Cost Segregation & 1031 Exchanges: Combining Tax Strategies for Real Estate

For years, real estate investors have leveraged industry-specific tax strategies to minimize their overall tax liability. Two of the most effective and commonly utilized strategies are cost segregation studies (conducted upon purchase) and IRC Sec. 1031 exchanges (a type of like-kind transaction made at the time of sale). These strategies have been key factors contributing to significant tax savings by real estate investors over the years.

Key Takeaways:

• Cost segregation is an IRS-approved, engineering-based study that reclassifies building components into five-, seven-, and 15-year asset categories, accelerating depreciation and increasing cash flow.
• A 1031 exchange allows real estate investors to defer capital gains taxes by reinvesting sale proceeds into a like-kind replacement property through a qualified intermediary.
• The TCJA limited 1031 exchanges to real property, but IRS final regulations (T.D. 9935) confirmed that most building components identified through cost segregation qualify as real property for exchange purposes.
• Combining cost segregation with a 1031 exchange allows investors to accelerate depreciation deductions on replacement properties while deferring gains from the sale of the relinquished property.
• Investors must observe strict 1031 timelines: 45 days to identify replacement property and 180 days to complete the exchange.
• Proper documentation, qualified professionals, and periodic reviews are essential to maintain IRS compliance when using both strategies together.

What is a Cost Segregation Study?

Cost segregation is an IRS-approved engineering-based study in which an engineer performs a site tour walkthrough of a property and identifies the IRC Sec. 1245 personal property with accelerated useful lives, segregating it from the IRC Sec. 1250 real property. Cost segregation studies are generally done during the earlier stages of the owner’s use, such as at the time of purchase or time of improvement.

In a  cost segregation study, engineers identify and quantify various building assets, assigning each asset a cost based on IRS-approved pricing guides. These costs are then categorized according to their depreciable asset class lives. Base building or "shell" assets remain in their default MACRS class life for real property; however, many assets can be reclassified into shorter-lived categories:

• 5-Year Assets: Carpet flooring, countertops, breakroom sinks, cabinetry and decorative moldings, specialty lighting, dedicated outlets, fire extinguishers, and more
• 7-Year Assets: Office furniture
• 15-Year Assets: Land improvement such as drainage pipes, parking lots, landscaping, outdoor swimming pools, protective bollards, sidewalks, and more

By segregating these assets into shorter-lived categories, they can be depreciated more quickly, resulting in tax savings and increased cash flow.

What are the Tax Benefits of Cost Segregation Studies?

Cost segregation studies  allow real estate investors to accelerate significant amounts of depreciation into the earlier periods of asset ownership and increase cash flow by increasing depreciation expense in earlier years, thus reducing their income tax liability through a non-cash expense. Other benefits include:

• Defines and quantifies shorter-lived assets that qualify for bonus depreciation under the Tax Cuts and Jobs Act (TCJA).
• Provides data to support decisions on expensing under the Tangible Property Regulations.
• Identifies and segregates assets disposed and therefore eligible for the PAD election in a renovation.
• Defines and documents assets eligible for Section 179 treatment.

Which Properties Qualify for Cost Segregation?

A wide range of commercial and residential properties can benefit from cost segregation, including:

• Office buildings
• Hotels
• Retail spaces
• Garden-style multifamily apartment complexes
• Industrial/manufacturing facilities
• Auto dealerships
• Self-storage facilities
• Triple Net Lease Properties

Cost segregation can also be applied to not-for-profit tenants in for-profit spaces, a trend that has been increasingly observed lately.

What is a 1031 Exchange?

A 1031 exchange, also known as a like-kind exchange, allows real estate investors to sell or swap one investment property for another while deferring taxes on the capital gains. The proceeds are held in escrow through a qualified intermediary, with specific timelines for identifying and purchasing replacement property.

Can You Combine a Cost Segregation Study With a 1031 Exchange?

While the Tax Cut and Jobs Act (TCJA) introduced changes to 1031 exchange rules, combining cost segregation studies with these exchanges is still possible. A key concern was whether personal property identified through a cost segregation study would disqualify a property from a 1031 exchange.

However, after drawing on legal precedents like Whiteco Industries Inc. vs Commissioner, tax professionals have clarified that many components previously considered personal property can be treated as real property for 1031 exchange purposes. This includes items like flooring, cabinetry, and certain fixtures that fit the definition of being considered permanently affixed to the building.

By combining these two powerful tax strategies, real estate investors can maximize their tax benefits by accelerating depreciation deductions on replacement properties acquired through 1031 exchanges.

How Do You Stay Compliant When Combining These Strategies?

When leveraging cost segregation studies and 1031 exchanges, it’s important to stay compliant with IRS rules to avoid penalties and noncompliance which would negate the benefits of either strategies. Key guidelines and compliance tips include:

• Engage qualified professionals: Work with experienced tax advisors and engineers who specialize in cost segregation and 1031 exchanges to make sure you receive accurate and compliant studies.
• Proper documentation: Maintain thorough records of all assets identified in the cost segregation study, including detailed descriptions, costs, and classifications.
• Follow IRS Guidelines: Adhere to IRS guidelines for asset classification, depreciation schedules, and the specific requirements for 1031 exchanges, such as the 45-day identification period and the 180-day completion period.
• Regular Reviews: Periodically review your cost segregation studies and 1031 exchange transactions with your tax advisor to maintain ongoing compliance and address any changes in tax laws or regulations.
• Stay informed: Keep up-to-date with any changes in IRS rules and regulations related to cost segregation and 1031 exchanges to make sure your strategies remain compliant and effective.

Ready to Maximize Your Real Estate Tax Savings?

Every property and transaction is different, and the right combination of cost segregation and 1031 exchange strategies depends on your specific portfolio and goals. Our real estate tax professionals can evaluate your situation, identify opportunities, and help you build a plan that reduces your tax liability at every stage of ownership. Fill out the form below to start the conversation.