A 1031 exchange is one of the most powerful tools available to real estate investors. But the complexity does not end when the replacement property closes. For investors hoping to layer cost segregation on top of the exchange, there is a specific calculation that trips up even experienced buyers and their advisors.
The issue is excess basis, and getting it wrong has consequences that go beyond leaving depreciation on the table.
Carrying Forward the Wrong Numbers
When you complete a 1031 exchange, the depreciation method from the property you sold carries forward into the new one. That carryover represents your existing basis. A cost segregation study generally only applies to what sits above it: the excess basis, meaning the genuinely new investment in the replacement property.
Brian Kiczula of CostSegRx sees investors and their CPAs regularly miscalculate this. The common error is treating the gain that was transferred in the exchange as a proxy for figuring out what is new and depreciable. “That’s not the right calculation,” Kiczula says. “You just want to make sure you’re not putting the 1031 at jeopardy, because you are exchanging like-kind property.”
The stakes here are not just about maximizing depreciation. Errors in the basis calculation can threaten the integrity of the exchange itself.
Not Every Exchange Creates a Cost Seg Opportunity
This is worth stating plainly: some 1031 exchanges do not produce enough excess basis to make a cost segregation study worthwhile. If the replacement property was acquired for only modestly more than the relinquished one, the new depreciable base may be minimal. Paying for a study in that scenario does not make financial sense.
That is why Kiczula recommends doing the math before engaging anyone. The first step is finding out whether an excess basis actually exists, not assuming it does because a new property was acquired.
Timing the Collaboration
The cost segregation provider and the tax preparer need to work together before the study begins, not after. To calculate the excess basis correctly, the cost segregation firm needs more than the closing statement and the exchange documents. They need the full fixed asset schedule from the relinquished property, showing what was depreciated and how.
Without that schedule, there is no way to accurately determine what the carryover basis is, and therefore no way to know what the cost segregation study should actually cover.
What to Prepare
Investors heading into a 1031 exchange who plan to explore cost segregation on the other side should have the following ready: the closing statements from both the sale and the acquisition, the exchange documents, and the fixed asset schedule from the property that was relinquished. That combination gives the cost segregation provider what they need to assess whether a study makes sense and, if so, what it should include.
A 1031 exchange can be a springboard into a larger, better-positioned investment. Cost segregation can amplify the benefit on the new side. But only if the numbers going in are right.
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.
