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Tax Deferral 1031 Exchanges and Cost Segregation Tax Deferral 1031 Exchanges and Cost Segregation Tax deferral through 1031 exchanges, or tax-free exchanges of real estate, have become a popular method of tax deferral of capital gains taxes. 1031 exchanges have attained almost pop-culture status with some real estate investors. Although real estate investors were slow to understand the power of 1031 exchanges, 1031 exchanges are now widely used by many real estate investors. Almost by definition, individuals who utilize the 1031 exchange option are reluctant to pay taxes that can legally be avoided. 1031 exchangers have asked if they can receive tax deferrals and enhance depreciation. The short answer is yes. What makes evaluating cost segregation for 1031 exchanges slightly more complicated is that the cost basis is equal to the remaining cost basis of the property exchanged plus additional cash contributed in acquiring the new property. The cost basis is not simply the purchase price for the new property. A complete answer needs to consider the remaining cost basis for the property that has been exchanged. If the remaining cost basis is minimal then tax deferral is minimal and, it is probably not financially feasible to utilize cost segregation. If the remaining cost basis (plus the amount of additional cash contributed) is at least $500,000, tax deferral is increased and it is worth reviewing whether cost segregation makes sense. The total value of the new property is proportionally allocated to the remaining cost basis of the 1031 exchange property (and any additional basis from new investment). For example, if the five-year property is 10% of the value of the new property, and the remaining cost basis is $3,000,000, a value of $300,000 ($3,000,000 x 10%) would be allocated to the five-year property. One interesting issue is whether five-year property in the new property is considered personal property. To gain the tax deferral benefits, a 1031 Exchange must involve like-kind property. For example, if you sell a house and purchase a lake house, boat and jet ski as your exchange property, the boat and jet ski would be considered "boot", taxable as ordinary income and the owner does not receive any tax deferral. The boat and jet ski are considered "boot" since they are personal property and the property that was sold was real estate. Since five-year property is referred to as personal property in IRS documentation, there has been confusion regarding this issue. The IRS defers to state law regarding whether items are real property or personal property for the purpose of determining whether there is "boot". Carpet and vinyl tile are both significant five-year life components. While they are considered personal property for depreciation purpose, they are considered real property by state law (in most states). Hence, they are not considered "boot" and the owner can experience tax deferral. Consult your tax preparer or a cost segregation expert if you have questions regarding whether a portion of the property is considered real property or personal property. Tax deferral from cost segregation is effective for 1031 exchange purchases provided the remaining cost basis is at least $500,000. Exchange buyers can defer taxes and reduce taxes on the old property and increase depreciation for the new property. Cost segregation is a powerful tax reduction technique. Real estate investors can both defer and reduce federal income taxes through the use of cost segregation. Cost segregation reduces federal income taxes by converting the nature of income from ordinary income to capital gains income. It defers payment of federal income taxes from when income is earned until the property is sold, or a gain on the sale is recognized. Click here for a FREE preliminary analysis of tax deferral and tax savings resulting from your property. Cost segregation produces tax deferrals and reduces federal income taxes across the country and in every size market. Below are just a few examples of where cost segregation generates meaningful tax deductions. City:
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