The best of both worlds: a combination of cost segregation and like-kind exchanges can save on real estate taxes
* 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. Thus, real estate owners can benefit from both the gain deferral under section 1031 for real estate exchanges and the enhanced cost recovery deductions of the cost segregation study.
COMBINING 1031 WITH COST SEGREGATION
While it's good news that real estate owners can take advantage of both cost segregation and section 1031 exchanges to defer the maximum amount of income taxes, the interaction of the two must be carefully examined. First, CPAs must determine whether a cost segregation study will be beneficial for a replacement property acquired in a section 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 section 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.
Let's say, for example, that a taxpayer disposes of land and building property he has owned for six years with a value of $3 million and an adjusted basis of $1 million. He treated the entire building as section 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 section 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 section 168(k) includes regulations relating to the depreciation of the basis of the replacement property in an exchange under section 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 to treat 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.
Planning tip. Consider having your clients elect out of the section 168(k) rules if this results in a shorter recovery period and faster depreciation.
Also, taxpayers often exchange up in value and, under the 168(k) regulations, the taxpayer treats the "excess basis" in the replacement MACRS property as property that is placed in service in that taxable year. The depreciation allowances for the excess basis are determined using the applicable recovery period, depreciation method and convention prescribed under section 168 for the replacement MACRS property at the time of replacement. Therefore, the taxpayer can accelerate the depreciation deductions on the excess basis through the cost segregation study.
For example, John Smith disposes of land and building with a value of $4 million. The building has an adjusted basis of $1 million. He acquires land and building with a value of $6 million. The excess basis is $2 million; 85%, or $1.7 million, is allocated to the building. The "exchanged" basis in the building, $1 million, is depreciated under the prior method unless Smith elects out. The $1.7 million excess basis may be depreciated under an accelerated method as determined through the cost segregation study.
Planning tip. Cost segregation studies are most useful when the taxpayer is exchanging up in value significantly, or exchanging from nondepreciable property, such as land, to depreciable property.