The Best of Both Worlds: A Combination of Cost Segregation and Like-Kind Exchanges Can Save on Real Estate Taxes
Allen, William Edward,, III, Foster, Mary B., Journal of Accountancy
* COMBINING COST SEGREGATION AND SECTION 1031 exchange allows taxpayers to defer the maximum amount of income taxes.
* USING COST SEGREGATION, OWNERS CAN RECLASSIFY real property as personal property in order to obtain faster depreciation write-offs.
* IN AN IRC SECTION 1031 EXCHANGE, real estate owners can defer the tax on the disposition of an appreciated property by acquiring a like-kind replacement property for investment or business use.
* TAXPAYERS CAN USE COST SEGREGATION on replacement property acquired in section 1031 exchanges. This is a particularly good option if the owner is exchanging up in value.
* IN CERTAIN SITUATIONS COST SEGREGATION may give rise to depreciation recapture as ordinary income in otherwise nontaxable exchanges.
Tax-deferral strategies are a great way to minimize taxes, and cost segregation and IRC section 1031 exchanges are two of the most valuable tax-deferral strategies available to commercial real estate owners today. This article examines the interaction of these two strategies, the increased benefits that result from using them in combination, and the recapture issues that CPAs may encounter after the fact and how to plan for them.
Section 1031 exchanges of real estate have long been a favorite tax-deferral tool for owners. In these exchanges, business or investment property is disposed of through a qualified intermediary, and the proceeds are used to purchase a replacement property of like kind. This results in a deferral of all or most of the gain that otherwise would be subject to income tax on the disposed property. The replacement property has a carryover tax basis that is generally the value of the replacement property less the gain deferred in the exchange.
New guidance from the IRS and sortie of the most taxpayer-friendly legislation since the Tax Act of 1986 also have made a second form of income tax deferral--cost segregation-increasingly popular. The primary goal of cost segregation is to identify building components that can be reclassified from real property to personal property. This results in a substantially shorter depreciable tax life and accelerated depreciation methods. Ordinarily, the cost of real, or section 1250, property is recovered over lengthy periods (27.5 and 39 years for residential and nonresidential property, respectively), using the straight-line method of depreciation. Personal, or section 1245, property is recovered over considerably shorter periods (5, 7 or 15 years), and employs accelerated or "front-end loaded" methods of depreciation, such as 200% or 150% declining balance.
When section 1250 property is reallocated to section 1245, the differences can be great. For example, installed carpet purchased with a facility is considered personal property for depreciation purposes and recovered in a 5- or 7-year period using the 200% declining balance method of depreciation. Otherwise the carpet generally would be included in the value of the real property and the cost would be capitalized and recovered on a straight-line basis over 39 years. It takes a unique combination of engineering and tax expertise to properly analyze construction information, compute industry-standard estimates and identify and segregate the subcomponent costs needed for cost segregation, however. CPAs without that expertise might consider hiring a consultant.
REAL VS. PERSONAL PROPERTY
In a section 1031 exchange, real property must be replaced with real property in order to defer the gain. In general, the definition of real property under section 1031 is determined by state law. In contrast, the definition of real and personal property for tax-depreciation purposes is determined under federal law. State law tends to classify fixtures in a building as real property. Therefore, property such as wall coverings, carpeting, special purpose wiring or other installations affixed to the building can be considered real property under state law and like kind for section 1031 purposes, but personal property in cost segregation studies. …