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How to Co-ordinate Cost Segregation with Like-kind Exchange

The Tax Cuts and Jobs Act (TCJA) was signed by the President on December 22, 2017. The TCJA is the most significant overhaul of Internal Revenue Tax code since the 1986 Tax Act under President Reagan. The Committee Report has over a thousand pages of modifications to many areas of the tax code. One piece of the new legislation (that concern most real estate investors) involves changes to the like-kind exchange rules.

When certain conditions are met, no gain or loss is recognized when a taxpayer exchanges property of like-kind (used in a trade or business or for investment purposes). Before the TCJA, a taxpayer could exchange real property for real property; and personal property for personal property (with some restrictions) without recognizing gain on the exchange. For exchanges completed after December 31, 2017, the TCJA limits this tax-free treatment to an exchange of real property only. Personal property no longer qualifies for like-kind exchange after this date. Many taxpayers and tax preparers are asking the question: How does this impact an exchange of real property that went through a cost segregation study?

Cost segregation is a valuable tax strategy to accelerate depreciation deductions. When the timing is right, this strategic tool can save taxpayers thousands of tax dollars. The primary goal of a cost segregation study is to identify all costs that can be depreciated over shorter depreciable lives. By accelerating depreciation, a taxpayer can defer federal and state income taxes and increase cash flow. If timed correctly, a taxpayer can claim more deductions in a high marginal tax year and less deductions in low marginal tax year resulting in a permanent tax savings.

The building costs identified with shorter depreciable lives (by the cost segregation study) are depreciated as Section 1245 property. Most tax preparers believe that means that these assets are personal property. The distinction that needs to be made is between the personal property (machinery and equipment) from the real property fixtures that qualify as 1245 property for tax purposes but are deemed to be real property by state law. State law generally determines the classification of property as real or personal. For like-kind exchange purposes, the courts have held that state law, although not controlling, is generally followed to determine whether property is real or personal. As such, fixtures can be 1245 property with a shorter depreciable life for depreciation purpose but real property for like-kind exchange purpose. Taxpayers still need to be aware of the potential recapture rules under 1245(b)(4) and 1245(d)(4) but this personal property vs. real property distinction should help taxpayers navigate like-kind exchanges with more comfort.

Finally, according to the Committee Report, it is the intention of the Congress that real property eligible for like-kind exchange treatment under prior law continue to be eligible under TCJA. The expert opinion is that this language means that the treatment of real property that went through cost segregation study should continue to be eligible for like-kind exchange treatment as it has in the past.

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Wondering About a 1031 Exchange

Perhaps you’ve heard of 1031 exchanges or like-kind exchanges, but you’re unsure of the benefits or whether you even qualify. The Internal Revenue Code 1031 is available to those who hold a property that qualifies as productive use in business or investments. If you have a piece of investment property, a 1031 exchange allows you to swap it for a similar property.

What is a 1031 exchange?

This type of exchange happens when an investor trades his or her real property for a similar or “like-kind” property. Investment properties such as shopping malls, residential buildings, stadiums and more can all be traded among themselves — like-kind merely refers to the type of investment and not the physical form. However, certain types of properties, such as those considered stock in trade, are excluded from 1031 exchanges.

Benefits of a 1031 exchange

The primary benefit of a 1031 exchange is that the investor can trade in their property and defer any capital gains or losses due at the time of sale, as well as any capital gains taxes. There is also no limit on how many times you can exchange property. From an investor’s standpoint, this means that you can continue to make a profit on each additional swap, but you won’t pay any tax on it until you finally sell it off down the road.

What does like-kind exchange mean?

Investors can exchange a single-family home for a beauty salon, a recreation center for an apartment building, and so forth — the physicality of the property is not associated with the term like-kind. Although the guidelines for like-kind may seem open-ended, there are some restrictions that you don’t want to fall prey to, so make sure to hire a professional to assist you with the process.

What are the deadlines?

Once the sale closes on your first property, your facilitator will receive the cash from the sale and you must submit, in writing, the property you are exchanging it for to your facilitator within 45 days. You have 180 days, starting on the day of sale of your first property, to close on the second.

How to choose a facilitator

There are many restrictions when choosing a facilitator, mainly because the facilitator cannot also function as an agent. Attorneys, Realtors or CPAs are all unsuitable as a facilitator; however, you can ask them for recommendations for a facilitator.

These are just the basics; there are a lot of details and exceptions in the fine print of the tax code. Give us a call or email a WFY advisor at info@cpa-wfy.com so we can help you decide when and how a 1031 exchange might be right for you.

© Copyright 2017. All rights reserved.