Cost Segregation and Bonus Depreciation Following the OBBB

Bonus depreciation began to phase out in 2023 under the 2017 Tax Cuts and Jobs Act. Going into 2025, the threshold was set at 40%. The OBBB reinstated bonus depreciation on eligible purchases starting after January 19, 2025. Bonus depreciation applies to assets with a useful life under 20 years, such as office furniture, computer supplies, machinery, equipment, and certain improvements. The OBBB made bonus depreciation a permanent provision of the tax code.  

Generally, nonresidential real property, like a commercial building, is depreciated over 39 years on a straight-line basis. This means that a $1,000,000 building would warrant an approximate deduction of $25,641 each year for the next 39 years. However, the OBBB created a new provision that allows for the 100% deduction of certain Qualified Production Property (QPP). Assuming the $1,000,000 building from our example is eligible, you would be able to immediately expense the entire amount, which can create huge tax savings on day one.  

Under the OBBB, eligible buildings must be for qualified production activities, such as manufacturing, refining, or chemical production. The deduction applies to newly constructed buildings and certain existing buildings. Eligible facilities must be placed in service before January 1, 2031, and construction must have begun after January 19, 2025, and before January 1, 2029. 

There are a few other key components of the QPP deduction to be aware of. Let's cover these items in more detail.  

Nonresidential Portions are Excluded  

One stipulation of this new provision is the exclusion of non-production components. Let's say that you construct a new building that is used 80% for manufacturing and 20% for office space. Only the 80% portion that is attributable to manufacturing is eligible for the deduction. The remaining 20% of office space will be depreciated over 39 years.   

The Food and Beverage Industry is Excluded 

Food and beverage commercial buildings are excluded from the QPP deduction. While restaurants technically transform ingredients into meals, food sold at the same facility does not qualify. However, if the building was constructed to manufacture food, that would be an eligible facility.  

Leases Disallow Deduction 

The QPP deduction is intended for taxpayers who create their own manufacturing facilities, not landlords. If you own a facility and lease it to a manufacturer, you will not be eligible for the upfront expensing. The original manufacturing use must be with the taxpayer constructing the building to qualify.  

Second-Use Limitations 

While the provisions of the QPP deduction generally apply to new construction, there are certain exceptions for existing properties. The existing property must not have been used for qualified production activities from January 1, 2021, to May 12, 2025. Similarly, the property must not have been used by the taxpayer before the acquisition, such as through a lease. Related-party transactions are also disallowed.   

Cost segregation studies are a crucial component of maximizing accelerated depreciation deductions. A cost segregation study identifies different components in the building that are eligible for an expedited deduction, like office furniture, qualified improvement property, and machinery. These studies are performed by tax and engineering professionals who perform an in-depth analysis and provide you with a report that can be used to support your tax deductions. Cost segregation studies generally include five main steps, including:  

1. Feasibility Analysis – A feasibility analysis involves determining if a full cost segregation study will be beneficial for the property owner by evaluating the trade-off between expected costs and tax savings.  

1. Information Gathering – If the property passes the feasibility analysis, a cost segregation company will evaluate documents, including invoices, blueprints, appraisals, and site surveys.  

1. Property Analysis – Next, an engineer will physically inspect the building to verify the individual components.  

1. Asset Reclassification – Assets eligible for a shorter useful life will be identified and listed by asset class, such as five years or seven years.  

1. Final Report – The cost segregation company will issue a final report that includes all relevant support to justify your tax position.  

Let's say that you place a commercial building in service that costs $2,000,000 to build. Without a cost segregation study, the building would be depreciated over 39 years. By investing in a cost segregation study, you might find that $50,000 went toward office furniture and $150,000 went to qualified improvement property. By picking out these expenses, you can use accelerated depreciation options, like bonus depreciation and Section 179, to expedite your depreciation expense in the year placed in service.  

Cost segregation studies are important when looking to maximize upfront depreciation deductions in any new purchase; however, they are particularly important when claiming the QPP deduction. For one, a cost segregation study will separate production and administrative assets. While you can't claim the QPP deduction on administrative components, they may be eligible for other forms of accelerated depreciation, like Section 179 or bonus depreciation.  

