Many investors are looking for ways to maximize their tax deferral and improve their investment opportunities. Cost segregation offers many benefits for investors and property owners, including increased cash flow. Pairing cost segregation and a 1031 exchange is one of the most valuable tax strategies investors can utilize, helping reduce operating costs and defer capital gains.
Below, we'll guide you through cost segregation, the benefits you stand to gain as a real estate investor or property owner, how tax-based depreciation calculations can vary and who should consider a cost segregation study for their property.
About Cost Segregation
Cost segregation is a tax strategy that identifies individual elements of a property and splits them into different categories. Real property has more assets than just the building itself, including plumbing fixtures, fencing and sidewalks.
If an investor purchases these assets separately, they would depreciate at a different rate. However, these assets are written off when purchased together as a building acquisition or development. They're considered to have the same useful life as the building itself.
The useful life for non-residential real property is 39 years, while the residential property is 27.5 years. Cost segregation will split assets into different categories and change their useful life to five, seven or 15 years. Real property is eligible for cost segregation if placed into service in 1987 or later. This includes purchased, constructed, remodeled or expanded buildings.
With new tax laws in place, conducting a cost segregation study at the same time as a 1031 exchange can greatly benefit taxpayers by improving their cash flow and saving on taxes. The Tax Cuts and Jobs Act (TCJA) has created new opportunities for investors to utilize a cost segregation analysis to identify short-life assets and assets that will be fully depreciated and retired. Once these assets are retired, they're no longer considered part of a Section 1031 exchange and therefore have no depreciation recapture tax.
Before the TCJA, Section 1031 rules applied to real and personal properties, with a few restrictions. These new laws have removed personal property for eligibility through a cost segregation study. Now, beneficial tax deferrals are only possible through the exchange and acquisition of real property.
The Benefits of Cost Segregation
When performed correctly and by a tax professional, a cost segregation study becomes a sizable asset for investors by reducing the amount of taxes owed for years. Residential and commercial property owners can enjoy substantial tax cuts and advantageous write-offs when an asset becomes damaged or needs to be completed replaced.
Investors can experience many other benefits from cost segregation studies, including:
1. Depreciation Time
Without a cost segregation study, many assets maintained the same useful life — 27.5 years for residential properties and 39 years for non-residential real properties. Cost segregation studies split various assets into different categories of depreciation.
The new regulations established by the TCJA allow investors to accelerate depreciation and deduct 100% of assets within the first year of service that will depreciate in five, seven or 15 years.
2. Tax Savings
If your property's structural components have been appropriately segregated by a tax professional, each component can be depreciated over the correct tax life. Accelerated depreciation will also reduce tax liability owed to local, state and federal entities.
The more investors save on taxes, the more money they'll be able to put towards other uses, such as portfolio diversification or property improvements.
3. Retroactive Savings
Cost segregation studies can be done retroactively to determine unrecognized depreciation in properties acquired in the last three years. However, the statute of limitations can go further by requesting a change in your accounting method with the IRS.
Once the cost segregation study is complete, the amount of depreciation that should've been claimed is subtracted by the amount you've actually claimed throughout the years, and what remains is the new deductible.
4. Cash Flow
By maximizing depreciation deductions in the property's early years, accelerating depreciation of specific assets and deferring local, state and federal income taxes, investors can increase their cash flow. Reducing the taxable income of a property will allow investors to reinvest tax savings into other business ventures, which can help increase cash flow further.
5. Expensing and Retiring Assets
Investors can report the costs of certain assets once the accounting period comes around according to the assets' depreciation schedule. Once these expenses have been reported, the asset can be retired. For example, if your property has an air conditioning unit that stops working, you can report the expenses and take an immediate deduction equal to the remaining value of the asset.
6. Tax Relief
If the property needs renovations, remodels or additional structural development, property owners might be responsible for the cost of construction materials that won't be used or sold for a reduced price. A cost segregation study will assign a specific value to the products and construction materials that go unused, creating additional tax deductions for property owners.
7. Early Retirement Loss
Early retirement is appealing but can reduce benefits by five-ninths of 1% for each month, lasting for 36 months or until reaching regular retirement age. If more than 36 months go by before reaching regular retirement age, benefits are reduced by five-twelfths of 1%.
These losses can be made up by utilizing the savings gained from cost segregation. Investors can also choose to reinvest their savings into other profitable properties and use the money earned to fund early retirement losses.
How to Minimize Recapture Tax
The benefits of cost segregation studies can be an excellent asset to investors and property owners. Many investors and property owners worry about recapturing regarding cost segregation studies, but there are ways to minimize this tax. Recapture is a tax incurred once a depreciated building or building asset is sold. The gains made from the sale of a property would fall under a recapture tax for what can be depreciated at the time of sale.
Cost segregation studies create substantial depreciation deductions for the current investor or owner. These studies can still be beneficial for investors, despite the recapture tax, as long as steps are taken to minimize the tax.
First, it's recommended to hold a property for at least three to five years after a cost segregation study is completed. By holding the property for this time, you can use the newfound cash flow to invest in new property, equipment or employees for your business. By using extra funds, you're increasing the potential or increased gains. The cash flow earned after depreciation deductions will offset the recapture tax once it's time to sell the property.
