Under the Tax Cut and Jobs Act, the benefits of combining cost segregation and Section 1031 exchanges have become an even more important tax strategy for real estate investors. With the recently passed TCJA, the rules for Section 1031 exchanges have been modified and depreciation rules have been expanded. The interplay of these new rules creates new opportunities that one might overlook -- namely, the ability to utilize a cost segregation study to identify short life assets that will be fully depreciated and ultimately retired. The no-value assets are then not considered to be a part of the Section 1031 exchange – resulting in no depreciation recapture tax.
A cost segregation study allows a taxpayer who owns real estate to reclassify certain assets as Section 1245 property with shorter useful lives for depreciation purposes, rather than the longer useful life for Section 1250 property. This property may then be depreciated over a shorter period of time -- five, seven or 15 years -- while Section 1250 property is depreciated at 39 years for nonresidential property and 27.5 for residential property.
By utilizing this technique, the owner can take advantage of the immediate cash flow generated from tax savings, particularly the tax savings attributable to the catch-up adjustment that is often available in the year the cost segregation study is completed.
Meanwhile, while an exchange of property is generally treated as a sale that triggers gain, under Internal Revenue Code Section 1031, a taxpayer may defer tax on the gain of the sale of investment or business property if they replace that property with a qualified “like-kind” property. The tax deferral includes the depreciation recapture, as well as the appreciated value. With proper planning a taxpayer can continually use this exchange rule effectively deferring the tax indefinitely.
The Tax Cuts and Jobs Act
The TCJA has made several changes that impact the cost segregation and Section 1031 rules. Up until the TCJA was enacted into law in December 2017, the Section 1031 exchange rules applied to both real and personal property (although with some restrictions). The new law has eliminated personal property, meaning the beneficial tax deferral is now only available to the exchange of real property.
It is important to note that real-versus-personal property for Section 1031 are not necessarily the same for purposes of depreciation. Section 1031 does not turn on the distinction between Sections 1245 and 1250 property. Instead, it looks to state real estate definitions to determine what is defined as real or personal property. Most state laws classify all items that are fixed to the property as real property. This distinction can result in property qualifying for Section 1031 exchange treatment, but still be depreciable as Section 1245 property.
The TCJA also updated Section 179 by including improvements made to nonresidential property, such as: roofs, HVAC, fire protection systems, alarm systems and security systems, as well as the scope of the bonus depreciation.
The bonus depreciation has been increased from 50 percent to 100 percent for qualified property acquired and placed in service after Sept. 27, 2017, and before Jan. 1, 2023. Taxpayers may still utilize bonus depreciation in excess of the maximum deduction with no limit. Note that the intent of Congress was to allow qualified improvement property the benefit of the 100 percent bonus depreciation; however, a drafting error currently excludes it.
Excluded from qualified improvement property are improvements that are attributable to the enlargement of the building, any elevator or escalator, or the internal structural framework of the building.
After tax reform
The cost segregation and Section 1031 exchange combination has become even more critical for taxpayers. With personal property being eliminated from a Section 1031 exchange, a taxpayer may now have the best of both worlds. The best scenario for a taxpayer to maximize optimal tax benefits is component retirement on the front end and immediate expensing on the back end. Therefore, deciding to conduct a cost segregation study on new property will become a critical tax savings decision for businesses post-TCJA.
In addition, with the updates to Section 179, the taxpayer has even greater opportunities to generate immediate cash flow with a cost segregation analysis to allocate basis to short-life property. When a Section 1031 exchange occurs in the future, the classification of real versus personal property will turn on state law definitions. At this point the Section 1245, or short-life, property should be fully depreciated and not considered part of the Section 1031 exchange.
Considering whether to perform a cost segregation study has now become even more appealing to taxpayers under the new tax law. Taxpayers stand to realize even greater increased tax savings through the deferral of income tax and the ability to immediately expense and then ultimately retire certain assets. Further, with lower income tax rates being implemented there is opportunity for some taxpayers see permanent tax deferrals.
