Both cost segregation and 1031 exchanges are powerful tax-saving strategies for real estate investors. However, using them together requires careful consideration of the benefits and pitfalls. Here's a breakdown:
Benefits:
- Maximize Depreciation: Cost segregation identifies building components with shorter depreciation lives (5 or 15 years) compared to the standard 27.5 or 39 years for real estate. This increases depreciation deductions, lowering taxable income and boosting cash flow.
- Defer Capital Gains Tax: A 1031 exchange allows you to sell a property and reinvest the proceeds in a "like-kind" property without triggering capital gains tax. This further amplifies the benefits of cost segregation's accelerated depreciation by allowing you to reinvest your tax savings.
- Improved Investment Returns: The combined effect of increased cash flow and deferred taxes can improve your overall investment return on both the original and replacement properties.
Pitfalls:
- Cost and Complexity: Cost segregation studies are typically expensive and require expertise. They may also trigger IRS audits if not done correctly.
- Potential Depreciation Recapture: Recapture rules apply if you sell a property with accelerated depreciation before its "normal" lifespan. In a 1031 exchange, recapture might negate some tax benefits if the replacement property doesn't have similar assets.
- Exchange Eligibility Concerns: While most cost-segregated assets qualify for 1031 exchanges, some elements might fall outside the "like-kind" definition, potentially disqualifying the entire exchange.
Additional Considerations:
- The Tax Cuts and Jobs Act (TCJA) made changes: Personal property is no longer eligible for 1031 exchanges, but thankfully, most cost-segregated assets are now considered real property for exchange purposes.
- Consult with professionals: Combining these strategies is complex, so seek guidance from qualified tax and legal advisors to ensure proper execution and optimize your tax benefits.
Ultimately, the decision to combine cost segregation and 1031 exchanges depends on your specific circumstances and risk tolerance. Weigh the potential savings against the costs and potential pitfalls and seek professional advice to navigate the complexities.