consideration of types of materials, asset class, and construction methods. We then reconcile cost components and segregate those reconciled asset components costs into appropriate recovery periods for federal tax purposes. Lastly, we perform an on-site property visit to verify the identification and implementation of all necessary components.
Strategy 2: §179D Energy Efficient Commercial Building Tax Deduction (§179D)
§179D is a federal tax incentive that is available to commercial building (e.g., warehouses, office buildings, etc.) owners and designers of nontaxable properties (e.g., Churches, Schools, etc.). It is available to new construction or renovations/retrofits, as long as the building meets certain energy efficiency benchmarks.
Check out this article to learn more about §179D: What is §179D?
While this incentive takes the form of a tax deduction of up to $5.00 per square foot of the eligible building, it effectively represents a form of accelerated depreciation. This is because the building basis (i.e., the total value of the building as an asset) is reduced by the amount of the deduction.
Strategy 3: §45L Energy Efficient Home Tax Credit (§45L)
§45L is a federal tax credit that is available to builders and developers of residential properties, such as apartments and condominiums that meet certain energy efficiency standards. Much like §179D, §45L acts as a form of accelerated depreciation by reducing the basis in the building. However, this incentive takes the form of a dollar-for-dollar credit as opposed to a deduction. This makes it an extremely valuable financial tool for builders and developers to utilize.
The §45L tax credit is worth up to $5,000 per eligible dwelling.
Strategy 4: Bonus Depreciation
Under certain circumstances, commercial building owners may be eligible for bonus depreciation under Section 168(K) of the Tax Code. This provision allows them to deduct a percentage of an asset’s cost in its first year of use. This is another form of accelerated depreciation, as it provides an immediate deduction that can significantly reduce taxable income.
What is an example of Bonus Depreciation?
Suppose a company purchases a piece of manufacturing equipment for $100,000 in 2023. Without bonus depreciation, the company would typically have to depreciate the equipment over several years, deducting a portion of its cost each year as an expense.
However, with bonus depreciation in effect, the company can deduct a significant portion of the equipment’s cost in the first year.
Let’s say the bonus depreciation rate is 80% for this type of asset (which has been common in recent years due to tax law changes). In this case, the company can deduct $80,000 (80% of $100,000) as a bonus depreciation expense in its first year of use. This reduces the company’s taxable income for the year by that amount.
If the company had a taxable income of $300,000 before considering the equipment purchase, it would now be reduced to $220,000 ($300,000 – $80,000) for tax purposes.
Why is engaging tax consultants a valuable investment?
Irrespective of the accelerated depreciation strategy a commercial building owner may choose, the laws associated with deploying these strategies can be complex and variable. This complexity depends on the specifics of a particular project. As such, seeking guidance from tax professionals with a deep understanding of depreciation laws and strategies is crucial to utilizing these strategies and incentives correctly.
At Leyton, our team of experts can guide building owners and designers through these processes. We ensure that they access the maximum tax advantage while minimizing their direct involvement. This will liberate cash flow, placing them in a position to focus on growing their businesses.
