In the realm of commercial real estate investing, strategic tax planning is paramount. Utilizing tools such as depreciation, cost segregation studies, and 1031 exchanges can not only maximize profitability but also ensure a competitive edge in today's fast-paced market. In this article, we'll deep dive into these elements, empowering investors to make informed decisions and unlock the full potential of their commercial real estate investments. For specific questions, or to explore our industry-leading financial models to help you evaluate your real estate investments, schedule a complementary meeting with us below:

I. Leveraging Depreciation in Commercial Real Estate

Depreciation is the act of allocating a tangible asset's costs over its useful life for tax purposes. Commercial property owners can use depreciation to reduce taxable income, potentially saving substantial amounts in taxes.

MACRS (Modified Accelerated Cost Recovery System)

Most commercial properties use the MACRS depreciation method, allowing for deductions taken over 39 years. This method consists of 31.5 years for nonresidential rental property placed into service before 1993 and 15 years for qualified leasehold improvements.

To compute annual depreciation, divide the property's depreciable basis—purchase price, excluding the land component—by the applicable recovery period (e.g., 39 years for most commercial buildings).

Bonus Depreciation

Thanks to the Tax Cuts and Jobs Act of 2017, eligible property additions can be subjected to 100% bonus depreciation in the year the qualifying asset is placed in service. This rule generally applies to property with a recovery period of 20 years or less, including many assets found in commercial buildings such as HVAC systems and office equipment.

II. Accelerate Depreciation with Cost Segregation Studies

A cost segregation study systematically dissects a property's depreciable components, assigning them to shorter recovery periods. This accelerates depreciation deductions, reducing current taxable income and increasing after-tax cash flow.

The Process

The cost segregation process relies on professionals who possess both construction costing experience and a firm grasp of current tax regulations. They'll perform a detailed study, breaking the property down into its various elements and classifying them under specific IRS-designated categories, to ultimately arrive at the depreciable life of each component.

Benefits of Cost Segregation:

·       Accelerated Depreciation: By segregating the cost of the property into smaller components, it enables property owners to depreciate assets over shorter lives, resulting in substantial tax savings over the short term.

·       Retroactive Application: As per IRS rules as of the time of publication, taxpayers who have acquired property in prior years and have not conducted a cost segregation study can do so at any time, and claim “missed” depreciation within the year of the study.

Drawbacks of Cost Segregation:

·       Depreciation Recapture: Rapid depreciation eventually leads to faster asset depreciation. This means a larger portion of sale proceeds could be subject to high depreciation recapture rates.

·       Increased Audit Risk: Due to the complexity of this exercise, it might increase the risk of IRS scrutiny and potential audits.

·       Initial Cost: Cost segregation studies may involve significant upfront costs, although the long-term benefits could very well outweigh these.

III. Defer Capital Gains Taxes with 1031 Exchanges

The 1031 exchange, named after Section 1031 of the Internal Revenue Code, allows investors to defer capital gains taxes on the sale of an investment property by reinvesting profits into a like-kind property. This process allows investors to use their entire profits for reinvestment into future deals.

Requirements for a Successful 1031 Exchange

To successfully execute a 1031 exchange, investors and deals are required to meet a certain criteria, which should always be confirmed with a tax professional and current tax code. In general, however, the requirements are as follows:

1.     Like-Kind Property: The relinquished property and the replacement property must be of "like-kind". This broadly means that both properties need to be used for investment or business purposes. It's important to note that like-kind refers to the nature or character of the property and not necessarily its grade or quality.

2.     Greater or Equal Value: In general, to fully defer the realized capital gain tax, the market value and equity of the property acquired must be the same as, or greater than, the property sold. Partial exchanges occur when the replacement property's value is not equal to or greater than the relinquished property value. In such cases, the investor must pay tax on any gain resulting from the difference, known as "boot."

3.     Productive use in Trade or Business: Both the relinquished and replacement properties, as per Section 1031(a), must be held for "productive use in a trade or business or for investment" and cannot be held as a personal residence.

4.     45-Day Identification Window: Post the closing of the sale of the initial property, investors have 45 days to identify potential replacement properties. This period begins on the date the investor transfers the relinquished property to the buyer.

5.     180-Day Purchase Window: The replacement property must be purchased and the exchange completed no later than 180 days after the sale of the exchanged property, or the due date (with extensions) of the income tax return for the tax year in which the relinquished property was sold, whichever is earlier.

6.     Title Holder Continuity: The tax owner who sells the relinquished property must be the one who acquires the replacement property. Essentially, the titles on both the sold and bought properties should be in the same name.

