How Can I Maximize Cash Flow?
Cost segregation and tax-deferred exchanges under IRC Section 1031 are two valuable tax-planning strategies available to commercial real estate owners today. Section 1031 Exchanges permit a taxpayer to defer income taxes that would otherwise be generated on a sale of investment real property, and cost segregation studies can generate accelerated depreciation benefits that increase after-tax cash flow earlier in the ownership period. With proper tax planning, both tax strategies can be used on the same property to obtain maximum tax benefits.
What is Cost Segregation?
Cost Segregation is an extremely valuable tax planning tool that provides significant savings to real estate owners by increasing cash flows through accelerating depreciation deductions. A study employs civil, structural, and architectural engineering knowledge coupled with tax law to identify components that qualify for accelerated depreciation.
Commercial real estate owners can utilize a cost segregation study to increase current depreciation deductions on newly acquired improved real property and property that may already have been placed in service. In the absence of cost segregation, certain tangible property associated with the acquired real property is lumped together with the real property depreciated using the straight-line depreciation method over 27.5 to 39 years. By engaging a cost segregation expert, certain tangible property is carved out and more accurately classified as property eligible for accelerated depreciation.
Using cost segregation, depreciation recovery periods for certain components associated with the property can be reduced to a period as short as 5 years. Moreover, by reclassifying such property, a taxpayer will be able to use an accelerated depreciation method available under current tax law. In general, a shorter depreciation recovery period will generate larger depreciation deductions in the early years of ownership. Increased deductions reduce taxable income and will generate significant cash flow benefits.
What is an IRC Section 1031 Exchange?
An IRC Sec. 1031 like-kind exchange is an effective method for investors to defer taxable income from the sale of business investment real property by reinvesting the sales proceeds into like-kind property of equal or greater value (i.e., avoid gain recognition on the sale of appreciated real property). Effectively, the exchange allows an investor to swap one real property investment for another of like-kind, within a certain period of time and, assuming IRS rules are met, defer (and not pay) income taxes on the gain on the sale of the exchanged real estate investment property.
Functionally, an investor participating in such a transaction transfer their property to be relinquished into an escrow account, managed by an unrelated third-party (“qualified intermediary”), who, at their direction, sells the property and deploys the funds into a replacement property (of equal or greater value).
The exchange allows an investor to:
- Defer any income taxes on the sale of real estate.
- Enjoy maximum flexibility reinvest in new real estate.
- Flexibility to reduce debt on future real estate acquisitions.
Generally, an investor must identify the replacement property within 45 days of the sale of the relinquished property and complete the exchange within 180 days.
Relationship between Cost Segregation and IRC Section 1031 Exchange
- Both strategies can be used on the same property.
- Both techniques are used to defer taxes and, therefore, improve cash flow.
- Both can be performed on every type of commercial property held for investment.
- Both encompass complex areas of tax law and necessitate the use of specialists.
Tax Planning and Considerations
Regarding a cost segregation study, a benefits proposal will help the building owner and taxpayer determine if a study will be beneficial for the replacement property in a IRC Section 1031 exchange, given the carryover tax basis. In general, cost segregation studies are most advantageous when the building has a basis greater than $1 million. Taxpayers who choose to proceed with a cost segregation study should also plan for the possibility of future depreciation recapture which may generate taxes in a later sale.
Templeton partners with proven cost segregation practices whose expertise allows for optimal outcomes and documentation that can withstand IRS scrutiny. If you have additional questions, would like to discuss the topic further and/or request a cost-benefit analysis, please feel free to reach out to our team.
Regarding an IRC Section 1031 exchange, there is no limit to the number of like-kind exchanges an investor can complete. So long as each transaction’s “intent” is for long-term investment – rather than solely tax avoidance – investors can “swap until they drop”. Why? Upon the investor’s death, the tax basis for the real estate investment steps up to the fair market value at the date of death (when the heirs take possession) that is, all the built-in gains disappear upon the investor’s death. In other words, the value of the property at the date of your death passes through the investor’s estate to his or her heirs. If the heirs decide to sell the asset(s) immediately, they will not owe capital gains taxes. They also will not be responsible for any of the depreciation recapture from which the investor may have benefited over the lifetime of the investment. Under current tax law, these deferred taxes can create a permanent exclusion from tax at death for up to approximately $25,840,000 for a married couple.
Like-kind exchanges are an excellent tax-deferred way to dispose of investment or trade or business assets. Templeton partners with IRC Section 1031 specialists to provide 1031 Exchange services to our clients. We assist in the buying and selling of business assets by deferring income taxes, increasing their cash flow and promoting growth and profitability. We partner with experienced Board-Certified tax attorneys & exchange professionals who will:
- Identify and implement the best tax strategy to maximize the cost savings utilizing over 26 years of extensive tax lawyer expertise;
- Review any and all documents in connection with the transaction to avoid errors or mistakes in connection with the exchange; and
- Provide an audit ready package with tax forms, documentation and a tax opinion, if requested, that protects the client from IRS penalties and interest thereon.
We offer branded exchange services to meet our client’s needs. If you have additional questions or would like to discuss the topic further, please reach out.