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Back from that Caribbean vacation already?
Great, hope you had fun because they’ll be plenty more if you combine these strategies.
In previous posts, we discussed cost segregation, depreciation recapture, and 1031 exchanges. Today we’ll discuss how you can combine these strategies to pay as little tax as possible on your real estate investments.
A Quick Recap
Cost segregation is a tax strategy that utilizes accelerated depreciation deductions to increase cash flow and reduce federal and state income taxes by reclassifying certain building costs into personal property or land improvements that are depreciated over 5, 7, and 15 years.
A 1031 exchange allows real estate investors to defer the capital gains tax and use the full proceeds from a sale towards the purchase of another property.
Combining Cost Segregation & 1031 Exchanges
Depreciation is a non-cash expense that lowers your taxable income, and this tax liability, but not cash flow. For this reason, we want to maximize this expense.
As discussed previously, we achieve this using cost segregation. Under this strategy, the depreciation expense will typically be greatest during the first year(s) of ownership. After the first year(s), much of the personal property will be completely depreciated and all suspended losses will be used. This leads to an increase in taxable income and lower cash flow.
The goal is to sell the property before this occurs to take maximum advantage of cost segregation. This is where the 1031 exchange comes into play.
As we know, 1031 exchanges allow us to defer the capital gains tax upon the sale of a property. However, in some face depreciation recapture on the sale of personal property (caused by cost segregation), which is taxed as ordinary income. The way to avoid this is to purchase a property with at least as much personal property as the property being sold. This is discovered through a cost segregation study on the property being purchased.
The best way to use these two strategies together is to do a cost segregation study on every property you purchase and utilize a 1031 exchange on every property you sell until death. Then at death, your heirs will inherit the property at a stepped-up basis (the fair market value of the property at the time of your death) and will eliminate the deferred taxes from the 1031 exchanges. (Hey, it’s not like you could take it with you, right?)
Note: The Tax Cuts and Jobs Act changed the definition of a 1031 exchange to only include "real property". We are still waiting on guidance from the IRS to see how this will affect personal (5, 7, and 15-year) property during a 1031 exchange.
Non-Tax Issues to Consider
Tax issues aside, there is another factor to consider when using this strategy, and that is market cycles. If you purchase a property near the top of the market cycle, then you can potentially be in the down part of the cycle by the time you're ready to sell.
In this scenario you may run past the point where all of the personal property is completely depreciated, causing higher taxable income and lower cash flow. While this isn’t necessarily detrimental, it isn’t optimal for this strategy.
Ideally, you want to purchase the property at the bottom of the cycle or as the cycle is just starting to turn in an upward trend. That way you can ride the market up and then sell before the peak to lock in profits.
The Bottom Line
Although complicated, if done right, combining the use of cost segregation and 1031 exchanges can be a smart way pay as little tax (and take as many vacations) as possible throughout your real estate investing career.
As always you’ll want to work with qualified tax professionals when considering or implementing these strategies. Check out our Become a client page to learn more about how we can help you minimize your tax liability with tax strategy and planning!