Top 10 Things You Must Know Before Diving into TY 2023

November 17, 2023

Preparing for tax season is a tremendous endeavor. The tax code keeps evolving, and while diligent practitioners may want to review everything, time simply doesn’t permit.  

We therefore present The Top 10 Things You Must Know for TY 2023:  

10. 1031 Exchanges and 754 Step-Ups have Inherent Cost Segregation Potential 

The 754 step-up is notoriously complicated, and it’s easy to overlook the inherent cost seg potential while dealing with all the moving parts. It’s important to remember that the new basis and service date seen in a step-up may tee up an excellent cost seg opportunity.  

Similarly, changes in the TCJA have created a climate in which 1031 Exchanges and Cost Segregation are often employed simultaneously. The use of Cost Segregation may in fact offset the potential tax liability generated by the exclusion of personal property from a 1031 exchange. 

9. Section 179 Federal Expensing Limits Increase Again for TY 2023: 

  • Overall expensing limitation $1,160,000 (up $80K from $1,080,000 in TY 2022) 
  • Phase out threshold $2,890,000 (up from $2,700,000 in TY 2022)  

In contrast to bonus depreciation, Section 179 expensing continues to permit the immediate expense of 100% of an asset cost. Before bonus rates began to decline, both incentives were essentially equivalent. With bonus at 80% and dropping, Section 179 expensing may play a much larger role in tax planning moving forward 

Caveats: Section 179 expensing can only be taken on a trade or business, so it won’t apply to every real estate situation. Plus, the immediate benefit of Section 179 expensing is generally limited to profitable entities.  

8. Little Sandy Et. Al. Demonstrate the Significance of Adequate Documentation  

Taxpayers must provide “sufficient documentation” to support their R&D Tax Credit claims, and the IRS is scrutinizing returns closely. To qualify for the Credit, a research activity must pass all 4 parts of the Four-Part Test, and the burden of proof is on the taxpayer.   

The Little Sandy Coal Company, Inc., v. Commissioner of Internal Revenue case may serve as a cautionary tale. Little Sandy Coal (LSC) is the parent entity of a shipbuilding company that claimed the R&D Tax Credit in TY 2014. They had designed and constructed 11 first-in-class vessels, and claimed employee wages, third-party wages, and supply costs. The Credit was disallowed by the US Tax Court in 2021, and the subsequent appeal affirmed the Tax Court’s decision, largely due to a failure of proof that the research activity involved a Process of Experimentation.    

The author concluded with an explicit statement: “The lesson for taxpayers seeking to avail themselves of the research tax credit is to adequately document that substantially all of such activities were research activities that constitute elements of a process of experimentation. Generalized descriptions of uncertainty, assertions of novelty, and arbitrary estimates of time performing experimentation are not enough.”  

7. IRA – Impact of Prevailing Wage and Apprenticeship Requirements (PWA) 

This is the first of three IRA-related “must-knows” on this year’s list – testimony to the importance of this piece of legislation.   

Theoretically, the maximum benefit possible for both 179D Deductions and 45L Credits may increase tremendously under the IRA.   Taxpayers could pocket up to $5.00/SF of improved property when claiming a 179D Deduction, and up to $2,500-5,000/unit when claiming a 45L Credit (Energy Star/ZERH Standard).   

However, there is one major caveat – contractors must meet Prevailing Wage and Apprenticeship Requirements in order to be eligible for maximum benefit. (Note: To claim 45L, only Prevailing Wage Requirements must be met.) If requirements are not met, benefits for both incentives plummet. 179D hopefuls would receive only $1.00/SF — less than the $1.88/SF possible pre-IRA – and 45L applicants would pocket between $500-$1000/unit, again, far less than the $2,000/unit possible pre-IRA.   

Notice 2022-61 provided additional detail on PWA Requirements, and the IRS released proposed regulations on 8/29/2023, further expanding on required documentation.  

The big question is – will the potential benefit of these incentives be worth the financial investment and the time required to comply with the Requirements? That’s a question that each taxpayer must answer based on their personal facts and circumstances, but it’s safe to say that the impressive IRA benefits come with major strings attached.   

6. Bonus Depreciation Rates are at 80% and Falling  

Taxpayers have been fortunate enough to enjoy 100% bonus rates since the TCJA took effect in 2018. This incentive has been a tremendous source of benefit and boosted the utility of the cost segregation study. However, rates have dropped to 80% for TY 2023 and will drop 20% annually through 2026. It’s important to note that cost seg studies will continue to bring benefit at any bonus rate, but when possible, we encourage clients to place properties in service before end of year, to capture the higher rate of depreciation.  

