A 1031 or “like-kind exchange” is a well-known advantageous election allowing real estate taxpayers to defer the tax on gains from a sale or disposition by reinvesting the entire proceeds in like-kind property. A cost segregation study is a tax planning strategy that allows commercial and residential real estate owners to accelerate depreciation deductions. Combining a 1031 and cost segregation is a home run for the real estate taxpayers.
In the following sections, we will detail each stage of such a transaction. Using examples, we will first briefly review the benefits of a section 1031 exchange. Then, we will detail how a cost segregation study can unlock further value, before exploring bonus depreciation.
1031 101: Tax Deferral
In a typical 1031 exchange situation, the gain is deferred. For example, a taxpayer purchases a building for a $500,000 and the property has appreciated in value to $700,000. The building has been depreciated by $150,000 and has adjusted tax basis of $350,000 after depreciation. The investor could sell the building for $700,000 and realize a taxable gain of $350,000. But if the investor were to complete a like-kind exchange and acquire another property valued at $1 million, the investor would be able defer the gain and roll the gain into the replacement property. The basis in the replacement property is calculated by reducing the cost of the replacement property by the deferred gain: a $1 million cost, less $350,000, equals the new basis of $650,000.
1031 102: Separating Components for Depreciation
In situations involving excess basis, the taxpayer can elect to treat the adjusted basis of the relinquished property as if it was disposed at the time of the exchange, then treat the carryover basis and excess basis as if the replacement property was placed in service on the date it was acquired. The depreciable basis is now the adjusted basis of the exchanged property plus any additional amount paid.
The combined carryover basis of the replacement property can now benefit from a cost segregation study on the replacement property. The resulting analysis will apply to all aspects of the combined basis. So, a tax basis which would depreciate over 27.5 years for residential property or 39 years for nonresidential property can be separated into components that are not real property for tax purposes and therefore subject to quicker depreciation periods of five, seven or 15 years.
1031 103: Bonus Depreciation
Bonus depreciation allows for an immediate deduction of a percentage of the cost of qualifying assets in the year it is placed into service. Remember that, in the example above, the replacement property was placed into service in the year it was acquired. Furthermore, as the statute stands, bonus depreciation is 60% for 2024 and reduced by 20% for each following year — so 40% in 2025 and 20% in 2026 before reaching 0% in 2027.
Until 2027, then, taxpayers may qualify for bonus depreciation on the portion of the excess basis attributable to qualifying property identified in a cost segregation study.
That means that the more expensive replacement property from our previous example (the replacement property valued at $1 million) now carries a tax basis of $650,000 with $300,000 of excess basis. Any personal property or land improvements allocated to the excess basis qualifies for bonus depreciation.
The Fine Print
Not all states allow for bonus depreciation. Instead, they require the “addback adjustment” restoring the difference between the federal bonus depreciation claimed and the depreciation without the bonus. Always consider the state tax statutes that apply in your circumstances as they could result in state tax liability to increase when bonus depreciation is claimed.
Applying Tax Advantages
Powerful incentives can be realized by combining likekind exchanges under Section 1031 with cost segregation studies. Applying these strategies effectively requires taxpayers to consult with tax professional who can provide tailored advice to maximize the benefits and comply with tax laws.
Joel Berenson
Managing Director
CBIZ (Formerly Marcum LLP)
Boston, MA
joel.berenson@cbiz.com
