Cost Segregation and 1031 Exchanges: What You Need to Know

By Peter A. Elwell, CFA | April 10, 2023

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A cost segregation study is an effective way to minimize tax burdens and maximize depreciation deductions, while a 1031 exchange enables you to defer capital gains taxes on the sale of an investment property. Cost segregation and 1031 exchanges are two ways investors create a tax planning strategy.

For instance, a real estate investor can use a cost segregation study to accelerate depreciation and increase cash flow, but once they decide to sell the property, they may be met with depreciation recapture. By performing a 1031 exchange, investors can defer capital gains taxes by purchasing new, like-kind properties. These exchanges and cash segregation studies can help investors avoid depreciation recapture and reap tax benefits.

Learn more about cost segregation in real estate with this guide.

What Is Cost Segregation?

Savvy real estate investors take advantage of opportunities to minimize their tax liability. One way to do this is through cost segregation — a tax planning practice that reduces taxable income by accelerating depreciation. 

Depreciation involves deducting the value an asset loses over time due to wear and tear from average use. Under the General Depreciation System (GDS), residential properties depreciate over 27.5 years, and commercial properties depreciate over 39 years. While most real estate depreciates as a whole, cost segregation can speed up the process for certain components of the property.

Whether you invest in a residence or an office, the building includes more than just the structure itself. It also has plumbing, lighting, carpeting, and many other features that make it usable. These assets would depreciate over five, seven, or 15 years when purchased separately. However, they are typically included as part of the property acquisition and not independently after investing.

Real estate investors can speed up the depreciation timeline for certain building components by performing a cost segregation study on the property, reducing their tax liability. 

A cost segregation study is a tax deferral procedure performed by tax advisors and engineers who examine and break down the interior and exterior components of a building and reclassify them.

What Is a Cost Segregation Study and When Should It Be Conducted?

A cost segregation study is a tax deferral procedure performed by tax advisors and engineers who examine and break down the interior and exterior components of a building and reclassify them, such as:

  • Fencing
  • Carpeting
  • Sidewalks
  • Lighting fixtures
  • Plumbing fixtures
  • Ventilation system
  • Electrical components dedicated to appliances or equipment

In addition to these components, tax advisors and engineers will also evaluate all available records, blueprints, inspections, and documents related to the property. This process allows them to identify all property-related costs that can be depreciated, decide how much each property element costs on its own, and determine which ones fall into tax categories that can be written off much faster than the structure itself.

When these items are replaced, owners can claim a loss deduction. Cost segregation studies provide investors with an accelerated depreciation timeline for the components so they may receive deductions for their real estate assets in the early years of owning the property.

If you’ve purchased a property or recently completed a 1031 exchange, it’s best to have a cost segregation study performed during the year you acquire it. It’s also a good idea to have a cost segregation study done before you do any construction or remodeling.

Cost segregation sets the baseline for the original purchase, so performing the study before the remodeling or improvements makes it easier for the tax advisors and the Internal Revenue Service (IRS) to calculate remodeling costs and depreciation.

Example of Cost Segregation

Let’s say you obtain a multifamily residential property through a 1031 exchange for $1 million. It’s determined that the value of the improvements is $800,000 and the land is worth $200,000.

Land isn’t depreciable, so with standard depreciation over 27.5 years for residential properties, you could take $29,091 as your annual depreciation expense.

However, you can use a cost segregation study to classify $100,000 as land improvements with a depreciation term of 15 years and $75,000 as equipment with a depreciation term of five years. This reclassification reduces the building value to $625,000. Using these categories, you can take annual depreciation of $6,667 for land improvements, $15,000 for equipment, and $22,727 for the building, which brings your total depreciation deduction to $44,394.

You can also take advantage of bonus depreciation during the first year of ownership under the Tax Cuts and Jobs Act (TCJA). Under the TCJA, you receive 100% depreciation for land improvements and equipment for the first year in addition to accelerated depreciation. This means you can take an additional $175,000 in depreciation deductions, increasing your total the first year to $219,394.

