It is safe to assume that real estate owners and investors are interested in reducing and/or deferring their taxes. Cost segregation studies and 1031 Exchanges are two of the most valuable tax strategies available to real estate owners today. By utilizing a strategy that combines both, a property owner may reduce operating expenses and defer capital gain taxes. However, property owners should take into consideration some important factors.
Depreciation is a method of allocating the cost of a tangible asset over its useful life. Residential real property (including apartment complexes) is generally depreciated over 27.5 years. Commercial real property is generally depreciated over 39 years. Both use straight-line depreciation methods. However, personal property is generally depreciated over five, seven or fifteen years using an accelerated method of depreciation. Additionally, the recently passed Tax Cuts and Jobs Act grants owners of personal property “immediate expensing” which means that in certain situations, 100% of the depreciation deductions may be taken in the first year of ownership.
There may be significant tax savings by strategically utilizing the depreciation schedules. For example, $500,000 of depreciable value using 39 year straight-line depreciation will produce an annual depreciation deduction of $12,305. However, the same $500,000, if depreciated as personal property over a seven year period, will produce a deduction of $71,450 for the first year and a deduction of $100,000 for the first year if depreciated over five years. Therefore, a property owner can generate large tax savings by reclassifying parts of a building for depreciation purposes from real property (§1250 property) to personal property (§1245 property).
A cost segregation study is performed for the purpose of “segregating” personal property from real property for depreciation purposes. The IRS accepted this concept after losing the case of Hospital Corporation of America v. Commissioner and subsequently issued a cost segregation audit techniques guide. In the Hospital Corporation case, some of the items reclassified to have a five-year depreciable life included: wiring to television equipment; conduit; carpeting; kitchen hoods and exhaust systems; and special plumbing to x-ray machines.
To create a valid cost segregation study, the IRS requires that an actual study be performed. A specialized company or an accounting firm utilizing engineers and/or construction management professionals typically prepares these studies. A proper cost segregation study requires a knowledge of accounting, tax law and construction. An engineering report should segregate the real estate asset into four categories: land; land improvements; building and structural components; and tangible personal property. Generally, a cost segregation study will reclassify 25 to 50% of a building as personal property for depreciation purposes. By doing this, depreciation deductions are increased and taxes are reduced.
Although beneficial to increase cash flow and reduce taxes, a cost segregation study may complicate a future like-kind exchange under section 1031. If the replacement property contains less section 1245 property than the relinquished property had, the exchanger will have to recapture the prior depreciation (to the extent of the gain) as ordinary income. To avoid depreciation recapture, the exchanger may need to find replacement property that has had a valid cost segregation study done on it or have a cost segregation study done on the replacement property prior to closing.
Similarly, the immediate expensing of building improvements or reclassified property (after a cost segregation study) can create tax consequences when the property is sold. If those items (that have a zero basis) have value when sold, the seller will have to recapture the prior depreciation (to the extent of the gain) as ordinary income. Although cost segregation and immediate expensing can be very beneficial, it is important to be certain the advantages outweigh the disadvantages. In planning for a 1031 Exchange of property that has involved cost segregation or immediate expensing, it is very important to consult with a tax advisor to avoid any unexpected tax consequences.