Section 1031: Don’t Miss This Depreciation Election

As you likely remember, the Section 1031 exchange allows you to sell a piece of appreciated real estate and defer all the taxes as long as you invest the entire proceeds in like-kind property.

And then consider this: a cost segregation study allows you to separate qualifying real estate into separate components with shorter depreciable lives that speed up deductions and in many cases create immediate write offs.

Can you (a) defer a large gain via Section 1031 and (b) immediately create a large write-off on the new asset with a cost segregation study?

You can, but you have to make sure you don’t miss this one important step.

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1031 Exchange Overview

The Section 1031 exchange allows you to sell appreciated real estate and defer all taxable gains when you fully reinvest the sales proceeds into new qualifying real estate.

Key point. Many savvy investors continue using 1031 exchanges until death, when their relatives inherit the asset with a stepped-up basis. And then, because of that stepped-up basis, those relatives can likely sell that asset federal-income-tax-free.

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Cost Segregation Overview

Residential real estate is depreciated over a life of 27.5 years, and commercial real estate is depreciated over a life of 39 years.

An applied cost segregation study breaks that $800,000 building into components such as appliances, flooring, lighting systems, and land improvements. The components have lives of 20 years or less, qualifying them for faster depreciation and bonus depreciation as well.

For 2022, bonus depreciation is 100 percent, but it drops to 80 percent for 2023.5

Key point. Cost segregation studies use the depreciation rules in effect when you place the property in service, not when you do the study. But you realize the tax benefits in the year of the study.

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Calculating Basis in a 1031 Exchange

When you complete a 1031 exchange, the basis in your new asset is calculated by reducing its value by the deferred gain. That new basis amount can be accounted for in two different ways, described below.

Method 1: Track two assets. With this method, the remaining basis of the old asset continues on its original timeline and the new “additional” basis of the new asset starts on a new schedule.

Method 2: Track one asset. Here, you make the IRS regulation 1.168(i)-6(i)(2) election. This election allows you to treat the sum of the exchanged basis and the new/excess basis as one asset, both put into service at the same time.

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Cost Segregation Can Change the Game

If you will use cost segregation on the newly acquired Section 1031 asset, you may want to make the 1.168(i)-6(c)(5)(iv) election because that applies cost segregation to the entire basis.

Here, you can see that with cost segregation, the track-one-asset method is the winner—assuming you will keep the property in your real estate portfolio until death.

But we have to point out: there is more to consider that could change the result. For example, how long will you keep the property? With a short holding period, recapture on bonus depreciation and Section 179 expensing comes into play and could impact your selection of method.

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Takeaways

Combining a Section 1031 exchange with a cost segregation study can produce great results.

Continuous use of the Section 1031 exchange enables you to continue upgrading your real estate portfolio without incurring any federal taxes on the upgrades. And you can keep doing this until you die.

When you upgrade your real estate using the Section 1031 exchange, you have the opportunity to use a cost segregation study to create large deductions in the year of exchange.

If you are going to use cost segregation on an asset acquired via a 1031 exchange, you need to consider the IRS Reg. Section 1.168(i)-6(c)(5)(iv) election to treat the sum of your old basis and your new basis as one asset.

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