In my 20 years as a cost segregation professional, I have seen how changes in Washington can impact our tax strategies.
Cost segregation is a planning tool that allows the acceleration of real estate deductions to reduce tax rates in the current year. A basic calculation involving the time value of money shows this is a good thing. Reducing tax rates early increases cash flow, which allows taxpayers to reinvest the funds or pay down debt. However, sometimes the calculation needs more thought.
The Tax Cuts and Jobs Act of 2017 reduced the top marginal tax rate from 39.6% to 37%. This is reduced even further for taxpayers with businesses eligible for qualified business income deductions, or 199A deductions. This deduction is equal to 20% of the business income. While not all businesses are eligible for this deduction, the ones that are have an even lower federal tax rate — approximately 29.6% (80% of the 37% rate). For those taxpayers, this is the lowest tax rate since 1990, when the tax rate was 28%.
So, how does this affect cost segregation calculations and similar tax strategies that involve a timing difference? Should taxpayers hold back on a timing difference until tax rates go up?
This is not an easy question to answer, as it often depends on the taxpayer. But for most taxpayers, the answer is to take your money now! While it may sound like a smart idea to delay deductions, this can be a dangerous move.
After Barack Obama was elected in 2008, we had clients look at delaying deductions. Their concern was that tax rates would increase under a Democratic president and Congress. However, that strategy didn’t work well for everyone. The top marginal tax rate did not increase until 2013 (from 35% to 39.6%). Take a business that could have taken a $100,000 deduction in 2009 but saved it until 2013 when tax rates went up. At a 35% rate in 2009, the taxpayer would have saved $35,000 compared to $39,600 in 2013. Over a four-year period, this equates to about a 3% rate of return. Nothing to brag about.
Moreover, businesses during this four-year period were dealing with the economic upheavals caused by the Great Recession. Many businesses saw their income drop, some precipitously. For these taxpayers, the deduction in 2013 was worth much less, as their taxable income was nonexistent. As cash flow grew tighter during the recession, some taxpayers wished they had taken the deduction earlier.
What would have happened if the taxpayer had taken the deduction in 2009? According to some calculators that determine the time value of money, the value of that $35,000 in 2009 would have been $36,400 to $40,700 in 2013, depending on the index you use. This makes the decision to delay the deduction look even less valuable. Between the risk of the business faltering and the limited return, a taxpayer would have been better off accelerating the deduction.
This is not always the case. Sometimes a business will want to hold off on deductions, such as during a year in which the taxpayer is not at a top marginal tax rate or has experienced a loss. When given an option, a business owner will choose to take as much of a deduction as possible against a top tax rate.
In 2018, the top marginal tax rate started at $500,000 for a single person or $600,000 for a married couple filing a joint return. If a single taxpayer with $550,000 in taxable income has the ability to accelerate $150,000 in deductions, they may choose to hold off on some of the deductions. For this taxpayer, the first $50,000 would go against their top tax rate of 37%, while the rest would go at the lower tax rate of 35%. In this case, the taxpayer may not desire to accelerate all of these deductions.
Sometimes it’s advantageous to use delays for tax planning. We recently talked to a taxpayer who had purchased a building in 2018. Using cost segregation, we determined the building had $1 million in potential accelerated deductions. The taxpayer wanted to see what would happen over the next couple of years.
By not filing the deductions on the 2018 return, the taxpayer is left with a few options. The first is the taxpayer can amend the 2018 return with this deduction, but it must be done before they file the 2019 return. This is because, according to the IRS, once the taxpayer has filed the 2019 return, they have established a method of accounting and would have to file a “change in accounting method” on the next return.
When filing a change in accounting method, the deduction is taken in the year of change, not the year of the original deduction. This means the taxpayer has the ability to look at a few years. In this taxpayer’s case, they filed their 2018 return on September 15, 2019. If they plan on filing the next return on September 15, 2020, they have a year to look at what happens to tax rates. In theory, they could amend the 2018 return and file a change in accounting method in 2019 or even in 2020. However, they have until September 15, 2020 to make this decision. This allows them to look at multiple years of information before deciding what is best for them.
Why is this coming up now? We are looking at a potential change in the federal government in 2020. In addition, there are concerns the United States is looking at the end of a long period of economic expansion and a potential recession. This makes tax planning and discussions like this more critical than ever. Taxpayers who understand how tax rates and deductions work can potentially maximize their benefits through careful tax planning.
The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.