May 2008 Technical Update

DEPRECIATION METHOD ELECTIONS
How to Decrease Your Taxes Through Elections

The current political environment with the impending presidential elections reminded us of the fact that elections can make an immediate impact on your profitability. We’re not talking about voting for our next commander-in-chief but rather some uncommon elections the IRS allows you to make to decrease your taxes.  

Our discussions with clients have addressed concerns over how to more effectively utilize their depreciation based on current and anticipated future cash flows. This is occasionally an issue with a retroactive cost segregation study because they typically provide a one-time depreciation adjustment which may be too large for the taxpayer to use in the current tax year. While the taxpayer can typically carry the loss forward for Federal purposes, they may not be able to for state purposes based on the laws of the specific states. This concern has also arisen with newly constructed properties (i.e. an office building not yet fully occupied) that may not have enough income to use the excess depreciation created by a cost segregation study.

In these situations proper planning and a review of the depreciation method options can optimize the impact of the additional depreciation. You may think that this is counterintuitive considering the objective of a cost segregation study is to create as much additional current depreciation as permissible. In actuality, the various elections allows the taxpayer to create significant additional depreciation over the first few years of ownership with the tax savings more evenly allocated over the first 5 or 7 years as shown in the following table.

Tangible depreciable property is generally recovered using 1) the applicable recovery period [5, 7, 15, 27.5, 39 years, etc.], 2) convention [half-year, mid-month, etc.], and 3) depreciation method. The most common depreciation methods consist of the 200-percent declining-balance method (“200% DB”), 150-percent declining-balance method (“150% DB”) and straight-line method. The depreciation method is typically determined by the recovery period and asset type.  For instance, 5 and 7 year property typically uses the 200% DB method. However there are other options available to the taxpayer that can help them optimize the timing of their depreciation deductions. The available options include:

150-Percent Declining Balance Method Election
A taxpayer may make an irrevocable election to use the 150% DB method to depreciate 5 and 7 year property.  In effect, this election allows the taxpayer to use the AMT depreciation calculation instead of the typical depreciation. The election applies to all assets within a property class for which an election is made and which are placed in service during the tax year of the election.

Straight-Line Election
A taxpayer may elect the straight-line method over the recovery periods. The election applies to all assets within a property class for which an election is made and which are placed in service during the tax year of the election.

Election out of Bonus Depreciation
In our March 2008 technical update, we covered the specifics of Bonus Depreciation which was recently brought back for 2008.  Bonus depreciation must be claimed unless a taxpayer makes an election out by the due date (including extensions) of the return for the tax year in which the bonus depreciation property is placed in service.

If a property is currently being depreciated over 27.5 or 39 years but actually includes personal property and land improvements, these elections have not come into play because the 5, 7 and 15 year property was not previously segregated.  A cost segregation study would be able to identify these shorter lived assets which would then create an opportunity to utilize the most effective depreciation option to match the taxpayer’s projected cash flow stream.  

In some instances a taxpayer may choose to take the full depreciation expense allowed under IRS regulations and carry forward the deductions not absorbed in the current year.

The combination of the cost segregation study and the depreciation options provide appropriate tax savings even though the taxpayers’ depreciation schedule may not be as aggressive as permitted under IRS regulations.  The end result is an optimized depreciation schedule based on the specifications of the taxpayer’s property and financial position.