Cost segregation and 1031 exchanges are both well-established tax strategies in real estate. Used together, they can be powerful. But there is a step investors frequently skip when combining them, and skipping it can mean paying for work that delivers little value or, worse, creating problems with the exchange itself.
The question is simple: is there actually an excess basis on this property?
What Excess Basis Means and Why It Controls Everything
In a 1031 exchange, the depreciation history from the property you sold does not disappear. It carries forward into the replacement property as your existing basis. A cost segregation study is typically only applicable to the amount above that, what is called the excess basis, representing new capital invested in the replacement property.
Brian Kiczula of CostSegRx works through this scenario regularly with investors and their tax advisors. The misunderstanding he sees most often is investors looking at the gain that transferred in the exchange and using it as a shortcut to back into the excess basis. “That’s not the right calculation,” he says, and the consequences of getting it wrong extend beyond depreciation. The 1031 exchange itself can be put at risk when the basis calculation is handled incorrectly.
When a Study Does Not Make Sense
If the replacement property was acquired for only slightly more than what the relinquished property sold for, the actual excess basis may be minimal. In that situation, the cost of commissioning a study is unlikely to be justified.
Kiczula is direct about this: “We need to calculate upfront whether there is a benefit for doing a cost segregation study, because there’s not always one.” The complimentary estimate of benefit exists precisely for this reason. It lets investors and their advisors see the actual numbers before committing to anything.
The Document That Changes the Whole Picture
Most investors know to pull together the closing statement and the 1031 exchange documents when working with a cost segregation provider. What is often missing is the fixed asset schedule from the relinquished property. That schedule is the record of what was already being depreciated and under what method. Without it, there is no way to accurately determine the carryover basis, and therefore no reliable way to identify what the new study should cover.
This is also why the tax preparer needs to be in the conversation before the engagement begins. The cost segregation provider and the CPA have to work from the same set of numbers from the start. Coordinating after the fact often means rework, revised projections, or discovering that the study cannot be applied the way the investor expected.
Getting It Right from the Start
A 1031 exchange is worth protecting. The deferral it provides is one of the more significant advantages available in real estate investing, and adding cost segregation on the replacement side can extend that benefit. But only when the basis calculation is accurate, the documentation is complete, and the right professionals are involved before any work begins.
About CostSegRx: CostSegRx is an engineering-based cost segregation firm led by Brian Kiczula, a member of the American Society of Cost Segregation Professionals. The firm works with residential and commercial real estate investors nationwide. CostSegRx provides complimentary estimates of benefit and supports investors and their CPAs through the full reporting process. Learn more at costsegrx.com or call (888) 850-4155.
Disclaimer: This article is based on information provided by the expert source cited above. It is intended for general informational purposes only and does not constitute legal, financial, or real estate advice. Readers should conduct their own research and consult qualified professionals before making any real estate or financial decisions.
