Both of these tax strategies are about how much of your money you can make use of now. A 1031 exchange enables you to defer capital gain taxes on the sale of an investment property, and cost segregation helps you obtain the benefits of accelerated depreciation.
Cost segregation is an IRS approved method that increases the amount of depreciation available to a commercial property owner by identifying which components of a commercial building are personal property, and therefore qualify for 5, 7 or 15 year depreciation, rather than the 39 or 27.5 year depreciation for real property. The total amount or property depreciated doesn’t change at all, but whatever can be accelerated creates “opportunity capital”, which you can use to invest or put into your business. The same benefits are available for expanded or remodeled properties.
The IRS requires that a formal cost segregation study be prepared by an independent third party. An IRS-defined and engineering-based cost segregation study prepared by a reliable firm is the way to avoid problems and to accurately identify all components of a property that legitimately can be reclassified as personal property.
The tax savings can be utilized fully in the tax year when the cost segregation study is applied. If the study was done before a depreciation schedule has been submitted, there is no additional paperwork. If a depreciation schedule has already been submitted, then an IRS Form 3115, Application for Change of Accounting Method, which is automatically accepted, and a §481 (a) adjustment are filed. Tax returns are not amended.
The IRS guidance on Cost Segregation is Rev. Proc. 2002-9 as modified by Rev. Proc. 2004-11.
TANGIBLE PROPERTY
New tax regulations recently released by the IRS allow for more favorable treatment determining whether to expense or capitalize expenditures on tangible property. The new regulations also expand the definition of “disposition” to include structural components of a building. This means that disposed-of building components allow for a deduction in the tax year they are disposed, up to the remaining depreciable basis of the disposed asset. Further, the IRS is allowing the commercial property owner to apply this treatment retroactively to account for any deductions missed through the previous year‘s disposition. This is accomplished with IRS Form 3115, and is limited to 2012 and 2013. Multiple 3115 Forms can be filed by the same entity for those tax years. The new regulations require defined units of property, and even discussed cost segregation as a method to establish the units of property. {Revenue Procedures 2012-19 & 2012-20}
DEPRECIATION RECAPTURE
Cost segregation and 1031 exchanges go hand-in-hand as part of a tax planning strategy. A commercial property owner can apply a cost segregation study to his building to accelerate deprecation and increase cash flow today in the amount of 5%-10% of his building’s cost basis. However, when this owner decides to sell his property, he may be faced with deprecation recapture. This is a tax at his ordinary income rate on gains made on personal property (property identified in the cost segregation study as accelerated) in the sale of his building, as opposed to capital gains tax rates. A 1031 exchange is the solution if you are using your proceeds to purchase another property. The new property must be like-kind, and contain as much personal property as the building that is being sold. A cost segregation study can be done on the new property purchased to bring cash flow to the owner through accelerated depreciation and identify like-kind assets so all taxes on capital gains in the sale are deferred.
An advantageous tax strategy would be to keep doing 1031 exchanges and have a cost segregation study done on each replacement property until you die, and the property ends up in your estate where there is a stepped up basis to your heirs, and potentially no depreciation recapture. This could be worthwhile to discuss with your tax advisor.
This article was written by Gene Tresenfeld of Cost Segregation Services, Inc., an engineering firm specializing in cost segregation and tangible property studies nationwide. For more information contact Gene Tresenfeld at 541-510-9162 or gene@uscostsegregation.com.
Asset Preservation, Inc. (API) does not endorse or recommend any commercial products, processes, or services. The information appearing in this newsletter is for general informational purposes only and is not intended to provide comprehensive legal or tax advice. As a “Qualified Intermediary” as defined in the Section 1031 regulations, Asset Preservation, Inc. is not able to provide tax or legal advice. We urge you to consult with your own legal and/or tax advisor before taking any action based on information appearing in this article.