Since this deduction is likely more than the property’s annual income, you can recognize zero income for the first year and carry the loss forward for future use. For example, say the property’s income was $50,000. In that case, you have deductions of $169,394 to carry forward into the second year. Your second year’s deductions will be the amount carried forward plus the segregated depreciation of $44,394 for a total of $213,788, which is still more than the annual income. You can carry the difference forward year after year and won’t need to pay income taxes until the income is more than your deductions.

How Does the Cost Segregation Process Work? 

Though we briefly discussed how a cost segregation study works, let’s examine the details of this process more thoroughly. The first thing to note is that the IRS does not maintain specific standards or required procedures for a cost segregation study, though they do provide a general guide for this process. However, the more accurate and detailed the study is, the faster the IRS can review it and provide the investor with their deductions.

Most cost segregation studies involve the following steps:

  1. Conducting a feasibility analysis to evaluate your current tax status and whether tax savings apply to your property
  2. Evaluating the building’s construction cost by assessing systems and components
  3. Documenting these systems and components and identifying how they are used
  4. Collecting and reviewing property information, including construction documents, condition reports, and project specifications
  5. Providing a detailed review of the assets, including site improvements, electrical systems, and decorative finishes
  6. Classifying each interior and exterior building component in their appropriate tax life using IRS guidelines
  7. Outlining indirect costs to each asset
  8. Writing and completing a report with study results, property photos, and relevant tax law to support asset classification
  9. Completing the necessary tax forms

Benefits of Cost Segregation

Segregating the costs of a property can provide significant long-term savings, but they may not be for everyone. The cost of cost segregation studies is usually around $10,000 to $15,000 — so they’re typically used by rental property owners or commercial real estate investors with significant real estate activity. 

Even with this upfront cost, investors can benefit from the tax savings from accelerating depreciation deductions, potentially leading to significantly increased cash flow over the first few years. Cost segregation studies also quantify your property’s major components and improvements, meaning you can write them off when you replace or remove them. Finally, using cost segregation specialists with the right expertise provides an independent third-party analysis that will withstand IRS review.

With that in mind, if your investment doesn’t generate enough money to offset the cost segregation study’s price, it may not be the right choice. Potential cost savings are highest for real estate investors with significant property investments. Cost segregation can potentially lead to tens of thousands in tax savings for those parties. However, you will reverse any upfront benefits if you decide to sell your property within a short period. So, if you don’t plan to keep the property for the long term — typically three to five years — a cost segregation study may not be the right fit.

If you believe you could benefit from a cost segregation study, it’s essential to work with qualified professionals who will conduct the study in accordance with current IRS standards.

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1031 Crowdfunding can help you find investment vehicles focused on tax deferral through our real estate investment platform. We offer some DST investments with cost segregation analysis already done, meaning you get the benefits of the analysis without having to complete the study yourself. With a 1031 exchange, you can gain the advantages of both tax strategies. Register with us today to access our marketplace of 1031 exchange-approved properties and speak with our real estate investment experts.

This material does not constitute an offer to sell or a solicitation of an offer to buy any security. An offer can only be made by a prospectus that contains more complete information on risks, management fees and other expenses. This literature must be accompanied by, and read in conjunction with, a prospectus or private placement memorandum to fully understand the implications and risks of the offering of securities to which it relates. As with all investing, investing in private placements is speculative in nature and involves a degree of risk, including loss of your principal. Past performance is not necessarily indicative of future results and forward-looking statements and projections are not guaranteed to achieve the results described and your actual returns may vary significantly. Investments in private placements are illiquid in nature and there may be no secondary market or ability to sell the investment should the need for liquidity arise. This material should not be construed as tax advice and you should consult with your tax advisor as individual tax situations will vary. Securities offered through Capulent, LLC Member FINRA, SIPC.

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