Second, a cost segregation study will separate each asset according to a different depreciation schedule, so it's essential to look at how the property's sales prices will be allocated. Each asset will be sold, including real property, tangible personal property and land property. Personal property often loses value over five years before entirely depreciating.
Rather than assigning more gain to assets that will depreciate, more gain should be assigned to appreciating assets that will gain value over time, such as land improvements. Properly assigning gain will reduce the recapture tax once it's time to sell the property.
If you take these steps to minimize recapture tax, recapture shouldn't be cause for concern or prevent investors from taking advantage of cost segregation studies. These studies are often more of an asset to investors and property owners than a liability. You can even use the increased cash flow to pay off debts, further invest in your business or portfolio or fund capital improvements.
How Tax-Based Depreciation Calculations Vary Based on the Circumstances
If an investor has acquired a like-kind property through a 1031 exchange, it's essential to have tax preparers look at several factors to determine the carryover depreciation. Additionally, further analysis will be necessary if a cost segregation study is considered simultaneously. With new tax laws, such as the TCJA, conducting a cost segregation study at the same time as a 1031 exchange can offset tax liability for personal property.
When real property is obtained through a 1031 exchange, taxed-based depreciation calculations will vary based on different circumstances. One of the reasons depreciation calculations can vary is because of bonus depreciation. Under the new laws and regulations established by the TCJA, specific properties are now eligible for 100% bonus depreciation. Properties that were obtained and placed in service after September 27, 2017, are eligible for bonus depreciation.
However, properties that aren't in service by January 1, 2023, are not eligible. Bonus depreciation can only be applied to properties with a tax life of 20 years or less. The more excess basis a property has, the more it'll benefit from bonus depreciation.
For example, a property sold through a 1031 exchange for $1 million has $700,000 worth of depreciation at the time of the exchange. If the property received during the exchange is sold for $1,500,000, only the excess basis of $500,000 will be eligible for bonus depreciation. Qualifying assets can be written off for the first year once placed in service.
There are two additional circumstances where like-kind exchange depreciation calculations will vary:
1. Like-Kind Properties
For property acquired during a like-kind exchange, taxpayers have to depreciate the value of the carryover basis. The same depreciation method and convention must be used for the relinquished and acquired property. Calculations for depreciation will need to be done separately for the excess and carryover basis.
With this option, cost segregation for the newly acquired property is only allowed for the excess basis. This option is best suited for properties that have reached or are nearing the end of their tax life.
2. Relinquished Properties
Taxpayers can handle the adjusted basis of the relinquished property as though it were disposed of once it's time for the 1031 exchange. The carryover and excess basis can be treated as though it's in service at the date of the exchange.
If you add the property's adjusted basis to the additional amount paid for the property, that will be the new depreciable basis. It's now possible for taxpayers to use various preferred methods for depreciation while also simplifying their record-keeping process.
Incorporate a 1031 exchange and cost segregation analysis once you've closed on the replacement property. You can get an estimation of the benefits of a cost segregation study on the new property and determine if the benefits are worthwhile for your investment. If you believe the benefits to be advantageous, you can take the necessary steps to receive a cost segregation analysis by the time of your filing date.
Who Shouldn't Pursue a Cost Segregation Study
Before the TCJA, properties acquired through a 1031 exchange with a cost basis of less than $1 million or $2 million weren't the best candidates for a cost segregation study, but that has since changed. Properties with depreciation costs of at least $750,000 could stand to benefit from cost segregation, making these studies valuable for smaller acquisitions.
While cost segregation can be beneficial for many investors, there are certain instances where it's not the best option. If you're holding property for three years or less, a cost segregation study won't be as valuable. The study will depreciate the value of certain assets to five, seven or 15 years, so you won't see as many of the benefits if you're only holding the property for three years.
If you're holding the property for three years or less and have a 1031 exchange strategy in place, cost segregation may still be suitable for you. You'll be able to defer your gains and depreciation recapture, but cost segregation studies would need to be conducted on the replacement properties to avoid future taxation.
Additionally, cost segregation can cause some complications with a 1031 exchange. If the like-kind replacement property has fewer section 1245 properties than the relinquished property, the person doing the exchange may need to recapture the initial depreciation.
After a cost segregation study, making property improvements can also create complications and tax consequences once the property is sold or exchanged. If the improvements are determined to have value, the seller will need to recapture the preceding depreciation as regular income. There may also be an additional tax on gains made at the sale or exchange of the property.
Reap the Benefits of Cost Segregation and Contact 1031 Crowdfunding
Cost segregation is a tax strategy that many investors and property owners use to increase their cash flow, maximize their tax savings and reduce their tax liability. Investors and property owners can use increased cash flow to fund additional investments, make qualified property improvements and pay off debts. Cost segregation studies offer the most benefits when paired with a section 1031 exchange.
If you want to learn more about how a cost segregation study paired with a tax-deferred 1031 exchange can benefit your investments, browse our website or give us a call at (844) 533.1031 to speak with one of our representatives.