Like so many aspects of 2020, year-end tax planning will likely be different this year. Construction company owners should, first and foremost, review the provisions of tax-related legislation such as the Coronavirus Aid, Relief, and Economic Security (CARES) Act and determine how it affects their tax liability.
But some tried-and-true strategies remain viable, including Section 179 expensing and “bonus” depreciation. Both tax breaks are tied to the purchase of fixed assets such as equipment, vehicles and certain building components and improvements.
Under Sec. 179 of the Internal Revenue Code, you can “expense” the full cost of a qualifying fixed asset to reduce your taxable income. This means you can deduct the purchase amount immediately rather than having to depreciate the asset over many years.
Both new and used fixed assets can qualify — though vehicles have complex limits based on their size, weight, capacity, style and use. The maximum overall deduction allowed in 2020 is $1.04 million, with a total equipment purchase limit of $2.59 million.
The good news is that you can carry forward unused deductions to future tax years. However, if you sell the property before you use up all the carryforward deductions, you must add them back to the asset’s basis. This can create adverse tax consequences if not thought out carefully.
Assets that are built-in equipment in buildings can also be expensed under Sec. 179; this is called tangible personal property. Qualified improvement property (QIP) can be expensed this way, too. These are improvements to a commercial space that aren’t related to a building’s enlargement, an elevator or escalator, or internal structural framework. Roofs, HVAC equipment, fire protection systems and security installations can all be Sec. 179 expensed.
Purchased assets with a depreciable life of 20 years or less can be 100% expensed using bonus depreciation as long as you don’t expense them under Sec. 179. Before the Tax Cuts and Jobs Act (TCJA), bonus depreciation could be applied only to new assets, but most used property now qualifies as well.
If you’d prefer to keep an asset’s basis on your balance sheet, you must opt out of bonus depreciation. This election cannot be revoked without IRS permission.
As you may have read earlier in the year, the CARES Act eliminated the “retail glitch” in the tax law that previously excluded QIP from bonus depreciation. Most businesses can now claim 100% bonus depreciation for QIP, assuming all applicable rules are followed. What’s more, the correction is retroactive to any QIP placed in service after December 31, 2017.
If a major asset purchase isn’t in the cards for your construction company, and your business owns a building, you might want to instead consider a cost segregation study.
Under this process, accounting and engineering techniques are used to identify building costs that are allocable to tangible personal property rather than real property. As mentioned, tangible personal property can be expensed under Sec. 179, and you can claim these deductions over much quicker time frames than real property, which is typically depreciated over 39 years.
In addition, the TCJA’s significant improvements to the depreciation rules have made cost segregation studies even more attractive to building owners. (Note: If your company doesn’t own real property, you may want to suggest a cost segregation study to certain clients. Contractors often serve as consultants on these projects, which could mean additional revenue for you.)
Engaging an engineer and CPA for the purpose of cost segregation will entail some costs, but they’ll be tax-deductible. In your cost-benefit analysis, decide whether such an outlay this year would produce enough of a reduction in your construction company’s taxable income for the next several years to be worthwhile.
Take a building that you bought recently. You’ve likely been looking at depreciating 100% of its total cost over 39 years. But following a cost segregation study, you might be able to lower that percentage to 70%, while expensing the other 30% over shorter depreciation periods. Some building components may be 100% expensed immediately if they’re eligible for bonus depreciation. This could mean thousands of dollars more in tax deductions this year and over the next several years.
Discuss a cost segregation study with your business partners (if any), top managers and advisors. Some pertinent factors to consider:
- When (or if) you plan to sell the building,
- Whether you intend to renovate it,
- If it will be owner-occupied or leased, and
- Whether you might want to someday let go of it in a like-kind exchange.
If you didn’t acquire your building recently, a cost segregation study’s benefits will be less significant because most of the structure’s depreciable components will have already been expensed and its basis adjusted downward.
Depreciation tax breaks remain valuable avenues to tax savings, assuming you qualify and properly follow the required steps to claiming them. As always, turn to your CPA for guidance and expertise.
Separate cash management from tax planning
It may seem obvious that more tax deductions lead to lower taxable income, so you pay less in taxes. That’s why Section 179 expensing and bonus depreciation have long been useful to construction companies, which tend to regularly need to buy new equipment and vehicles.
A forward-looking contractor will spend money on deductible expenses that improve business capacity or effectiveness while reducing taxable income in the current period so future revenues will be higher.
A word of caution, however: Be sure to manage cash flow independently of tax deductions. There will always be a time lag between cash spending and tax benefits. Don’t neglect receivables and backlog, which can lead to cash shortages very quickly if these aspects of your business falter.
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