Is cost segregation a good idea to combine with 1031 Like-Kind Exchanges?

First, what is a §1031 Like-Kind Exchange? A §1031 exchange, a.k.a. tax deferred exchange, is a simple strategy and method for selling one qualified property and then proceeding with the acquisition of another qualified property within a 180-day time period. The qualified property must be identified within the first 45 days after divestiture of the previously owned property. The IRS rules can be found at www.IRS.gov.

Bill Edward and Allen Mary Foster weigh in on the subject: While it is good news that commercial property owners can take advantage of both cost segregation and Section 1031 (§1031) exchanges to defer the maximum amount of income taxes, the interaction of the two must be carefully examined. First, CPAs that are experienced in §1031 exchanges must determine whether a cost segregation study will be beneficial for a replacement property acquired in a §1031 exchange with the carryover tax basis. Second, CPAs must consider depreciation recapture resulting from the cost segregation study if the property is later disposed of in a §1031 exchange.

The taxpayer receives a carryover tax basis for the replacement property in a §1031 exchange, rather than a fair-market-value tax basis. Nevertheless, it is entirely feasible for taxpayers to benefit from a cost segregation study on the replacement property.

As an example, consider that a taxpayer disposes of commercial property owned for six years with a tax-basis of $3 million and an adjusted basis of $1 million. The entire building was treated as §1250 property for depreciation purposes. He then buys land and a building with a total value of $3 million, 85% of which is allocated to the building. Therefore, the basis in the building is $850,000 (85% x $1 million). A cost segregation study identifies the portions of the building that qualify as personal property and land improvements for depreciation purposes (but are still like-kind for §1031 purposes). The result of a typical study on an office building might identify 10%, or $85,000, as land improvements, and another 15%, or $127,500, as personal property qualifying for a 7-year recovery period and the 200% declining balance method of depreciation. This leaves $637,500 as real, or 39-year, property.

The results of combining the two tax-deferral methods are a gain deferral from the §1031 exchange of $2 million and an increase of $50,000 in depreciation deductions in the current year, resulting in reduced taxes of nearly $20,000, assuming a 40% ordinary income tax rate.

Note that §168(k) includes regulations relating to the depreciation of the basis of the replacement property in an exchange under §1031 for Modified Accelerated Cost Recovery System (MACRS) property. The carryover or “exchanged” basis of the replacement MACRS property is depreciated over the remaining recovery period of, and using the depreciation method and convention of, the relinquished MACRS property. Thus, in our example, the taxpayer could depreciate the exchanged basis for the building over the remaining 33 years on the straight-line method. The regulations also allow taxpayers to opt for treatment of the replacement MACRS property as MACRS property placed in service at the time of replacement if this results in a shorter recovery period. Using the cost segregation study results should yield more gain deferral.

Cost segregation studies are most useful when the taxpayer is significantly exchanging up in value or exchanging from non-depreciable property, such as land, to depreciable property. Cost segregation generally reclassifies §1250 property as §1245 property for depreciation purposes. Land improvements, however, remain §1250 property. §1245 property has significant depreciation recapture rules in a §1031 exchange; generally the replacement property must contain the same value of §1245 property as the relinquished property, or the taxpayer will recapture the difference (up to the realized amount) at ordinary income tax rates. Despite the potential of future taxes in a §1031 exchange, cost segregation still can be justified due to the tremendous present value of the accelerated depreciation deductions. Based on the fundamental principle of the time value of money, a dollar saved today through reduced taxes is always worth more than a dollar in later years. Furthermore, an owner can exchange into other real property with similar amounts of personal §1245 property and avoid the recapture tax altogether.

Always consult your trusted tax advisor when engaging in a §1031 Exchange and cost segregation as there are depreciation recapture rules.

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