A great deal has been written about 26 U.S. Code § 1031, both by us and other sources. Better known as the “1031 exchange” or the “like-kind” exchange, Internal Revenue Code Section 1031 allows for the “exchange of real property held for productive use or investment” as a tax deferral strategy.
If you are an investor who follows the rules of “exchanging” a relinquished property into a like-kind property, you can postpone the payment of capital gains taxes generated from the sale.
What might not be as familiar, however, is the concept of cost segregation. But when combining cost segregation with the 1031 exchange process, you can not only defer capital gains taxes on the sale of real estate assets, but you could also reap the benefits of larger deductions.
Delving into Cost Segregation
Cost segregation is an IRS-approved depreciation tool and tax strategy. Specifically, cost segregation allows investors who have built, purchased, or remodeled their real estate holdings to accelerate depreciation deductions, while also deferring income taxes on both the state and federal levels. This is done through a cost segregation study.
Before going any further, let’s provide a brief recap of depreciation, specifically, straight-line depreciation. Depreciation helps a real estate investor deduct the cost of a property over its useful lifetime; this is a fancy way of saying that the IRS defines what is considered the useful period of time for real estate. Specifically, residential real estate property used for trade or investment is depreciated over 27.5 years, while commercial real estate carries a 39-year depreciation timeframe.
But a cost segregation study, or cost allocation study, provides an analysis of specific property components, rather than lumping the entire property together. Some of those tangible assets might fall into specific tax categories that offer shorter recovery periods than the close to three or four decades of specific real estate.
For example, equipment, furniture, and fixtures, known by the IRS as § 1245 property, is tangible personal property with a shorter recovery/depreciation period of around five or seven years. Such property can represent up to 35% of a real estate investment. Through a cost segregation study, it could be eligible for accelerated depreciation, and larger tax write-offs.
Combining the Two
A cost segregation study can generally be applied to replacement property after closing. Specifically, you might obtain an estimate of benefits conferred if you were to allow a cost segregation study. If it makes sense, you’d move forward on a detailed cost segregation report, and coordinate it with your tax-filing date. If successful, you could enjoy potentially larger write-offs on your replacement property in the first year following the exchange.
While the process can help you save more on taxes, keep in mind that it takes time, and requires outside help (meaning more expense). Furthermore, there are times during which 1031 basis calculations might be required before a cost segregation study can even be considered. It could also complicate any future like-kind exchanges, especially if your future replacement property has less 1245 property than the relinquished property did. Finally, immediate expensing of property can lead to depreciation recapture if that property is eventually sold through an ordinary method.
To conclude, cost segregation and the 1031 exchange can provide a viable tax strategy. Given the complexity of cost segregation, however, it's best to check with your tax advisor before proceeding.