5. IRA Benefits Extended to Designers of Non-Profits  

Government buildings have long been recognized as excellent candidates for 179D studies. The deduction is generally allocated to the property’s design professional – usually an architect and/or engineer. The benefit is quite significant in this scenario, whereas a property owner would have to reduce his property basis by the amount of the deduction, the designer does not.  

The IRA extended this benefit to designers of properties owned by tax-exempt entities as well. These entities include:  

  • Religious and charitable organizations 
  • Private schools 
  • Native American tribal governments 
  • Non-profit organizations 

4.  Cost Segregation Growing in Popularity on Affordable Housing Projects (LIHTC Credit Projects)  

Affordable housing, a critical concern amidst the U.S. housing crisis, ranks as a top issue in real estate, according to the Counselors of Real Estate’s 2024 Top Ten Issues. Large corporations and banks, acting as investors in this sector, contribute capital to affordable housing deals, utilizing credits and losses against their overall income. The Tax Cuts and Jobs Act (TCJA) established ten years of set bonus rates, providing predictability to depreciation expenses. This predictability has heightened interest in cost segregation studies within the affordable housing sector, as investors can confidently incorporate bonus depreciation rates into their projections and yield calculations. 

Cost segregation can be performed throughout the life cycle of an affordable housing project. Many investors are having studies done while the deal is being modeled, and including the results in their projections. A study can certainly be performed after acquisition or renovation as well.  Look-back studies are less common on affordable housing properties.  

Additionally, affordable housing projects are generally energy-efficient to contain utility costs for residents. The 45L Tax Credit may be applicable to these projects as well.  

3. TPRs and Bonus-Eligible QIP Remain Lucrative in Renovation Scenarios 

The Tangible Property Regulations (TPRs) have not gotten much ink lately, with attention focused on newer legislation. However, the TPRs are very much still in play, guiding taxpayers through expense vs. capitalization decisions.  They also work well in tandem with other tax strategies.  

The TPRs also permit the immediate write-off of the remaining depreciable basis of a retired asset. This Partial Disposition Election (PAD) can be quite powerful, but it can only be taken in the year in which the retired asset was taken out of service.   

Bonus-eligible QIP is an additional win that continues to pay off in renovation scenarios. The CARES Act, which retroactively assigned QIP a 15-year life – was signed 3/27/2020. Since then, Casptan clients have saved over $500M in deductions through bonus-eligible QIP alone.  

Notice 2023-63 Confirms Mandatory Amortization of Sec. 174 Expenses

Notice 2023-63, discusses the scope of Section 174 at length, clarifying the nature of qualifying expenditures and how they must be amortized. Yes, at least for now, expenses paid or incurred in taxable years beginning after 12/31/2021 cannot be immediately deducted. They must be amortized over 5 years, or 15 years in the case of foreign R&E. Taxpayers should consider available mitigation strategies and take advantage of Rev. Proc. 2023-11 to avoid filing a Change of Accounting Form 3115.  

The notice also includes proposed regs with promises of clarification to come on subjects including Sec. 460 long-term contracts, software development, and contract analysis.   

One final note regarding Sec. 174 amortization — the IRS will be scrutinizing reports looking for consistent treatment of costs. Carefully review expenses to determine the proper classification between Section 174 and Section 162. 

1. 45L Tax Credit: Transitioning to New Standards and Procedural Changes 

The 45L Tax Credit has undergone significant changes. It was extended for 10 years by the IRA, and Energy Star and Zero Energy Ready Home Standards (ZERH) are the new criteria. The height requirement has been eliminated, and the maximum credit per dwelling unit boosted to a potential $5000 (with prevailing wage requirements met, of course.)   

The table below breaks down the range of potential 45L benefit under the IRA:  

Note the difference in benefit conferred by ZERH Standards and Energy Star Standards.   

The procedure for claiming the Credit is significantly different, and requires an extensive team:  

An application made with Energy Star for the project up-front 

  • An Energy Star-Certified HERS Rater who will be inspecting and verifying the property  
  • An Energy Consultant who will ensure that the property specifications meet either the Energy Star or ZERH Specifications  
  • A builder who is an “Energy Star Partner” 

Crucially, the 45L process must be initiated well in advance of construction.    

We’ve just scratched the surface of the Top 10. If we can provide more information on any of these topics, please reach out. We’re here to help as we roll into Tax Season.   

Preparing for tax season is a tremendous endeavor. The tax code keeps evolving, and while diligent practitioners may want to review everything, time simply doesn’t permit.

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