The 1031 exchange and cost segregation are powerful tools for tax optimization, and they can be even more powerful in conjunction if an investor uses them carefully. Professional service providers and a high level of organization are essential for a successful 1031 exchange with cost segregation.
When the 1031 Exchange and Cost Segregation Meet
Cost segregation allows an investor to separate personal property from real property to depreciate it more quickly. This is accomplished by having a cost segregation study prepared and using the findings in your tax calculations. The result will be a tax savings, since personal property always depreciates faster than real property. Thus, a property purchased as a single asset can be divided into four categories through cost segregation:
- Land, which is never depreciable.
- Buildings and structural components, which are depreciated over 27.5 years in the case of residential property, including multifamily, and 39 years for commercial property other than multifamily.
- Land improvements, which include paved areas, fences, lighting, landscaping, and similar items, are depreciated over 15 years.
- Personal property contained in or attached to buildings, such as floor and window coverings and electrical fixtures, which are depreciable over 5, 7 or 15 years.
Guidelines for what defines land improvements and personal property, and their service lives (which determine their depreciation time) are found in IRC Section 1245, whereas real property falls under IRC Section 1250.
Between 25 and 50 percent of a building is often reclassified during cost segregation. This can result in a large tax savings in the year of the cost segregation study and in following years, as individual items depreciate faster than the real property. This is especially so since the 2018 Tax Cuts and Jobs Act has increased bonus depreciation from 50 to 100 percent on purchases of personal property for business use made between September 27, 2017 and January 1, 2023, as defined by IRC 179. For a multifamily real estate owner, this could include such things as computers and software, telephones, office furniture and equipment, and vehicles and maintenance equipment.
Cost segregation has several consequences for 1031 exchanges. First, items that have fully depreciated are not considered to be part of the exchange and thus are not subject to depreciation recapture. Thus, the investor is able to exchange the property for one of equal or greater value and reduce his or her depreciation recapture at the same time.
Cost segregation makes the complicated 1031 exchange process even more intricate. A property that was previously viewed as a single piece of real estate is now a bundle of diverse assets. Since only real estate can be used in a 1031 exchange, which is also a result of the 2018 tax reform, this leads to a practically inevitable cash boot. This situation is complicated by the fact that IRC Sections 1245 and 1250 are not used in a 1031 exchange to define real and personal property, even though those criteria are the only ones admissible for cost segregation. For 1031 exchange purposes, the determination of personal vs. real property is based on the laws of the state in which the property is located.
Two Teams of Professionals
An investor should consider the amount of benefit he or she is likely to receive from cost segregation and compare it to the cost of the procedure and, if applicable, the cost it will add to a 1031 exchange. The IRS requires that a cost segregation study be carried out by a third party, which may charge for services by the hour and expenses, or as a percentage of the tax savings they generate. A 1031 exchange requires the services of a qualified intermediary (QI), whose task and fees will be greater due to the cost segregation. Nonetheless, in those cases where it is financially expedient, cost segregation can add significant value in a 1031 exchange.
At CWS Capital Partners, we are a fully-integrated multifamily real estate investment management firm that offers everything from due diligence and risk management to transaction support and property management. We specialize in assisting our clients with 1031 exchanges, acquisitions, repositioning, and development. We also own and manage luxury multifamily investment communities in major markets around the country, and we employ a team of experts who can help you hone your investment strategy.
For more articles like this one, check out our 1031 Exchange blog posts.
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