Real Estate Tax Tactics: Combining 1031 Exchanges and Cost Segregation for Ultimate Efficiency

Recently, several clients have asked if they should perform a cost segregation study after acquiring replacement property in connection with a “1031 transaction.” One of the most powerful tax deferral strategies available to real estate investors is the like-kind exchange under Internal Revenue Code (IRC) Section 1031. Coupled with cost segregation, investors can optimize their tax savings. This article discusses 1031 exchanges and the role of cost segregation, the concept of “excess basis,” and how it can qualify for bonus depreciation.

Generally, a “like-kind exchange,” or “Section 1031 exchange,” allows real estate investors to defer the tax on the gain they would normally incur upon a sale or disposition of that property (“relinquished property”) that has been owned for a significant amount of time and which has appreciated over that time. This strategy allows an owner or investor to reinvest those proceeds into another real property (“replacement property”). Instead of paying taxes on the gain at the time of sale, the tax payment is deferred until the replacement property is sold in a taxable transaction.

The deferred gain is essentially rolled over into the replacement property’s basis, reducing its initial depreciable basis. Consequently, the investor defers the capital gains tax that would have been due upon the sale of the relinquished property. So, establishing the replacement property’s basis is imperative. Take a simple example. A taxpayer sells a commercial building for $500,000 with an adjusted tax basis after depreciation of $150,000. If the taxpayer wanted to pick up the gain and pay the tax, he would pay tax on a $350,000 gain. However, the taxpayer decides to complete a like-kind exchange for this sale. In the like-kind exchange, the taxpayer acquires another commercial building for $500,000. The basis of the replacement property is calculated as follows: Cost of Replacement Property ($500,000) less the Gain Deferred in Like-Kind Exchange ($350,000) equals the Basis of Replacement Property or $150,000.

For purposes of determining the depreciation on the replacement property, generally, a taxpayer will depreciate the carryover basis of property acquired in a like-kind exchange during the current tax year over the remaining recovery period of the property exchanged and is required to use the same depreciation method and convention that was used for the relinquished property. So, in the simple example, the taxpayer will continue to depreciate the $150,000 basis of the replacement property over the remaining life that existed at the time of the sale.

However, what happens if the taxpayer trades up in value and buys a more expensive piece of property? Let’s say the same taxpayer purchases replacement property worth $700,000. Calculating the basis would be the same. The cost of Replacement Property ($700,000) less the Gain Deferred in Like-Kind Exchange ($350,000) equals the Basis of Replacement Property or $350,000. In this second example, the basis of the replacement property is $200,000 greater than the historical basis of the original relinquished property in the first example ($150,000). This “excess basis” in the new property represents the difference between the fair market value of the replacement property and the carryover basis from the relinquished property. When a taxpayer encounters an excess basis situation, tax planning opportunities may arise, and consideration could be given to engaging in a cost segregation study on the new replacement property.

In a situation involving excess basis, the taxpayers can elect to treat the adjusted basis of the relinquished property as if it was disposed of at the time of the exchange. Under this election, a taxpayer treats the carryover basis and excess basis for the replacement property as if it was placed in service on the date it was acquired. The depreciable basis of the new replacement property is the adjusted basis of the exchanged property plus any additional amount paid for it.

Once the election is made, this new “combined” carryover basis of the replacement property presents a taxpayer with an opportunity to obtain a cost segregation study on the replacement property and apply the analysis to all aspects of the combined basis. In this scenario, a cost segregation study separates the tax basis of the replacement property that would typically be depreciated over 27.5 years for residential property or 39 years for non-residential property into more identifiable components that are not considered real property for tax purposes and consequently can be depreciated more quickly, typically, over five, seven, or 15 years.

Here’s where excess basis, discussed previously, comes into play, and the taxpayer may qualify to claim bonus depreciation on the portion of the excess basis attributable to qualifying property identified in a cost segregation study. Bonus depreciation allows for an immediate deduction of a percentage of the cost of qualifying assets in the year they are placed in service. And although bonus depreciation has been reduced to 60% for 2024 and in the ensuing years, 40% for 2025, 20% for 2026, and 0% beginning in 2027, the shorter lives attributable to either personal property (5 year/7 year) or land improvements (15 years) still make this opportunity very attractive to real estate investors.

Going back to the second example referenced above, where the replacement property was purchased for $700,000, which now carries a tax basis of $350,000 (including $200,000 of excess basis) if a cost segregation study were to be performed on this property, any personal property or land improvements allocated to the excess basis would qualify for bonus depreciation.

Lastly, one must always consider the State tax consequences of bonus depreciation. Certain states do not allow bonus depreciation. Instead, these states will require an adjustment (“State add-back”) for the difference between Federal bonus deprecation taken and depreciation as if the bonus was not permitted. In these states, it’s quite possible for the state tax liability to increase when bonus depreciation is claimed. So, it is particularly important to consider the impact of state tax as well.

Real estate investors can maximize tax deductions and enhance cash flow by understanding the synergy between like-kind exchanges under IRC Section 1031 and cost segregation studies. Identifying excess basis and applying bonus depreciation to qualifying components further leverages potential tax benefits. As with all tax strategies, it is crucial to consult with tax professionals who can provide guidance tailored to individual circumstances and ensure compliance with the ever-evolving tax code.