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Opening a new restaurant? Consider a cost segregation study

New restaurant owners frequently ask “How can I find more tax deductions to offset my tax liability and increase cash flow?” Even the most astute taxpayers who implement effective tax planning measures still ask this common question. There is an unexpected option that may help — real estate! A restaurant owner’s new building can be a great way to accelerate tax deductions to offset taxable income and increase cash flow. The method used to determine the tax deductions from the real estate is called a cost segregation study.

A cost segregation study analyzes real estate (39-year assets) to identify the land improvements and personal property (15-, seven-, and five-year assets) to be reclassified to shorter tax lives. Shorter tax lives can accelerate tax depreciation expenses, reducing taxable income and the resulting tax liability, and improving cash flow. For the restaurant owner, real estate includes the construction of a new restaurant, the purchase of an existing restaurant, or a renovation of a restaurant. A cost segregation study applies to any taxpayer who owns real estate and expects to pay federal or state income taxes. However, if the taxpayer reports a loss, the results of the study would increase the net operating loss (NOL) which can be carried forward to offset future tax liabilities.

Fortunately, it is never too late to perform a study. If the construction, purchase or renovation of a restaurant occurred in a previous tax year, an analysis can be performed on the fixed assets that were already placed into service and recorded on the tax depreciable schedules. The analysis reclassifies land improvements and personal property in the current year but considers the accumulated depreciation that was reported in previous tax years and brings forward or “catches up” the deductions with a 481(a) deduction that is reported on a Form 3115. This is an automatic change in accounting method and does not require an amended tax return. Although assets may be examined dating back to 1987, a more practical approach would be to go back no more than 10-15 years.

There are many benefits that a restaurant owner can achieve by performing a cost segregation study. The acceleration of tax deductions in earlier years benefits taxpayers with the time of value of money. It also provides immediately improved cash flow by lowering taxable income resulting in less tax paid by taking advantage of the current tax rules regarding 80% bonus depreciation in 2023. Bonus depreciation allows taxpayers to initially deduct a large amount of the purchase price of an eligible asset and depreciate the remaining amount over the tax life of the asset. For example, if five-year bonus eligible restaurant equipment costs $2,000, then 80% of the basis ($1,600) can be deducted immediately and the remaining basis ($400) will be depreciated over five years. Bonus eligible items are new or used assets that are acquired that have a tax life of twenty years or less.

Performing a cost segregation study on the renovation of a restaurant can also provide substantial benefits by taking advantage of the Qualified Improvement Property (QIP) rules. QIP is a tax classification that includes internal, non-structural improvements to a commercial building that has previously been placed into service. QIP is classified as a bonus-eligible fifteen-year asset even if the item would normally be a thirty-nine-year asset if QIP did not apply. For example, if a new restaurant owner leases and renovates a building that was previously placed into service, many of the internal renovations that would have normally been assigned a thirty-nine-year life, such as ceramic tile, painting, drywall, electrical, plumbing, etc., would be classified as 15-year QIP and eligible for 80% bonus depreciation. Utilizing QIP and the related bonus deprecation rules will help the restaurant owner achieve a more rapid return on investment from the large initial capital investment for the renovation.

To better understand the value of performing a cost segregation study, the following client success story illustrates the benefits that can be achieved:

In 2023, a client opened a new restaurant in an existing building located in a downtown city center. Although the building was previously occupied by a retail clothing store tenant, the client renovated the interior of the building to turn it into a seafood restaurant. The client decided to perform a cost segregation study on the renovation cost, and because the property was previously placed into service, the Qualified Improvement Property classification applied. Of the $5 million renovation cost, the following asset classifications were determined as a result of the study:

39-year real property $600,000 12%
15-year qualified improvement property $1,900,000 38%
Seven- and five-year personal property $2,500,000 50%
Total renovation cost $5,000,000 100%

Of the $5 million total renovation cost, $4.4 million was classified into 15-, seven-, and five-year bonus eligible tax lives thereby providing an accelerated tax depreciation expense deduction of $3.52 million ($4.4 million x 80% = $3.52 million) in tax year 2023 as a result of applying the 80% bonus rules. This large additional tax deduction allowed the client to reduce taxable income and the resulting tax liability and improve cash flow. It was especially helpful in the initial year of opening the new restaurant when financial resources were limited.

Performing a cost segregation study on restaurant real estate is a very efficient and cost-effective way to obtain the additional tax deductions that are needed by restaurant owners to improve cash flow. after l the processes and procedures of analyzing the real state are complete, new restaurant owners may finally have the answer to their question of how to find more tax deductions to offset tax liability and increase cash flow — a cost segregation study.

For more information on this topic, or to learn how Baker Tilly tax specialists can help, contact our team.

The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.

Ty Riley
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