Tax Strategy Combinations – Cost Segregation & 1031 Exchanges

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. 

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. 

Eligibility for Cost Segregation Studies 

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.  

Cost Segregation Study on 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.  

IRS Guidelines and Compliance for Cost Segregation Studies for 1031 Exchanges  

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.  

If you need help to determine the suitability of cost segregation studies for your specific situation and make informed decisions that align with your financial goals, reach out to our team by filling out the form below.