Cost Segregation After a 1031 Exchange: Stacking Two Tax Tools

A 1031 exchange solves one problem: the tax on the property you sold. It does nothing, on its own, to reduce tax on the income from the property you bought.

Cost segregation addresses the second problem. It can accelerate depreciation on the replacement property so that more of the deductions arrive in the early years, when they are most valuable. The two tools stack, but not in the simple way some marketing suggests.

What is cost segregation?

An engineering based study that splits a building's cost into components with shorter depreciation lives.

A commercial building normally depreciates over 39 years and residential rental over 27.5. But a building is not one thing. It contains carpeting, certain electrical and plumbing serving specific equipment, cabinetry, parking lots, landscaping and other items that the tax code allows to be depreciated over 5, 7 or 15 years instead.

A cost segregation study identifies and values those components so they can be depreciated faster. The total depreciation over the life of the property is the same. What changes is when you get it: more in the early years, less later.

How does a 1031 exchange affect the depreciable basis?

This is the part that is often misunderstood.

In an exchange, your basis in the old property carries into the new one. That carried over basis generally continues to be depreciated on the old schedule, as though the old building simply continued. It does not restart as a brand new 39 or 27.5 year asset.

If you trade up, spending more than the carried over basis by adding cash or taking on more debt, that extra basis is treated as newly acquired property. It depreciates on a fresh schedule, and it is the portion most clearly available for cost segregation.

There is also an election that allows the entire basis to be treated as newly placed in service, which simplifies calculations but gives up some of the remaining depreciation from the old schedule. Which approach is better depends on the numbers.

Where does cost segregation create value?

• ›When you trade up significantly. The larger the new money or new debt, the larger the fresh basis available for faster depreciation.
• ›When the replacement has substantial short life components. Hotels, medical offices, self storage and multifamily with significant interior improvements often produce larger reclassifications than plain warehouses.
• ›When bonus depreciation rules allow front loading. Short life components may qualify for bonus depreciation depending on the rules in force when the property is placed in service, which can bring a large share of the deduction into the first year.
• ›When you have income to offset. Deductions are only valuable if you can use them, which depends on passive activity rules and whether you qualify as a real estate professional.

What is the trap?

Faster depreciation now means more depreciation recapture later.

Every dollar of accelerated depreciation reduces your basis. When the property is eventually sold in a taxable sale, that depreciation is recaptured. Depreciation on the short life components can be recaptured as ordinary income, at rates potentially higher than the 25 percent that applies to building depreciation.

There is also a subtler issue for exchanges. Since 2018, only real property qualifies for 1031 treatment. Components that were classified as personal property in a cost segregation study may not be exchangeable in the future, which can create recapture even inside an otherwise successful exchange. How much of a problem that is depends on the components and on how the next exchange is structured.

When is it worth it?

Cost segregation studies cost money, often several thousand to tens of thousands of dollars depending on the property. They tend to pay off when the replacement property has substantial new basis, the owner can use the deductions, and the expected hold is long enough for the time value of the deductions to matter.

They pay off less when the replacement basis is mostly carried over, the owner cannot use passive losses, or a taxable sale is expected soon.

What about Delaware Statutory Trust interests?

Investors in a DST receive their share of the trust's depreciation, which the sponsor calculates. Some sponsors perform cost segregation on the trust's property. It is worth asking whether they do, and how the depreciation is allocated, because it affects the tax picture of the distributions.

Can you do a cost segregation study on a property you already own?

Yes. If you acquired a replacement property in an earlier year without a study, a look back study can often be performed later. The missed accelerated depreciation can generally be caught up in the current year through a change in accounting method, rather than amending prior returns.

That makes cost segregation a decision you can revisit. If your income rises, your tax position changes, or you realise the building contains more short life components than expected, a study can still produce value years after purchase.

How does this fit the long term exchange plan?

For investors who intend to exchange repeatedly and hold until death, accelerated depreciation can be especially attractive. The deductions reduce tax during life, and if the property is held until death, heirs generally receive a stepped up basis that can eliminate the deferred gain and the recapture that would otherwise have been due.

For investors who expect a taxable sale within a few years, the calculation is less favourable, because the recapture arrives soon after the deductions. Matching the depreciation strategy to your exit plan matters more than the size of the first year deduction.

What to do first

Before closing on a replacement property, ask your CPA to estimate the depreciable basis split between carried over and new basis, and whether a cost segregation study is likely to produce a meaningful benefit given your income and plans. If the answer is yes, commission the study in the year the property is placed in service.

Nothing here is tax, legal or investment advice. Depreciation rules change and depend on your circumstances. Confirm your plan with your CPA before acting.