A 1031 exchange allows investors to improve returns at the time they dispose of any property held for investment by providing the opportunity for tax deferral of all recapture, federal and state capital gain taxes and the new 3.8% Section 1411 net investment income tax when applicable. IRC Section 1031 has been a part of the tax code since 1921 and savvy investors have been taking advantage of this powerful investment strategy for many years. A cost segregation study helps investors improve their investment returns via the time value of money through the proper reclassification of property providing for shorter depreciation schedule on the reclassified property thus substantially bolstering an investor’s return on investment (ROI). Investors who take advantage of both 1031 exchanges and cost segregation can obtain the best of both worlds – better returns on their current investment property coupled with full tax deferral at the time of disposition.
An investor should be aware that for tax purposes investment property can often consist of two types of property: (A) Section 1250 property which consists of improvements to real property generally depreciable over 27.5 years if residential property and 39 years if commercial property and (B) Section 1245 property which includes any property that is of a character subject to the allowance for depreciation and is either personal property or certain property described in IRC Section 1245(a)(3)(B) through (F). An investor exchanging should compare the Section 1250 and Section 1245 property in the relinquished property and then do the same comparing for both the Section 1250 and Section 1245 property on the replacement property (or properties if more than one replacement property is acquired). Keep in mind that both the Section 1031 like-kind rules and the depreciation recapture rules of Section 1250 and 1245 must be met if the investor desires 100% tax deferral. An exchange that qualifies for Section 1031 deferral may still have depreciation recapture under Section 1245. The recapture provisions of Section 1245 only apply to the Section 1245 property.
Also, if the relinquished property is personal property for Section 1031 purposes, the investor must meet the stricter like-kind standard for personal property exchanges. The personal property must either meet the “like-class” safe harbor or be similar or related in service or use to be like-kind. Generally, once an investor has taken advantage of cost segregation and a 1031 exchange, they typically continue exchanging because the accelerated depreciation leads to more capital gain absent a 1031 exchange. Many investors exchange throughout their lifetime and upon death their heirs receive a full step-up in basis. The additional purchasing power provided by the tax deferral allows investors who exchange and take advantage of cost segregation to acquire significantly more investment property than those who sell and pay their capital gain taxes.