FAQs on Cost Segregation, Section 179D and Section 45L
Windham Brannon’s Micah Greenberger, Tax Principal, recently sat down to chat with Chad Niehaus, Director of Business Development at KBKG, to discuss some frequently asked questions regarding cost segregation and tax incentives with Section 179D and Section 45L. Chad works with companies in various industries, including manufacturing, transportation, technology/software and real estate, helping them find tax-saving opportunities that help lower their tax burden.
What is a cost segregation study, and what are its key benefits?
Cost segregation is a commonly used strategic tax planning tool that allows companies and individuals who have constructed, purchased, expanded or remodeled any kind of business real estate (both owned or leased) to increase cash flow by accelerating depreciation deductions and deferring federal and state income taxes. Such a study can provide crucial information regarding real estate property, as these studies are designed to dissect the construction cost or purchase price of the property that would otherwise be depreciated over 27.5 or 39 years. The primary goal of a cost segregation study is to identify those building components that are eligible to be depreciated over a shorter tax life (5, 7, 10 or 15 years); however, a cost segregation study will also establish tax basis for all the different building structural components that remain in 27.5 or 39 years (such as the roof, windows or HVAC units). Therefore, when these components are replaced, a loss deduction can be claimed by leveraging the original cost segregation analysis. For leased property, tenant leasehold improvements would also be separated.
A cost segregation study can be used to identify related energy-efficiency building components that are considered part of 39-year property and are eligible for other energy tax incentives such as Section 179D or 45L.
What are the potential risks or challenges associated with cost segregation?
There are generally three main risks/challenges when engaging in a cost segregation study:
IRS Scrutiny – Any CPA firm can produce a cost segregation report with results that save you a lot of money; but the real question is whether it will stand up to scrutiny from the Internal Revenue Service (IRS). The true value of the fee you pay is how easy (or painful) the audit process will be. Every cost segregation company will say they stand behind their work, but how can you really know what will happen when the IRS audits the report? Engaging a firm with a proven and long-standing reputation for providing cost segregation services should give you confidence to successfully defend your study against a potential IRS audit.
Additionally, utilizing a cost segregation provider that has been reviewed by certified members of the American Society of Cost Segregation Professionals (ASCSP) will ensure the cost segregation analysis has been performed utilizing the utmost in quality standards, documentation, references and legal basis that mirror the IRS’ own Audit Techniques Guide, which the IRS provides to their examining agents.
Depreciation Recapture – If a taxpayer sells real estate property for a gain in which accelerated depreciation deductions were generated through a cost segregation study, the property may be subject to depreciation recapture at higher ordinary income tax rates as opposed to lower capital gains tax rates.
The longer the property is held, the less of a concern depreciation recapture is. Typically, when the taxpayer owns real estate property for longer than three or more years, the cash tax savings generated through a cost segregation study tend to outweigh the extra taxes due from depreciation recapture.
Passive Activity Loss Limitations – When taxpayers invest in real estate that is considered a passive activity, challenges arise when a taxpayer creates additional depreciation deductions through a cost segregation analysis resulting in passive activity losses.
Depreciation deductions are limited to the amount of rental (passive) income and cannot be used to offset ordinary income. If passive income is not available, the passive losses are carried forward to the following tax year.
For real estate investors with passive investments, tax planning is crucial in evaluating the potential benefits derived from a cost segregation study
What are the eligibility requirements for claiming the Section 179D deduction?
To claim this deduction, you generally must be either the building owner or the designer of buildings owned by a government or not-for-profit organization. This ensures the people who put the most effort into making the building more efficient receive the benefits.
Building Owners – Entities that invest in constructing or renovating a commercial building that meets the appropriate energy requirements can claim the Section 179D tax deduction. Ideally, the building would be a large commercial property with high square footage in order to get the most tax benefit from the deduction. It’s important to note that an owner who wishes to take advantage of this deduction cannot be in a tax-exempt situation – if they are, they no longer qualify.
Building Designers – Since many of the largest commercial spaces are run by tax-exempt groups such as not-for-profits, hospitals, educational groups and government agencies, there are many cases in which a commercial building owner cannot claim the Section 179D deduction. In these situations, it may be possible for the designer to claim the deduction instead.
