What You Need to Know about Cost Segregation and 1031 Exchanges

 

We have written extensively about 26 U.S. Code & 1031, both ourselves and in other publications. 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.

Capital gains taxes can be postponed for investors who follow the rules for "exchanging" relinquished properties for like-kind properties.

A concept that may not be as familiar is cost segregation. The combination of cost segregation with the 1031 exchange process, however, allows you to defer capital gains taxes on the sale of real estate assets, as well as benefit from larger deductions. In this article, the leadership team from Riverside 1031 will discuss exactly that.

 

Taking a closer look at cost segregation

Tax strategies such as cost segregation are IRS-approved depreciation tools. With cost segregation, investors can accelerate depreciation deductions while deferring state and federal income taxes on their real estate holdings. An analysis of cost segregation is conducted to accomplish this.

First, let's review depreciation, specifically straight-line depreciation. A real estate investor can deduct the cost of real estate over its useful lifetime through depreciation; in other words, the IRS defines how long real estate can be used for. Residential real estate used for trade or investment is depreciated over 27.5 years, while commercial real estate is depreciated over 39 years.

The cost segregation study, or cost allocation study, analyzes specific property components rather than the entire property. Certain tangible assets may fall into specific tax categories that have shorter recovery periods than specific real estate, which can take three to four decades to recover. 

It is worth mentioning that tangible personal property, such as equipment, furniture, and fixtures, has a shorter recovery/depreciation period of around five or seven years, known by the IRS as 1245 property. It is possible for such property to represent as much as 35% of a real estate investment. A cost segregation study could allow the company to take advantage of accelerated depreciation and a larger tax deduction.

 

Bringing the two together

After closing, cost segregation studies can generally be applied to replacement property. If you allow a cost segregation study, you might receive an estimate of the benefits conferred. The next step would be to prepare a detailed cost segregation report, and coordinate it with your tax filing date. In the first year following the exchange, you could benefit from potentially higher write-offs on your replacement property.

It can save you more on taxes, but it takes time and requires outside assistance (meaning more expense). Moreover, 1031 basis calculations may be required before a cost segregation study can be conducted. Moreover, if your future replacement property has fewer 1245 properties than the relinquished property, it may complicate any future like-kind exchanges. Additionally, if the property is later sold through an ordinary method, immediate expensing can lead to depreciation recapture.

In conclusion, cost segregation and 1031 exchanges can be viable tax strategies. If you're unsure about how to proceed with cost segregation, consult with a tax professional.

The Riverside 1031 philosophy is based on confidence and simplicity. You want to keep more of your money and assets, but not at the expense of layers of legal complexity. That's why we use our considerable resources instead of depleting yours to take our clients from start to completion smoothly and methodically.

With Riverside Abstract, you'll enjoy the handholding and support of a personal 1031 facilitator, assurance of working with a Qualified Intermediary that meets Safe Harbor standards, and confidence in dealing with a Certified Exchange Specialist® who ensures each and every transaction is legal and legitimate.