Property owners have long turned to cost segregation studies to take advantage of accelerated depreciation methods, including bonus depreciation and Internal Revenue Code Section 179 expense deductions. Accelerated first-year deductions don’t change the total amount of tax that’s owed over an asset’s useful life, but they do change the timing of deductions, which lowers taxes and generates extra cash flow in the year an asset is placed in service.
Now, thanks to the Tax Cuts and Jobs Act (TCJA), the studies may also help taxpayers secure greater tax savings in so-called “like-kind” exchanges under Sec. 1031.
What are cost segregation studies?
Real property often comprises different types of assets with different depreciation recovery periods. Owners typically separate such property into individual components or asset groups with the same recovery periods and placed-in-service dates to maximize their depreciation deductions.
Cost segregation studies allow you to allocate the costs of buildings (Sec. 1250 property) to tangible personal property (Sec. 1245 property). Tangible personal property has shorter recovery periods (five or seven years under the tax code) and is eligible for accelerated depreciation. Sec. 1250 real property, by contrast, has longer recovery periods (27½ years for residential property and 39 years for nonresidential property).
How can a study improve a like-kind exchange?
Sec. 1031 lets taxpayers exchange business or investment real property (the relinquished property) for business or investment real property of a like kind (the replacement property) without recognizing any gain or loss until the disposition or liquidation of the replacement property. Taxpayers can defer both appreciated value and depreciation recapture.
Note that, under the TCJA, these exchanges are no longer available for personal property. For Sec. 1031 purposes, personal property is defined by state law, which typically classifies all items fixed to real property as real property. As a result, property that’s more quickly depreciable, such as Sec. 1245 property, can nonetheless qualify for like-kind exchange treatment.
If you’re in the market for a like-kind exchange, a cost segregation study can identify the replacement property’s Sec. 1245 components. Ideally, you can claim the Sec. 179 expense deduction for a component when you acquire property in an exchange and retire the component as fully depreciated before exchanging the property again. The component won’t be deemed part of the exchange, and you won’t have to worry about depreciation recapture.
Although the IRS approves the use of cost segregation studies, it also closely scrutinizes them. The studies should be performed by an individual with knowledge of the applicable tax law and experience in cost estimating and allocation. Contact a tax professional for more information.
HMWC CPAs & Business Advisors specialize in serving the financial and tax needs of privately-held businesses and their owners throughout Southern California.
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