Like-Kind Exchanges and Cost Segregation

For years, many real estate owners have shied away from cost segregation if the properties involved had been, or could be, the subject of a like-kind exchange. Cost segregation and like–kind exchanges were perceived to be at cross-purposes:

  • Cost segregation’s goal is to move depreciable assets from real property categories (27.5 or 39 years) to personal property categories (5- to 7-year lives).
  • When doing an exchange, one must exchange real property for real property, and cannot exchange real property for personal property.

So, in doing an exchange, cost segregation would cause the assets that were ‘segregated’ into 5- and 7-year categories to be considered taxable boot . . . not a good answer.

Recently (see “The PATH Act”), more and more categories of real property have been given a shorter life, have qualified for bonus depreciation or been allowed §179 expensing. The IRS also has provided guidance that the classification of an asset as 15-year property does not change its status as real property for like-kind exchange purposes.

These changes—more categories of real property assets with faster depreciation and IRS explicit guidance that the categories that are 15-year property are still considered “good” exchange assets—mean that the bias against cost segregation by serial exchangers is no longer as strong as it once was.

Major Repairs / Cost Segregation

Many times, taxpayers aggressively write off major repairs that are made to significant components of a property. The impetus for being aggressive in the expensing is that the recovery period of improvements has been extremely long. As noted in our other article in this issue, there are new provisions which lessen the cost of capitalizing a major repair by shortening the recovery period and allowing for some upfront expensing of significant percentages of the cost.

By themselves, these shortened lives and increased expensing are not enough to overcome the large benefit of immediate expensing. If the shortened lives and increased expensing are combined with cost segregation, however, the result can actually be larger upfront deductions.

The larger deduction is accomplished by writing off the basis of the building attributable to the component of the building that is being “repaired” and then recovering the replacement using a shorter life and/or bonus and §179 deductions.

A technical discussion of this concept could run thirty of these newsletters, so here’s one example.

Facts: A 15-story office building is acquired in 2015 for $30MM—$5MM allocated to the land and $25MM to the building—in the year of purchase. A cost segregation would assign $25K of the original purchase price to each bathroom. In 2016, pursuant to a new lease, the landlord undertakes major repairs to bathrooms on 5 of the 15 floors at a total cost of $125K.

Discussion: Normally, the taxpayer would want to expense these major repairs, taking the calculated risk that the IRS might disagree with the expensing and require capitalization. If, instead, the taxpayer conceded capitalization, it might get the following result: the landlord could expense the full $125K of the costs under §179 and could write off an allocable share of the original cost associated with the 5 renovated bathrooms ($75K in this example).

These two applications, and many variations on the same theme, make the risk/reward analysis tilt more and more in favor of cost segregation.