Moreover, the final report provided with a cost segregation study is essential to support your tax position, especially given the newness of this deduction. Your final report will include applicable in-service dates, the cost basis of different assets, and more important information that will be essential to support your tax position.  

While accelerated depreciation can be a great way to frontload depreciation, it does impact your basis. Let's say that you take $100,000 of accelerated depreciation on a $1,000,000 building. After the first year, your basis in the property is reduced to $900,000. If you were to sell the property, you might be subject to depreciation recapture. Depreciation recapture is taxed at ordinary income tax rates, which could reach 37%, depending on the other factors of your return.  

Depreciation recapture requires a complex calculation that should be completed by a tax professional. However, personal property recapture under Section 1245 applies to the entire amount of depreciation, up to the gain on sale. Let's say that your gain on sale is $150,000. You took $80,000 of accelerated depreciation. Your depreciation recapture would be $80,000, and the remaining gain on sale is generally taxed at more favorable capital gains rates.  

It is important to note that real property, like the building itself, is generally not eligible for accelerated depreciation. As a result, only excess depreciation is recaptured as ordinary income, which is the difference between the depreciation amount claimed and the amount under the straight-line basis of depreciation.  

However, the new QPP deduction can create depreciation recapture on real property, following similar rules to Section 1245 property. While the finite details of depreciation recapture related to the QPP deduction are still in the works, legislation does say that depreciation must be recaptured as ordinary income within 10 years if the facility stops being used for qualified production activities.  

When it comes to cost segregation studies and accelerated depreciation deductions, there are a few tax planning strategies to keep in mind. Let's explore these items in more detail.  

Consider Depreciation Recapture  

Depreciation recapture is an important consideration when timing real estate sales. While depreciation recapture is generally not applicable if you sell at a loss, most investors and business owners aim to sell at a gain. Before you elect accelerated depreciation, consider the impact on your basis and your timeframe for holding the investment.  

For example, if you plan on holding the building for 30 years and have excess taxable income now, it might make sense to complete a cost segregation study. However, if you plan on selling the building within a year or two, the fee for the cost segregation study and the unfavorable recapture rates might not be worth it.  

Invest in Cost Segregation Studies  

If you plan on claiming accelerated depreciation, a cost segregation study should be a priority. While you might be able to pick out certain invoices that clearly have a shorter useful life, the IRS will ask for extensive supporting documentation in the event of an inquiry or audit. A cost segregation study from a reliable company will be crucial to support your tax position and accelerated deductions.  

Leverage 1031 Exchanges  

1031 exchanges defer capital gains tax and depreciation recapture. In this tax planning strategy, the basis of the existing property is moved to the new property. Using a 1031 exchange can be a great way to defer high recapture taxes to future periods and still claim the upfront accelerated depreciation deduction. 1031 exchanges are subject to their own set of rules and regulations, making it important to consult with a tax expert if you are considering this method.  

Know Passive Activity Loss Limitations  

While you might be able to claim accelerated depreciation at the business level, you may face limitations at the individual level. The ultimate deductibility of pass-through business losses, which are commonly created using accelerated depreciation methods, relies on passive activity loss limitations.  

Let's say that you place a new rental property in service. You have a cost segregation study done and are able to take $100,000 of bonus depreciation. Now, let's say that you have no income for the year and incurred $50,000 of other operating expenses. In total, your rental property will show a $150,000 loss for the year. The deductibility of these losses depends on passive activity loss limitations.  

For example, if you put $150,000 into the property, you will be able to deduct the full amount since you have sufficient basis. However, if you only put $60,000 into the property, the remaining $90,000 loss might be disallowed and carried forward to future years. Considering passive activity loss limitations is important to determine if electing accelerated depreciation is worthwhile.  

Are you planning on purchasing, constructing, or investing in real estate over the next few years? If so, it's important to be aware of the implications of accelerated depreciation, like bonus depreciation and the new QPP deduction. Maximizing your tax savings in the real estate realm can take years of careful planning. For more information, contact one of our tax professionals.