Beyond 280E: Save More on Your Cannabis Business Tax Filings

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Real estate and utility tax tips to help you minimize your tax load.

January 18, 2019

Mehmet Hilmi Barcin | iStockPhoto

IRS Code section 280E restricts cannabis-related businesses from using many legitimate deductions and credits that non-cannabis businesses commonly utilize to reduce tax liability. However, there are situations where 280E does not apply if you structure your assets properly. In this article, we’ll detail two of them: real estate depreciation and the reduction of utility costs.

When the commercial real estate used by a cannabis business is owned separately and receives rent from the cannabis operation, common tax deductions become available to that separate entity. That’s because the commercial real estate company functions solely as the landlord and does not engage in cannabis trafficking, as federally defined. In such cases, the property is often owned in an LLC or different pass-through entity, either by the same owner(s) of the cannabis company or someone else. To receive accelerated depreciation and other common deductions, the real estate simply needs to be owned by an entity not subject to federal trafficking rules. It is irrelevant whether that beneficial property owner (taxpayer) also owns the cannabis (federal trafficking)-related business.

Once the cannabis business and the property-owning company are disentangled, commercial real estate owners have several tools at their disposal that allow them to reduce ownership costs. One is an engineering-based cost segregation study that enables the business to calculate depreciation on specific parts of the building (including walls, flooring, ceilings, lighting, wiring, cabinetry, shelving and more). The result can be significant tax savings, often in six or seven figures, passed through to the beneficial owner of the commercial real estate who, again, can also separately own the cannabis-related business.

Understanding Depreciation

Most businesses understand depreciation to be a tax deduction that allows a taxpayer to recover the cost of certain property. Essentially, it is an annual allowance for the property’s reduced value (future upkeep costs) due to anticipated wear and tear, deterioration or obsolescence. For businesses not affected by code section 280E, most tangible property such as buildings, machinery, vehicles, furniture and equipment (but not land), are depreciable. For the taxpayer to be allowed a depreciation deduction for a property, the property must meet all the following requirements:

  • The taxpayer must own the property;
  • the taxpayer must use the property in business or in an income-producing activity; and
  • the property must have a determinable useful life of more than one year.

Depreciation can begin as soon as the owner begins using property in a business or to produce income. Depreciation deductions can no longer be received when the owner has fully recovered the original cost or sells/removes the property from business use. MACRS (the Modified Accelerated Cost Recovery System) is a common depreciation calculation method for most property listed on tax returns, although there are other methods that may apply for additional accounting functions, such as financial statements. Your tax preparer will identify the best method for you to calculate depreciation once she is given the breakdown of business personal property (anything beyond the building structure) categories from the cost segregation engineering study.

Accelerate Deductions, Accelerate Gains

Have you ever wanted to give or receive a large gift (birthday, graduation, wedding) in advance of the event? That is what engineering-based cost segregation can do for the entity that owns the commercial real estate and leases it to the cannabis operation. It is essentially a benefit that comes sooner than it otherwise would, hence the phrase accelerated depreciation.

Four IRS-approved methods of preparing a cost segregation study exist. Typically, the engineering firm assessing the building will select the method it will use to do the evaluation. Each method can generate different results toward achieving greater immediate tax savings by creating a positive time-value-of-money (compounding) benefit for the property owner. “Engineering Actual” is the gold standard of cost segregation studies, as it line-items each component as a reference point for defense of the depreciation calculation. It often yields the largest benefit in the cost segregation process, but can also be the most expensive engineering study.

Owners of commercial real estate leased to cannabis operations can elect to charge rent at the higher end of the local market range in order to capture more profit and available tax savings in the real estate ownership entity, instead of retaining additional profit in the more highly taxed cannabis operation. To achieve a financial benefit that is larger than the costs of an engineering study, most businesses will use engineering-based cost segregation for commercial real estate that has an acquisition cost in excess of $500,000, or for existing real estate renovated at a cost in excess of $250,000, which is a low barrier to entry.

The perception that cost segregation can be performed on new construction only is inaccurate. It can be facilitated immediately after purchasing an existing building, renovating existing property or completing new construction. It also can be completed with effective results up to 20 years after property acquisition. The cost segregation result does not generate any depreciation beyond what would be received if the building were owned for the typical 27.5- or 39-year depreciation period; however, it does front-load savings, which allows the business owner to create value sooner and compound growth in other areas by reducing debt or making additional property or business investments.

When evaluating cost segregation providers, ask these questions:

  • What is their experience level, and how many projects have they completed?
  • What documentation do they provide to defend their calculations?
  • Do they back up their work with audit protection guarantees?
  • How many cost segregation studies have been disputed and what was the outcome?
  • How many cases experience “shrink back,” where the depreciation deduction was adjusted in an audit?
  • Do they cap their fees at a percentage of the tax savings generated, assuring value to the property owner regardless of initial estimates?

Maximize Savings from Commercial Property Taxes

Additionally, a consequence of an engineering-based cost segregation study can be the reduction of commercial real property value (the building core structure) and an increase in business personal property value (walls, flooring, electrical), which allows the owners’ representative to negotiate with local taxing authorities for a reduction in commercial property tax assessed. This is because business personal property is not part of traditional commercial property tax and can often have its own lower tax rate. But to obtain that, the business personal property value must first be separated, which is what the cost segregation study accomplishes.

Sometimes, additional property tax reductions can be uncovered beyond negotiation by filing with the appropriate court jurisdiction and using the cost segregation study as evidence. For property owners whose taxes are more than $30,000 annually, the legal costs to achieve these results can yield positive short- and long-term results. Hiring a team that specializes in legal challenges to property tax assessments may generate positive results, especially if they cover those costs out of their fee or part of the savings split.

Reduce expensive electric costs by 5% to 10%

For cannabis grow locations, marijuana-infused products (MIP) and other production facilities, there is a 5-percent to 10-percent permanent utility cost reduction for agriculture available in most states (or for manufacturing in about 30 states). If you have not yet applied for exemption, you may want to do so now by hiring an engineering firm to document necessary data. States of Arizona, California, New Mexico, Ohio and Oregon do not offer this benefit—as some do not charge sales tax on utility usage. If the exemption requirements are met, a grow’s electric meter can qualify for a permanent sales tax exemption resulting in 5-percent to 10-percent savings on electric costs. These states allow businesses to use an engineering study (different from cost segregation) to determine how much utility usage is related to manufacturing product as opposed to office or administrative usage. The result is a sales tax exemption certificate issued by the state that allows a business to reduce or eliminate utility sales tax that is otherwise a line item on your electric bill (different from state income tax or sales tax collected by your business). The rules vary by state, but typically the benefit is permanent. For large utility consumers, such as grow and MIP operations, the benefit can be another source of significant savings not restricted by code section 280E.

Note: This column is not to be considered legal or tax advice. Please consult your tax advisor for specific advice.

Sean Covi, CFP™ is a senior advisor at GMG Specialized Tax Incentives, located in Denver, Colo.