Global Tax Insights
Real Estate Investors and Developers: Cost Segregation Studies Can Boost Like-Kind ExchangesNovember 12, 2019
Under the Tax Cuts and Jobs Act (TCJA), cost segregation studies may help businesses reap more tax savings from like-kind exchanges. Here are the details.
Like-kind exchanges under Internal Revenue Code Section 1031 have long been a popular way for businesses to defer their taxes on the gain generated as a result of selling certain property. While the TCJA has restricted the exchanges to real property, certain types of personal property may still qualify for the deferred treatment. Here’s how a cost segregation study can help you identify such property and reduce your tax liability.
TCJA’s Impact on Cost Segregation Studies
For tax purposes, commercial buildings are generally depreciated over 39 years, and apartment buildings and other types of residential property are depreciated over 27.5 years. But businesses can use cost segregation studies to take advantage of shorter useful lives and accelerated depreciation methods, including bonus depreciation and Sec. 179 expense deductions, for certain building components.
Under the TCJA, the bonus depreciation program was temporarily expanded, and the annual limit on Sec. 179 expensing has been permanently increased to an inflation-adjusted $1 million. (For 2019, the inflation-adjusted amount is $1.02 million.) A business that claims such deductions will pay the same total amount in taxes over an asset’s useful life, but it claims the deductions earlier. This reduces its taxes in the short term and produces greater cash flow in the year an asset is placed in service.
Real property frequently encompasses different types of assets that have different depreciation recovery periods. Owners usually segregate such property into individual components or asset groups with the same recovery periods and placed-in-service dates to maximize their depreciation deductions.
How to Supercharge Like-Kind Exchanges
For tax purposes, an exchange of property generally is treated as a sale, which may trigger a taxable gain. However, the gain may be deferred utilizing a like-kind exchange.
A like-kind exchange occurs when you exchange business or investment property (the relinquished property) for business or investment property of a qualified like kind (the replacement property). Sec. 1031 permits you to make such exchanges without recognizing any gain or loss until the disposition or liquidation of the replacement property, assuming you satisfy several additional requirements. You can defer both appreciated value and depreciation recapture.
The TCJA limits like-kind exchanges to real property. For Sec. 1031 purposes, though, personal property is defined by state law, not the federal tax code that defines it for depreciation purposes. State law generally classifies all tangible items fixed to real property as real property. That means that property fixed to a building — such as wall coverings, carpet and special purpose wiring — can qualify as real property for like-kind exchange treatment even though it’s depreciated as personal property under Sec. 1245.
A cost segregation study will identify such components in the replacement property. Properly planned, you can claim the Sec. 179 expense deduction for a component when you acquire property in a like-kind exchange and retire the component as fully depreciated before you again exchange the property. The retired component won’t be considered part of that exchange, and no depreciation recapture tax will apply.
The use of like-kind exchanges and cost segregation studies has been approved by the IRS. But both alternatives come with some strict and complicated rules. Our tax experts can help you navigate the complexities and structure your deals so they’ll withstand IRS and judicial scrutiny.
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