By Bruce A. Johnson, CRE, CEM

Commercial real estate owners, developers, and investors have many tools at their disposal with which to develop a strong tax strategy. In addition to the well-known strategies, the past few years have brought on new and expanded programs designed to incentivize real estate development. Two examples are the Section 1031 exchange and accelerated depreciation, also known as cost segregation. Until 2017, these two long-standing strategies had typically been mutually exclusive: a byproduct of the 1031 process is a low step-up basis, which mitigates the effectiveness of cost segregation. However, the Tax Cuts and Jobs Act (TCJA) of 2017 changed aspects of both tools in a way that has facilitated their simultaneous use.

Under the TCJA, 1031 exchanges are required to exclude personal property from the exchange basis. This exclusion may, in itself, trigger a taxable event.

The TCJA created several changes to cost segregation – the expansion of the bonus depreciation rules being among the most notable. Prior to the TCJA, the existence of bonus depreciation and its rate were typically known only from year to year. The TCJA ushered in a 10-year window of predictability. Bonus depreciation rates also increased to 100% through 2022. (Rates will decrease 20% per year until the incentive’s expiration at the end of 2026.) The 100% bonus depreciation allows for a qualifying asset – defined as having a depreciable class life of less than 20 years – to essentially be written off entirely in the year it is placed into service.

Perhaps the biggest game changer is that bonus depreciation is now applicable to used assets. This means that an acquired property’s qualifying assets – again, less than the 20-year modified accelerated cost recovery system class life – are eligible. This has improved the utility of cost segregation in smaller, lower-cost-basis properties. In the past, acquired properties with a cost basis of less than $1 million to $2 million were not necessarily good candidates for cost segregation, but this TCJA provision is making cost segregation worthwhile in smaller acquisitions.

These recent changes have created a climate in which 1031 exchanges and cost segregation are best used together, each adding its own unique economic benefit and creating a much more powerful tax strategy when used in tandem. The use of cost segregation may, in fact, offset the potential tax liability generated by the exclusion of personal property from a 1031 exchange. A recent example of this benefit is as follows:

Replacement property acquired Jan. 15, 2020 (Warehouse)

Acquisition price: $6 million

Step-up cost basis (for cost segregation focus): $2 million

Additional federal tax depreciation: $450,000

Year 1 tax savings (33% combined rate): $148,500

The typical process for incorporating a cost segregation into a 1031 exchange begins after closing on the replacement property by obtaining an estimate of benefits conferred if a cost segregation were to be performed. If the benefits are worthwhile, the cost segregation report can be completed in a timely fashion to coordinate with your desired filing date. An engineering-based cost segregation report – the most-detailed version of the cost segregation report format – can also provide potential future economic benefit: it documents necessary data to support future investment planning and expensing decisions under tangible property regulations.

Like many tax strategies, cost segregation has its unique qualifying processes, so please consult with your tax professional.

Bruce A. Johnson, CRE, CEM, is a co-founder and partner at Capstan Tax Strategies. He can be reached at bjohnson@capstantax.com. Capstan Tax Strategies is exclusive sponsor of the PICPA Firm Alliance.

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