Opportunity Zones paired with Bonus Depreciation?

Question

Everyone has heard about the potential tax benefit of Opportunity Zones, but has anyone noticed the even greater potential when combined with bonus depreciation. Our tax counsel pointed this out to me, and I was wondering if some of the other active CPAs here on BP have any opinions (I take that back, what are your opinions):

According to the opportunity zone regulations (copied below in full), the "substantial improvements" required can be significantly lowered by reducing your depreciable basis through a Cost Segregation Study.

Since your properties are eligible for bonus depreciation, you would be able to write off a large amount of depreciation immediately, and thus the substantial improvement requirement could be calculated based on a much lower amount.

The Proposed Reg. reads as follows, take note of the text in bold:

(8) Substantial improvement of tangible property--(i) In general. Except as provided in paragraph (c)(8)(ii) of this section, for purposes of paragraph (c)(4)(ii) of this section, tangible property is treated as substantially improved by a QOF only if, during any 30-month period beginning after the date of acquisition of the property, additions to the basis of the property in the hands of the QOF exceed an amount equal to the adjusted basis of the property at the beginning of the 30-month period in the hands of the QOF.

With this new information, we regard Cost Segregation as a very exciting and highly beneficial tool for opportunity zone investors. While we are still waiting for final regulations on the opportunity zone laws, the IRS has stated we can currently rely on the proposed regulations.

Bonus depreciation when done with a proper cost segregation study can create first year depreciation of 20-40% reduction of the basis.

What do ya'll have to say? @Michael Plaks @Brandon Hall @Daniel Hyman @Eamonn McElroy @John Woodrich @Linda Weygant @Natalie Kolodij

Eamonn McElroy · Answer

@Yonah Weiss

My practice's reading is the same as yours Yonah.

Adjusted basis instead of original basis per the code and regs is very favorable, as is the updated May reg language and revenue ruling that land doesn't have to be substantially improved.

I agree with your theory that cost segs are even more compelling in opportunity zones and may even be a necessity with some opportunity zone investments based on what we are working with now per 1400Z-2 and the related regs.

Still a lot of unanswered questions with those proposed regs, time will iron everything out.

Yonah Weiss · Answer

@Michael Plaks I knew I could count on you to disagree on at least one point :), and I happen to like your unsure point, which I am also unsure about.

The point that you disagree with is exactly the point I was highlighting.

I will explain it a little more clearly this time for the sake of all that may read this:

It is clear in the regs above that "during any 30-month period" the 'substantial improvements' are made to "exceed an amount equal to the adjusted basis of the property at the beginning of the 30-month period in the hands of the QOF."

The “Substantial Improvement” Requirement:

-Applies to tangible property, other than land, that was used in a QOZ prior to its acquisition by the QOF (or the qualified opportunity business)

-“Substantial improvement” = the QOF (or the business) must invest more in the tangible property during "any 30-month period" than the adjusted basis in the property (excluding land) at the beginning of such period

So, how does this rule interact with the 100% bonus depreciation rule?

The bonus depreciation rules allow a taxpayer to fully expense certain assets (but not real estate) upon acquisition, resulting in a zero basis in those assets.

A literal application of the QOF rules in this context would mean that $0.01 of capital improvements could result in a substantial improvement to tangible property other than real property.

This is our understanding of the literal reading of the regs and have heard similar explanation from other CPAs and attorneys engrossed in the subject.

Taylor L. · Answer

There's been a lot of talk about Opportunity Zones not being taken advantage of by investors as much as the government had expected. Cost Seg and Bonus Depreciation could be the way that OZs start taking off. Thanks for sharing!

Jeff Greene · Answer

Are we still of the opinion that bonus depreciation reduces the basis in regards to the substantial improvement test?

Yonah Weiss · Answer

I appreciate your comment @Eamonn McElroy. Glad to know that you are reading it the same.

Michael Plaks · Answer

@Yonah Weiss

I agree with one part, unsure about another and disagree with yet another. :)

Agree:

Cost segregation will allow to increase deductible depreciation. With enhanced rules for Sec 179 and bonus depreciation, the traditional benefit of cost seg is amplified. This is not specific to OZ.

Unsure:

Since OZ rules allow basis step-up after 10 years, and at this point depreciation recapture has not been excluded from the basis step-up (as far as I know), it appears that depreciation taken by the OZ fund may become a freebie. If my understanding is correct, and it stays this way in the final regulations, then it's a tremendous incentive to take all depreciation you can squeeze out and essentially double-dip on it. I find it hard to believe that such huge double-dipping loophole is intentional and will remain open, but it's a possibility.

Disagree:

Accelerated depreciation does not affect the substantial improvement requirement. Your basis is fixed at the point of funding the OZ fund. If you cost seg it, you partition this basis into components, but the starting number for the substantial improvement remains as is and does not go down. Correct me if I'm wrong on this one.

Opportunity Zones paired with Bonus Depreciation?

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