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 stable of well-known strategies, the last few years have seen many expanded programs designed to incentivize real estate development. Two great examples are the 1031 exchange and accelerated depreciation, also known as cost segregation. Up until 2017, these two long-standing strategies have typically been mutually exclusive endeavors, as a byproduct of the 1031 process is a low step-up basis, which mitigates the effectiveness of cost segregation. However, the Tax Cuts for Jobs Act (TCJA) changed aspects of both strategies in a way that facilitates their simultaneous use.
Under the TCJA, 1031 exchanges are required to exclude personal property from the exchange basis. This very exclusion may trigger a taxable event.
Cost segregation (CSS) saw numerous changes under the TCJA, 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 ten-year window of predictability, and bonus depreciation rates also increased to 100% through 2022. (Rates will subsequently decrease 20% per year until the incentive’s expiration at the end of 2026.) 100% bonus depreciation allows for a qualifying asset — defined as having a MACRS depreciable class life of less than 20 years — to essentially be written off entirely in the year it is placed into service.
The final change to bonus, and perhaps the biggest game changer, is that bonus is now applicable to used assets. This means that an acquired property’s qualifying assets – again, less than 20-year MACRS class life — are eligible for appropriate bonus. This has improved the utility of CSS in smaller, lower cost basis properties. In the past, acquired properties with a cost basis of less than $1-2M were not necessarily good candidates for CSS, but this TCJA provision is making CSS worthwhile in smaller acquisitions.
These recent changes have created a climate in which 1031 and CSS 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 CSS 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 1/15/2020
Acquisition price $6,000,000
Step-up cost basis (for CSS focus) $2,000,000
Additional federal tax depreciation $450,000
Year 1 tax savings (33% combined rate) $148,500
The typical process for incorporating a CSS into a 1031 exchange begins after closing on the replacement property, by obtaining an estimate of benefits conferred if a CSS were to be performed. If the benefits are worthwhile, the CSS report can be completed in a timely fashion to coordinate with your desired filing date. An engineering-based CSS report, the most-detailed version of the CSS report format, can also provide potential future economic benefit. It documents necessary data to support future investment planning and expensing decisions under the Tangible Property Regulations.
Like many tax strategies, CSS has its unique qualifying processes. If you are interested, please consult with your tax professional. Capstan is also always available to help answer any questions you might have.