To do so, there are a few criteria to keep in mind. For starters, the designer must demonstrate that they are an architect, engineer or other party responsible for designing enhancements for the building that make the building envelope, lighting or HVAC more energy-efficient. There is also an extra step for designers: they need an allocation letter. This document makes it clear that the tax-exempt owner is allowing the Section 179D deduction to be passed on to the designer of their building. The designer will also need all relevant documentation regarding the improvements that were made and their associated costs.
Because of the complex nature of the Section 179D calculations to determine compliance, a licensed professional third party is required to complete and certify the Section 179D study. This means designers or building owners are not able to complete their analysis without the help of a Section 179D licensed expert.
How are the Section 179D deduction amounts calculated?
Section 179D offers a deduction of up to $5.36 per square foot of a qualifying building. For a 100,000-square-foot building, the deduction could be as much as $536,000.
How has Section 179D been impacted by recent changes in tax legislation?
The roots of government-driven green building tax programs trace back to the early 2000s, when the Energy Policy Act was launched in 2005, resulting from policymakers recognizing the urgent need to incentivize sustainable construction practices. While tax policies to drive more green energy were already in place, it was the signing of the Inflation Reduction Act (IRA) in 2022 that cemented the government’s commitment to further make sustainable buildings economically attractive for building owners and designers.
With the IRA taking effect on Jan. 1, 2023, the benefits of flagship programs, such as the Section 179D tax deduction, underwent a significant expansion that made these incentives more attainable. These programs, which had already been instrumental in encouraging the adaptation of energy-efficient building practices, now offered an even more compelling proposition. Eligible projects stood to gain more participants, as the IRA allowed for higher monetary claims, making sustainability a financially rewarding choice for potential candidates.
Now a staple behind tax incentives for commercial buildings, Section 179D now allows eligible parties to claim enhanced deductions for implementing energy-saving technologies and designs in commercial and tax-exempt buildings. This not only translates into immediate cost savings but also promises long-term operational efficiency and reduced expenses on energy consumption.
What are some practical tips for maximizing the benefits of Section 179D?
As with many deductions, Section 179D comes with many nuances that can make filing tricky. From knowing if your building qualifies to deciding if the deduction should be passed on to a designer and how to do so, there are many details to navigate. Ask your CPA or tax advisor if you may be eligible and determine if there are tax savings worth pursuing.
What are the eligibility requirements for claiming the Section 45L tax credit?
The Section 45L tax credit federal tax credit that rewards multifamily developers, investors and homebuilders that develop energy efficient homes and units that are sold or leased after Dec. 31, 2005. Eligible properties include apartment buildings, condominiums and single-family home developments. Eligible construction also includes substantial reconstruction and rehabilitation.
To qualify, a dwelling unit needs to meet certain energy efficiency criteria. Based on current construction trends and local building codes, many developments are adopting energy efficient measures that help towards qualification of the Section 45L tax credit.
It should also be noted that homeowners are generally not a good candidate for Section 45L.
How are the credit amounts calculated for Section 45L?
For properties leased by the end of 2022, the credit is worth $2,000 per dwelling unit. Starting in 2023, the IRA increases the tax credit amount to as much as $5,000 per dwelling unit for both single-family and multifamily developments. Additionally, all residential developments become eligible, whereas prior, only low-rise residential developments were eligible.
What are some practical tips for maximizing the benefits of Section 45L?
Every residential developer should consider Section 45L as part of their tax reduction strategy, especially affordable housing developers. Due to the new eligibility requirements beginning in 2023, is it important to engage your advisor and begin the Section 45L certification process before breaking ground on new residential properties.
About Windham Brannon
At Windham Brannon, we’re passionate about helping our clients plan for the future and meet their strategic goals. As a recognized leader in providing advisory, assurance and tax services to clients both nationally and globally, we’re in the business of offering more proactivity, more attention and more investment into your goals, ambitions and priorities. We act as trusted advisors to our clients, who receive top-notch service tailored to their goals and priorities with access to national and global resources.
About KBKG
Established in 1999 with offices across the United States, KBKG provides turn-key tax solutions to CPAs and businesses. By focusing exclusively on value-added tax services that complement your traditional tax and accounting team, we always deliver quantifiable benefits to clients. Our firm provides access to our knowledge base and experienced industry leaders. We help determine which tax programs benefit clients and stay committed to handling each relationship with care and diligence. Our ability to work seamlessly with your team is the reason so many tax professionals and businesses across the nation trust KBKG.
