After the tax law change in 2017, you will be penalized if your tax losses are too large. Cost segregation studies can play an important part of managing this issue.
The new tax law allows you to immediately write off the 5 year property. For example, if you buy a group of buildings and allocate $50 million to the buildings, a cost segregation study would be expected to produce a tax write off of $7.5 to $10 million dollars.
Right now you are thinking, “Great, huge tax loss.” The problem is that the 2017 tax law made another change. Starting in 2018, on your personal return you can only deduct partnership, s-corporation, and rental losses up to $500,000. If you are reporting net losses greater than that, the loss is limited and carried over to the next year. The loss carried over to next year can offset any type of income on the tax return. However, you can only deduct the carryover loss up to 80% of that next year’s income.
The new loss limitation rule works this way. You have wages, interest, capital gains, and pension income of $1.7 million and you have nursing home operator and property losses of $5 million. The new rule says that you can only deduct $500,000 of the nursing home losses. As a result you have to pay tax on $1.2 million of income. The loss in excess of $500,000 carries over to the next year.
To illustrate, assume as a nursing home operator you have a $10 million loss in the first year. In year 2, you have $10 million of income from the nursing home activity. Before the law change, the $10 million net loss from year 1 carries over to year 2 and offsets $10 million of the year 2 income. That leaves you with no taxable income in year 2. In two years you paid no tax.
After the law change, in year 2 you can only use carryover losses to offset 80% of the year 2 income. Therefore, to continue the example, in year 2 you can only use carryover loss to offset $8 million of the $10 million income. While you had zero income in the two years combined, you have a tax bill on $2 million of income. The unusable loss in year 2 carries to year 3.
The solution to this is to wait to implement a cost segregation study.
If you do not depreciate your property to the fullest, fastest extent permitted by the rules, you are allowed to change that deprecation to catch up for the lost depreciation. You do this by simply attaching a form to your tax return for the year you want to take the catch up amount. This form must be filed by the date you file your company tax return. Therefore, you have until September 15 of the following year to decide to take catch up depreciation.
So let’s say you have a $50 million building and depreciated all of it over 27.5 years instead of classifying part of it as 5 years. Your depreciation would be $1,818,000 per year. When you are doing the tax returns for year 3, you see that you will have significant income in that year. You now have a cost segregation study prepared and file to take the catch up depreciation. The catch up depreciation tax deduction would be $6,029,200 assuming a 20% cost segregation report. You do this by attaching a form to the business tax return as it is being filed by September 15.
If you would have taken all the depreciation the year you bought the property, your loss carryover to the later year would only have been usable up to 80% of the that year’s income. By taking the catch-up depreciation, you are decreasing the income that year and not using a loss carryover subject to limits.
The loss limitation rule and being limited to 80% on a carryover applies to all business losses and is not just an issue for depreciation. It just happens that depreciation is the easiest tax item to control and change.
Kuno S. Bell, CPA, J.D., is the Director of Tax at Pease & Associates LLC in Ohio.