1031 exchange and cost segregation: Two powerful tax tools that can be used together

Cost segregation is a powerful tax strategy that helps you create more cash flow out of your commercial properties by increasing the amount of depreciation expenses you claim sooner in your property’s lifecycle. However, you can magnify that impact when purchasing new properties by combining a cost segregation study with a 1031 exchange. 

In this article, we’ll explain what both tax strategies are and how to best use them together. 

What is 1031 exchange? 

Named after section 1031 of the IRS code, a 1031 exchange is considered a ‘like-kind exchange’. It allows investment property owners to defer paying capital gains taxes after selling a property if another ‘like-kind’ property is purchased using profits from the sale. 

Using this tax advantage can make a significant impact on your yearly cash flow through a greatly reduced tax burden. Instead of being hit with tens or hundreds of thousands in capital gains taxes, you can grow your real estate portfolio in other ways or re-invest your tax savings back into your business. 

There are, however, specific rules to be aware of and mistakes can be costly. The most important of which is that the ‘like-kind exchange’ must happen within a certain timeline (e.g. you must close on a new like-kind property within 180 days) in order for the purchase to be eligible for the tax benefit. It’s always advisable to discuss using a 1031 exchange with your CPA before moving forward.  

How does a 1031 exchange affect depreciation recapture?

Property owners utilizing a 1031 exchange must be aware of depreciation recapture, as it can profoundly affect potential tax liability down the road. Depreciation recapture is a tax that you pay upon the sale on the amount of depreciation you’ve claimed on your property over the length of your ownership. This tax applies whether or not you’ve done a cost segregation study and taken accelerated depreciation on certain components of your property. 

Some property owners who use a 1031 exchange assume that they’re able to skip out on paying depreciation recapture altogether. The truth is they are not eliminating it, just deferring it along with their capital gains tax. So, if you eventually sell your property without doing another 1031 exchange, both the capital gains tax deferment and depreciation recapture will come due. 

How can a cost segregation study impact a 1031 exchange?

Doing a cost segregation study can provide benefits outside of increasing the amount of depreciation expenses you can claim on your next return and boosting your cash flow. 

The most advantageous tax strategy for your investment properties is to purchase a like-kind property using a 1031 exchange to defer both capital gains and depreciation recapture. Then, you do a cost segregation study on the new property. 

This helps you achieve three beneficial outcomes:

  1. When purchasing a like-kind property for a 1031 exchange, the new property must contain as much personal property as the building you’re selling. Doing a cost segregation study can identify all like-kind personal property on the new property, which helps you ensure that you can take the capital gains deferment. 
  1. You’re able to take accelerated depreciation expenses starting on year one of owning your new property, which maximizes your cash flow on top of the savings you gained from avoiding capital gains and depreciation recapture. You can even take bonus depreciation if that makes sense (based on the results of your cost segregation study). 
  1. If you continue this strategy for the rest of your life for every new investment property, you could continue enjoying maximum tax savings and possibly eliminate capital gains taxes and depreciation recapture for your heirs. That’s because the step-up in basis rule that goes into effect when your property is passed on after death increases the ‘cost basis’ of your property to a fair market value. Increasing the cost basis can decrease or eliminate the capital gains and depreciation recapture taxes owed by your heirs. Talk to your tax advisor to make sure you’re setting this up correctly. 

So, in a nutshell, the most advantageous tax strategy for your commercial investment properties is to purchase through a 1031 exchange whenever possible and to always do a cost segregation study on a new property within the first year. Repeat for the rest of your life to provide maximum benefit to your heirs as well. 

A better way to do cost segregation studies

Traditional cost segregation studies can be long, cumbersome, and expensive. They require a team of engineers to pour over every nook and cranny of your property and can take months to complete. At Commercial Property Refund, we’ve created a new, proprietary software for completing cost segregation studies in a shorter time frame while strictly adhering to IRS guidelines.  

Interested in learning how much you can save on your next tax return through a cost segregation study? Check out our free commercial property refund calculator to get an estimate in minutes. 

About Author

Richard Bourgault

Graduating from Georgia Tech with a degree in Electrical Engineering, Richard has gained over a decade of expereince in Cost Segregation coupled with software UX.

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