FEATURE ARTICLE, OCTOBER 2008

COST SEGREGATION STUDIES AND 1031 EXCHANGES
A look at how these tax techniques can impact one another.
Brent Allen

Cost Segregation Studies (CSS) and IRC § 1031 Deferred Like Kind Exchanges (Exchanges) have each enjoyed progressively wider acceptance and market penetration over the course of the past 10 years. As the prevalence of each tax technique increases (and as the number of properties with a low adjusted basis due to acceleration or carry-over increases), so too does the need for investors and advisors to understand how the techniques impact one another. Investors and advisors will need to know whether there may be benefit to dovetailing or “stacking” CSS and Exchanges? The answer is yes. As discussed in more detail below, it appears that an Exchange (and a second CSS) can be used to preserve the initial benefit of a CSS in the event of portfolio expansion or reallocation, where a property previously the subject of a CSS is disposed.

CSSs are a technique by which a real estate project’s components are examined and segregated, and those components that qualify are characterized or re-characterized as what is known as MACRS (Modified Accelerated Cost Recovery System) or IRC § 1245 depreciable personal property. Absent a CSS those qualifying components (and their depreciable bases) are generally lumped in with the IRC § 1250 property (the depreciable building). The allocation away from §1250 to §1245 is significant because while commercial and residential rental real property (§ 1250 property) is depreciated over a period of 39 and 27.5 years, respectively, generally land improvement is recovered over a 15-year period and depreciable personal property (§1245 property) is recovered over a relatively quick 5- or 7- year period. The benefit from allocating assets and bases to the categories with a shorter recovery period with a supporting CSS can be substantial. By way of example (for hypothetical discussion only), a $4 million hotel (building value) might enjoy an increased cash flow in year one of $60,000 and, presuming a discount rate of 6 percent, a net present value benefit over the life of the project, of $190,000. IRC § 1031 Deferred Like Exchanges are a technique by which gain realized on the disposition of an investment or business property is not recognized (taxed) if other properly identified as like kind replacement property of equal or greater value is acquired within the exchange period (generally 180 days). While there are numerous ways to structure an Exchange, the easiest is to engage a qualified intermediary (QI). U.S. Treasury Regulations issued in 1991 provide a QI safe harbor by which the investor can avoid actual or constructive receipt of net proceeds (avoid a sale), and be deemed to have swapped the old for the new property with the QI, all notwithstanding that the old property is deeded from the investor to the buyer and the new property is deeded from the seller to the investor. The bitter with the sweet of the Exchange derived deferral is that the low adjusted basis of the old property is carried over into the new property.

In a similar vein, a Cost Segregation Study has its own slight bitter for individuals that enjoy the sweet of re-characterizing §1250 real property as §1245 property with a shorter schedule. If the subject property is later disposed of in a taxable transaction that occurs prior to the end of the §1250 period, the amount of taxable gain (resulting from recapture) will be greater as a result of shorter periods and earlier depreciation for some components. Further, for individuals, while gain attributable to straight line §1250 depreciation is taxed at a flat rate of 25 percent, gain attributable to §1245 recapture is taxed at the individual’s typically higher ordinary income rates. In other words, upon a subsequent taxable disposition in the relatively near term, the more successful the CSS was, the greater the taxable gain, and at a higher rate.  However, if the disposition is part of a portfolio reallocation or expansion, an Exchange (and an early CSS as to the likely replacement property) may be the key to preserving the initial benefit of the CSS by deferring tax associated with the §1245 gain.

As noted above, in a typical Exchange, generally no gain is recognized (taxed) provided a QI is employed and the relinquished property is exchanged for a sufficient amount of properly identified, timely acquired, like kind replacement property. However, an additional rule applies to investors attempting to defer § 1245 recapture, the kind of recapture that results from a prior CSS. In addition to acquiring sufficient like kind replacement property, the investor must, as part of the exchange, acquire sufficient § 1245 property to solve for the § 1245 property relinquished. Accordingly, an investor looking to defer all tax on the disposition of a property for which a prior CSS was done, will need to identify and timely acquire not only like kind property, but like kind property with sufficient § 1245 components. For that reason, exchanging investors that engage in CSS as a practice will find it advantageous, if not indispensable, to hire a CSS professional to perform at least a preliminary analysis on potential replacement properties. Not doing so risks coming up short on § 1245 property and paying tax on at least the difference at ordinary income rates. Consider also that the ID period for an Exchange ends 45 days from the disposition of the relinquished property, so as a practical matter, investors hoping to exchange out of a property for which a CSS was done will need to engage that CSS professional and begin to look for appropriate potential replacements well before disposing of the existing property.                

While this article focused on the benefits of an Exchange that follows a CSS, for the sake of completeness, it should be noted in closing that there is the question, in a reallocation or trade-up out of a property that has not previously been the subject of a CSS of whether it would be better to Exchange and then CSS the replacement, or instead to forgo the Exchange and simply CSS the replacement with a purchase money basis? Though not necessarily intuitive, this author’s preliminary, and admittedly non-scientific, spreadsheet modeling indicates that in many, if not most, contexts there is at least an incremental benefit when disposing of one property and acquiring another (within six months), to structuring the transactions as an Exchange followed by a CSS rather than a taxable sale followed by a CSS.

Brent Allen is counsel of LandAmerica 1031 Exchange Services.

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