Cost Segregation and 1031 “like-kind” Exchanges Doing Double Duty
Cost segregation and 1031 “like-kind” exchanges are both excellent tax-deferral strategies that can reduce your taxes. Taken together, the two methods offer even greater benefits for smart property owners.
Most owners of commercial property — from a large industrial building to the increasingly popular business condominiums — are aware of the value of IRC Section 1031 exchanges. In these transactions, commonly known as “like-kind exchanges”, owners dispose of business or investment property through a qualified intermediary, and the proceeds of the sale are used to purchase a replacement property of like kind. The transactions allow owners to defer taxes on all or a substantial portion of a gain on that sale. The replacement property typically has a carryover tax basis that is calculated by subtracting the gain deferred through the exchange from the value of the replacement property.
While 1031 exchanges have been around for a number of years, cost segregation is a newer, but now widely used tax-deferral strategy by commercial real estate owners. Cost segregation is the practice of identifying and segregating the depreciation of building components that support personal property or are related to the business activity rather than to the building itself. The building components that are reclassified from real property to personal property can be depreciated over substantially shorter time periods — ranging from 5 to 15 years — as opposed to 39 years for commercial property, using the standard straight-line method. Personal property can also employ accelerated, front-end loaded methods of depreciation, such as 200% or 150% declining balances, for even faster write-offs.
Essentially, cost segregation reflects the reality that while a building may well continue to be functional over four decades, there are many components — from carpeting and cabinets to landscaping and lighting fixtures — that will need to be replaced many times by then.
Cost segregation saves even smaller property owners tens of thousands of dollars through deferred taxes. A number of studies have suggested that as much as 25% to 30% of a property’s basis could be eligible for the accelerated depreciation. To make this determination, you’ll need the help of your CPA and perhaps an engineering consultant that can conduct the detailed study required.
Combining 1031 Exchanges with Cost Segregation
Recently, it has become clear that real estate owners can take advantage of both 1031 exchanges and cost segregation, enjoying the tax advantages of both strategies. According to an article in the Journal of Accountancy (August 2005):
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 property for section 1031 purposes, but personal property for 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.
In other words, you can have your cake, and eat it too!
A Few Considerations
Obviously, before embarking on these strategies, property owners need to consider a few factors.
First, will cost segregation be beneficial for the property you own? Borelli Investment Company performs cost segregation studies on each of the business condominiums it offers at its hot-selling complexes, such as AirTech Office Condominiums, Junction Office Center and Ringwood Business Center. Owners are, of course, advised to consult with their CPAs and are free to arrange for their own engineering studies if they wish.
Second, as a property owner, you should consult with your CPA about the impact of depreciation recapture in the future as a result of the cost segregation study, should you later dispose of the property through a 1031 exchange.
Regardless of some of the future risks, cost segregation offers such significant present value benefits through accelerated depreciation that the advantages often outweigh any potential disadvantages should a 1031 exchange later take place.
The bottom line is that relying on the two methods, buyers of Borelli Investment Company’s condominiums and other real property have tremendous potential to defer income taxes to future periods and improve their cash flow in the present.
For more information about cost segregation and 1031 exchanges, contact Borelli Investment Company at www.borelli.com, or call (408) 453-4700.