1031 Exchanges are mainly used for the benefit of deferring the taxable gain from the sale of real estate. By deferring the taxable gain, the taxpayer has more money to reinvest. When 1031 exchange is combined with bonus depreciation, the tax savings increase as bonus depreciation allows a 50% deduction on the new assets. However, for bonus depreciation to apply in a 1031 exchange certain circumstances must be met along with additional considerations for the taxpayer. In order to understand the benefits of using bonus depreciation, you must first qualify for a 1031 exchange and the assets placed in service on the replacement property must also qualify for bonus depreciation.
In the world of real estate, a 1031 exchange is common consideration when a property owner wants to sell their property and purchase a new one. Generally speaking, the gain on the sale of the first property reduces the cost of the new one, deferring any tax that would normally be owed. One of the many complexities in qualifying for a 1031 exchange is that the replacement property must be like-kind. For real estate, this means that the replacement property can be commercial, residential, or land. In order for bonus depreciation to apply, we have to understand the qualifications necessary to take a 50% deduction.
The America’s Small Business Tax Relief Act of 2014 created a special depreciation allowance known as bonus depreciation. The bonus depreciation is a 50% deduction for assets placed in service during the tax year. The general rule is that the asset placed in service must be the original use of the asset and the asset must have a depreciable life of 20 years or less. These two qualifications often preclude real estate from being eligible for bonus depreciation because the life of a building or residential unit is greater than 20 years and the building must be newly constructed. This is where a cost segregation study can be an effective tool for tax planning. In a cost segregation study the asset of the building, for example a 39 year asset, can be broken down to the structural components and depreciated over 39, 15, 7 and 5 years. While the 39 year portion of the building is not eligible, the 15, 7 and 5 year life assets will qualify for bonus depreciation. If the building is not newly constructed there still may be assets in the purchase that are original use, i.e. leasehold and tenant improvements. Bonus depreciation is also elective, meaning that it is optional each year.
The combination of the 1031 exchange along with bonus depreciation can be very effective for tax planning. The tax deferment of the 1031 combined with the 50% deduction on the non-building assets can save a large amount of tax. It is important to keep in mind that the cost basis of the new property will be reduced by the gain of the sold property, thus reducing the amount of available bonus depreciation. However the tax savings along with the time value of the money spent makes taking the bonus depreciation worth the reduction in basis. There are a lot of qualifications and special rules for both 1031 exchanges and bonus depreciation so it is important to know all of the facts and circumstances of your situation to see if either applies.