7.     Qualified Intermediary (QI): The taxpayer cannot touch the proceeds in between the selling of the relinquished property and buying of the replacement property. To ensure this, a qualified intermediary (QI) is brought in to handle all the money involved in the transaction.

IV. A Simultaneous Maneuver: 1031 Exchange + Cost Segregation

Utilizing cost segregation in combination with the 1031 exchange can yield exceptional tax planning benefits when orchestrated correctly. They can, however, present challenges that need vigilant planning, execution, and oversight from a tax professional. Furthermore, before we go any further, it’s crucial to understand the difference between Section 1245 and Section 1250 property as defined by the IRS. Primarily, these distinctions exist to classify types of property for tax considerations, specifically regarding depreciation recapture when a property is sold.

Section 1245 Property

Section 1245 of the IRS code deals primarily with depreciable personal property, including both tangible and intangible assets. This also includes certain types of depreciable real property, usually those that perform specific functions, such as a storage tank.

Depreciation on Section 1245 property is recaptured by treating it as ordinary income rather than capital gain when the property is sold. This happens when the selling price of the asset is more than the adjusted tax basis of the property. The aim of the recapture rule is to prevent taxpayers from getting double benefits of depreciation deductions, which reduce ordinary income, and capital gain rates, which are generally lower.

Section 1250 Property

Section 1250, on the other hand, typically refers to depreciable real property. This comprises commercial buildings and real property structural components like roofs and flooring. These are depreciated over more extended periods than Section 1245 property.

While Section 1245 property covers all depreciation recapture as ordinary income, Section 1250 only considers additional depreciation, categorized as the depreciation beyond straight-line depreciation, for recapture as ordinary income. Therefore, if straight-line depreciation has been used for Section 1250 property, there may be no depreciation recapture as ordinary income. Only the portion of depreciation in excess of straight-line would be recaptured as ordinary income.

In sum, Section 1245 property involves some real property and mostly depreciable personal property with depreciation claimed being subject to recapture as ordinary income. In contrast, Section 1250 property involves depreciable real property, with only extra depreciation claimed (in excess of straight-line depreciation) subject to recapture as ordinary income.

Understanding these differences is vital to planning a tax strategy, as they impact not only the present year's tax liability, but also future tax liability upon the disposition of the property. With that in mind, let’s go into some of the advantages and challenges of combining 1031 exchanges and cost segregation.

Advantages of combining 1031 exchanges and cost segregation:

·       Tax Deferral and Accelerated Deductions: With a 1031 exchange, an investor defers capital gain taxes while cost segregation accelerates the deductions that can enhance a property’s return on investment. Also, the ‘missed’ depreciation (Section 481 adjustments) from a cost segregation study done on a property involved in a 1031 exchange can be a powerful shelter against income from other sources.

·       Higher Cash Flow: The potent combination of the tax deferral mechanism and accelerated depreciation deductions could result in higher after-tax cash flow.

Challenges and Risks in blending 1031 exchanges and cost segregation:

·       Complex Tax Laws: The interaction of tax laws regarding both these strategies can be intricate. Improper execution can lead to potential pitfalls, including unwanted tax liabilities.

·       Depreciation Recapture: The accelerated depreciation of assets under cost segregation can lead to a reclassification from Section 1250 to Section 1245 property, resulting in potential depreciation recapture risks.

·       1031 Exchange Qualifications & Differences in Replacement Property: Taxpayers may have multiple issues to consider if the replacement property is different than the relinquished property. First, boot can come into play when a taxpayer is exchanging two properties that are in similar asset classes but are of different grades. For example, if a taxpayer is exchanging a high-end strip mall (with a high allocation of 1245 property) for a low-end strip mall (with a lower allocation of 1245 property), it will be difficult covering each exchange group unless there is sufficient step-up in value. Another area of concern is meeting the like-kind requirement with respect to the non-1250 real property.

Conclusion

Properly structured and executed depreciation strategies, cost segregation studies, and 1031 exchanges can result in significantly enhancing returns and optimizing commercial real estate investments; however, these sophisticated techniques, particularly when used together as a long-term tax strategy, demand expert guidance from tax professionals and advisors to ensure compliance and maximize benefits.

At Realty Capital Analytics, our expertise spans across real estate financial modeling, fund modeling, asset management strategies, creative deal structuring, syndication consulting, and pitch book preparation. Our seasoned team is dedicated to offering tailored solutions that enhance value and optimize outcomes for our clients. We invite you to leverage our comprehensive services for your real estate investment needs. Contact us for a complimentary consultation, and let's discuss how we can support your objectives with precision and professional insight.