The 1031 exchange is one of the most important tools investors use when dealing with real estate. A 1031 exchange allows an investor to roll the proceeds from a real estate sale into a future purchase of a like-kind asset without paying capital gains tax on the sale. The caveat being any cash received in a 1031 exchange that is not used to purchase a replacement property is referred to as “boot,” and these funds are generally taxable. With proper tax planning, this problem can be solved with a cost segregation study.
What is a cost segregation study?
A cost segregation study identifies and reclassifies personal property assets to shorten the depreciation time for taxation purposes, which can help reduce current income tax obligations. Personal property assets include a building's non-structural elements, exterior land improvements, and indirect construction costs. The primary goal of a cost segregation study is to identify all construction-related costs that can be depreciated over a shorter tax life (typically 5, 7, and 15 years) than the building (39 years for non-residential real property).
Bonus depreciation allows for an accelerated first-year deduction on property that is typically depreciated with a tax life of less than 20 years. Meaning all the 5-, 7- and 15-year property reclassed from the cost segregation would most likely be bonus eligible. Through the end of 2022, qualified property is subject to a bonus depreciation rate of 100%, which means 100% of the asset’s basis is deductible in the first year. Bonus depreciation rates phase down to 80% in 2023, 60% in 2024, 40% in 2025 and 20% in 2026.
Using bonus depreciation with the cost segregation for tax free cash
With bonus depreciation in place, let’s look at how a cost segregation study can be performed on the replacement property to generate enough first-year deductions to offset taxable income generated from receiving boot.
For example, in 2022 Taxpayer X sold a building that was acquired in 2016, which had a tax basis of $3,000,000, in a 1031 exchange for $4,000,000 + $500,000 in cash. The recognition of cash “boot” triggers a taxable event for Taxpayer X. As a result of the transaction the realized gain is $1,500,000, of which $500,000 is recognized gain (taxable) and $1,000,000 is deferred gain (non-taxable). The total tax due would be $185,000 ($500,000 x 37% tax rate).
Taxpayer X used the 1031 proceeds to acquire a replacement property for $5,000,000. The basis of the replacement property must be reduced by the deferred gain of $1,000,000, leaving a total basis in the replacement property of $4,000,000. Of the $4,000,000 in basis of the replacement property, the cost segregation generated $800,000 of additional depreciation deductions. The $800,000 of additional deductions can be used to offset the entire $500,000 of taxable gain from the cash received. Also, the remaining $300,000 of additional depreciation deductions can be used to offset other taxable income in 2022.
Using the cost segregation after the bonus depreciation phaseout
As bonus depreciation begins to phaseout after 2022, it becomes more difficult to generate first year deductions by performing a cost segregation study on the replacement property. In this case, you’d want to consider cost segregation on the relinquished property using a look-back cost segregation study.
In a look-back study, the cost segregation breaks out the different building components as of the date the property was acquired. The additional deductions from the look-back study will be picked up by a Section 481(a) adjustment in the year the study is implemented, and can be used to offset the gains from the cash received in your exchange.
Implementing a look-back study will make perfecting your 1031 exchange more complex, so careful planning is necessary. Based on the final 1031 regulations, relinquished property asset classifications should line up with the replacement property classifications. If a cost segregation study was performed on the relinquished property prior to sale, a study should be performed on the replacement property to ensure asset classifications are matched to avoid recognizing additional gain.
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