Using cost segregation in combination with a 1031 exchange real estate strategy can help commercial property owners significantly reduce their tax burden.
By James Su, Managing Director, Tax
Many commercial real estate investors and rental property owners have taken advantage of two popular tax deferral strategies: Section 1031 exchanges and cost segregation. Understanding how cost segregation and 1031 exchange rules interact, however, can give rise to a strategy that allow entities to pay little or no federal or state tax on their property holdings when making a sale or purchase. Oddly, there is a common misconception that these two strategies are mutually exclusive and cannot be applied simultaneously. Even some accounting professionals have been left with the impression that the tax depreciation benefits of cost segregation studies do not apply to property acquired as part of a 1031 exchange.
What are the 1031 exchange rules?
Under Internal Revenue Code (IRC) Section 1031, real estate owners can defer the capital gains tax on the sale of property by acquiring a replacement property in a “like-kind exchange.” In a 1031 exchange, the proceeds from the property sale are used to purchase a like-kind replacement property. For instance, if the proceeds from the sale of one commercial building are used to purchase another commercial building — with the cash being held by a qualified third-party intermediary — that would fulfill the 1031 exchange rules. The owner has 45 days from the sale of the relinquished property to identify a replacement property and 180 days to complete the purchase of the like-kind property.
Through this process, the capital gains on the sale of the property are deferred until the eventual sale of the replacement property, assuming a follow-up 1031 exchange is not utilized in a follow-up exchange transaction to further defer the taxes on gain.
One common misconception regarding 1031 exchanges is that only properties of similar type and character may be exchanged (e.g., apartments for apartments), when in actuality, any real property can be exchange for any other real property (e.g., raw land can be exchanged for an office building, and vice versa).
What is cost segregation?
Cost segregation, or “cost seg,” is another tax deferral strategy that applies to acquired, constructed or renovated real estate property. Taxpayers use this method to realize cash flow savings by accelerating their depreciation deductions for income tax purposes. Properties acquired for business use can generally be depreciated over 39 years (or 27.5 years for a rental property). To take advantage of these accelerated depreciation tax deductions, the owner would complete a cost segregation study, which takes a detailed approach to breaking apart the building costs into components, identifying and quantifying the property elements eligible for depreciation over five, seven or 15 years. Under the current tax regime, property with class lives of 20 years or less, which includes the property reclassified under a cost seg study into shorter class lives, would qualify for 100% first-year bonus depreciation.
As an added benefit, a cost seg can also identify property classified as qualified improvement property (QIP) or property eligible for Section 179 expensing. Qualified improvement property is any improvement to the interior of a building that is nonresidential real property and placed into service after the building was first placed in service, but, excludes expenditures for 1) the enlargement of a building, 2) elevators or escalators, and 3) the internal structural framework of a building.
How Section 1031 Exchange Rules and Cost Segregation Interact
Because buildings sold as part of a 1031 exchange real estate strategy are typically either fully or mostly depreciated, taxpayers and tax preparers often assume that using a cost segregation study to generate additional deductions has limited advantages. But understanding the nuances of how 1031 exchange rules and cost segregation studies interact can still yield meaningful symbiotic tax benefits. In fact, there are a number of different paths that allow owners to realize savings from both of these tax planning strategies, Consider the following examples:
Example 1: Exchange With No New Basis, Applying a Cost Segregation Study to the Old Carryover Basis
A taxpayer sells a property worth $5 million with an adjusted basis of $2 million. They complete a 1031 exchange and acquire a replacement property also worth $5 million and then commission a cost segregation study on the new property and apply the study results to the carryover basis of $2 million. The taxpayer can defer taxation on the $3 million of capital gains by completing the 1031 exchange and generate $220,000 of additional tax depreciation in the current year by utilizing the cost segregation study.
Example 2: Exchange up in Value, Applying Cost Segregation to New Excess Basis
Typically in 1031 exchange real estate transactions, the cost of the replacement property is greater than the value of the sold property, a process that creates a new or “excess” basis. In this example, a taxpayer also sells a property worth $5 million with an adjusted basis of $2 million. They complete the 1031 exchange and acquire a replacement property worth $6.5 million. They commission a cost segregation study on the new property and apply the results to the excess basis of $1.5 million. The old carryover basis of $2 million will continue depreciating under the prior method and depreciate alongside a separate entry for the new basis in the replacement property. The taxpayer gets to defer taxation on the $3 million capital gains by completing the 1031 exchange. Additionally, they also generate $290,000 of additional tax depreciation in the current year because of the cost segregation study.
Example 3: Electing Out of IRC Section 168(k)
In some situations, a taxpayer may find that electing out of IRC Section 168(k) (which allows bonus depreciation in the first year) may result in a more favorable depreciation schedule. Under this election, the taxpayer may treat the adjusted basis of the sold property as if it were disposed of at the time of the 1031 exchange. Instead, both the carryover and the excess basis may be treated as if placed into service when the taxpayer acquired the new property.
By doing so, the taxpayer gets to dispose of the carryover basis, but they forgo the one-year bonus depreciation benefit. In the previous example, where a $5 million property was exchanged for a $6.5 million property, the taxpayer would still get to defer the taxes on capital gains. However, they would take depreciation deductions more gradually, over a few years rather than all at once, since they would not benefit from bonus depreciation. By completing a cost segregation study, they could expect to see $100,000, $160,000, $90,000, $49,000 and $48,000 in additional tax depreciations in each of the first five years of service upon acquiring the new property. However, they still enjoy the advantage of accelerating depreciation that they would expect from a cost segregation study while keeping more simplified asset depreciation records for the exchange transaction.
There have been some significant changes to tax laws over the past couple of years which have extensive ramifications on both companies and individuals. As with many of the tax planning strategies that have been updated since these changes, the devil is often in the details. Do not simply assume there are no opportunities for savings.
The professionals at BPM have the knowledge and the resources you need to answer all of your Section 1031 exchange and cost segregation questions.To learn more about how BPM can help you find the optimal real estate tax planning strategy for your unique circumstances, contact James Su, Managing Director in our Tax practice, today.