Tax Strategy Combinations – Cost Segregation & 1031 Exchanges
- Mar 2, 2023
- Avi Jacob
For years, real estate investors have been taking advantage of industry-specific tax strategies to reduce their overall tax liability. Two of the most common and best strategies utilized have been cost segregation upon a purchase and IRC Sec. 1031 like-kind exchanges at the time of sale. In fact, these two strategies have been the main factors for significant tax savings by real estate investors for many years.
So, what is cost segregation? 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 out 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 time of purchase or time of improvement. Using this strategy, real estate investors can accelerate significant amounts of depreciation into the earlier periods of the ownership of the asset and increase cash flow by increasing depreciation expense in earlier years, thus reducing their income tax liability through a non-cash expense.
Despite IRC Sec. 1031 being part of the Internal Revenue Code since 1921, due to the significance of the tax savings, this has become a major target for recent presidential administrations as they look to increase revenue. President Obama proposed a limitation on the dollar amount of deferred gains allowed per taxpayer and President Biden proposed its elimination altogether.
However, after aggressive lobbying by various real estate groups, the IRC Sec. 1031 like-kind exchange has for the most part remained intact, and is still the best way for real estate investors to defer tax liabilities related to various gains and depreciation recapture at the time of sale.
An IRC Sec. 1031 exchange occurs when real property is sold and the proceeds of that sale are used to buy a replacement property of equal or greater value. Once a property is sold, the proceeds of the sale are then held in escrow through a qualified intermediary. The exchanger has 45 days to identify replacement property or properties, and 180 days to close on the identified property or properties. Should a replacement property be lower in value than the original property sold, the additional cash or reduction in debt from the initial sale would be considered “boot” and therefore taxable gain.
Using this strategy, real estate investors can defer the associated gains from the sale. Should an investor hold the replacement property or continue using this strategy until death, assuming lobbyists remain successful, the property would be transferred to the heirs as part of their estate with a stepped-up basis. The basis is stepped-up to the fair market value of the property at either the date of death or an alternative date up to six months after the date of the death. With the step-up in basis, the heirs would then eliminate any associated gains if the property is sold at the time.
In 2017, with the Tax Cut and Jobs Act (“TCJA”), Congress changed the IRC Sec. 1031 rules to limit the definition of “like-kind” exchanges to only include “real property.” While this change seems like it would not affect real estate investors, it threw the real estate industry into a frenzy. The tax strategy of using a cost segregation study and reclassifying assets as personal property appeared to now limit the portion of a real estate transaction that would still qualify within a1031 exchange. Initially, many tax professionals feared that the personal property identified through the use of a cost segregation study would automatically be disqualified from the 1031 exchange and be considered taxable “boot.”
To determine the exposure this new language in IRC Sec.1031 would cause, tax professionals went back to the drawing board and applied factors from the court case of Whiteco Industries Inc vs Commissioner. In this case, the tax court determined that, state law, which follows an inherently permanent rule based on fixation to land, does not apply to the definition of real property for federal income tax purposes. , This is a significant determination as it differentiates the treatment of real property for IRC Sec. 1031 from the definition of real property under state and local law. The tax court determined that for property to be considered inherently permanent for income tax purposes (and thus real property), a few tests must be performed:
- Is the property capable of being moved, and has it in fact been moved?
- Is the property designed or constructed to remain permanently in place?
- Are there circumstances that tend to show the expected or intended length of affixation, that is, are there circumstances which show that the property may or will be moved?
- How substantial a job is removal of the property and how time-consuming is it; is it readily removable?
- How much damage will the property sustain upon its removal?
- What is the manner of affixation to the land?
Using this distinction in language, tax professionals have gained comfort in determining that much of the IRC Sec. 1245 personal property identified in a cost segregation study can be treated as real property for 1031 exchange purposes. Some common examples of property that are affixed to the land and building and therefore meeting the state and local law definition of real property while still falling under the purview of IRC Sec. 1245 property would be flooring, cabinetry, countertops, and removable partitions. The remaining amount of IRC Sec. 1245 personal property identified would likely remain under the 15% incidental personal property safe harbor rules, and therefore not disqualify the exchange.
Based on these interpretations of the applicable tax laws for depreciation and IRC Sec. 1031, with proper planning and guidance from tax professionals, real estate investors can still take advantage of cost segregation along with 1031 exchanges.
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