Bonus Depreciation and 1031 Exchanges: Tax Savings vs. Long-Term Flexibility

Bonus depreciation can help lower your tax obligations in the year property is acquired, but can reduce the options you have for future 1031 exchanges. Here’s how it can work with Section 1031 to your advantage

Owners of business or investment real estate can face significant tax consequences when they sell properties, especially if those properties have been held for a long period of time, resulting in considerable capital gains. Section 1031 like-kind exchanges allow taxpayers to defer capital gains and other taxes on the sale of business or investment real estate so they can reinvest more of the proceeds into future properties.

Section 1031 isn’t the only tool taxpayers have for reducing their immediate tax burden. Accelerated depreciation rules can allow property owners to take large upfront deductions instead of spreading them out over time, a useful strategy in years when one faces a significant tax burden.

While both strategies can be valuable, they do not always work together as simply as investors expect. If bonus depreciation has been claimed on certain components of a property, the tax impact of a later sale or exchange may become more complicated, particularly where bonus depreciation recapture or depreciation recapture may apply. Here are the basics of the deduction and how it works alongside Section 1031.

What is bonus depreciation?

Bonus depreciation allows taxpayers to accelerate deductions on certain qualifying property components instead of depreciating those costs over a longer period. Bonus depreciation was first instituted in 2002 (“TCJA”), and has been updated over the years, most notably by the Tax Cuts and Jobs Act of 2017, which increased deductions from 50% to 100% for qualifying assets.

Under normal circumstances, property depreciates over time, and businesses are able to deduct that depreciation over the course of many years. But with bonus depreciation, businesses can immediately take the full deduction, receiving the entire tax benefit in the year the asset is acquired.

Only certain types of property are eligible for bonus depreciation. These can include:

• Tangible property with a useful life of less than 20 years
• Manufacturing equipment
• Water utility property
• Certain computer software
• Office furniture and equipment
• Certain building improvements (roofs, HVAC, security systems)
• Appliances and removable fixtures
• Carpet and non-permanent flooring
• Window treatments and removable lighting
• Security equipment and technology infrastructure

By taking bonus depreciation, taxpayers receive their entire tax savings up front, rather than spread out over multiple years. This can reduce one’s immediate tax burden, free up cash flow, and allow taxpayers to invest in other areas of their property or businesses now, making forward-looking tax planning especially important for investors considering future transactions.

There are some pitfalls to bonus depreciation. Once the election has been made, this decision can’t be revoked without IRS approval, and if the business elects not to take bonus depreciation on certain property, this must be made clear on their tax return. When the property is eventually sold, the business is required to recognize any recaptured amount as ordinary income, increasing the amount of taxes owed upon sale. Taking bonus depreciation isn’t right in every situation, but can help businesses that need to find savings now rather than later.

How this differs from a 1031 exchange

IRC Section 1031 also helps taxpayers avoid an immediate tax burden, but Section 1031 applies to different situations. If a taxpayer sells a business or investment property and uses the proceeds to acquire a like-kind property, taxes can be deferred until a subsequent property is disposed of in a non-exchange transaction.

Section 1031 helps taxpayers preserve investment capital, reinvest in new opportunities, consolidate or diversify holdings, and continue building a real estate portfolio without being slowed down by immediate tax recognition. Section 1031 can help small business grow, allows individuals to save for retirement, and can even mean the elimination of taxes if a 1031 property is held until death.

• 1031 exchange = “delay paying tax when you trade one investment property for another”
• Bonus depreciation = “take a tax write-off now rather than little by little over time”

In the past, 1031 and bonus depreciation both applied to personal property, but that changed with the passage of the TCJA. Since 2018, Section 1031 has only applied to real property (AKA real estate), not personal property. This means that Section 1031 and bonus depreciation apply to different kinds of property. However, that doesn’t mean they can’t be used in tandem.

Can I combine accelerated deductions and a 1031 exchange?

A commercial real estate transaction often contains both real property (the underlying real estate) and personal property that can be treated as separate from the property itself (parking lots, flooring and fixtures, landscaping, equipment, etc.). Those shorter-life items may qualify for bonus depreciation, which means you may deduct a lot of their cost upfront instead of slowly over many years, while the real property may still be considered for a Section 1031 like-kind exchange.

In order to determine which elements can qualify for accelerated deductions, a cost segregation study is required. Cost segregation can identify eligible property components and separate their value from that of the real property components.

It is possible to perform a Section 1031 like-kind exchange on a property for which you have taken bonus depreciation, but the math will change. When bonus depreciation is claimed, the basis of the affected assets is reduced. A lower basis can increase gain when the property is later sold or exchanged. That may create additional tax considerations, including possible depreciation recapture and bonus depreciation recapture. In practical terms, an investor may receive a valuable tax benefit up front, but face a more complicated tax picture later.

It’s also important to understand that certain properties have more depreciable assets than others. If you’re exchanging from one property type to another, it may be impossible to replace the depreciated assets, making a larger tax burden inevitable.

Property owners are faced with a choice:

• Perform a cost segregation study, take bonus depreciation on the eligible components, and pay recapture when the property is exchanged
• Don’t take bonus depreciation, simplifying a future exchange

Here’s how the deduction would look if taken on the relinquished or replacement property in an exchange, including how carryover basis and excess basis can affect future deductions, and why someone might choose option 1 or option 2.

What happens when the relinquished property was already depreciated?

Let’s imagine an investor has purchased a property for $1,000,000. The investor commissions a cost segregation study that results in the following allocation:

• Building/real property: $800,000
• Shorter-life property that qualifies for bonus depreciation: $200,000

The investor claims bonus depreciation on the $200,000, creating a sizeable first-year deduction. This helps the investor reinvest in other areas of their business, but also affects their basis, which is now $800,000, because the $200,000 portion has been removed. This means that when the property is sold, the basis will be $800,000, not $1,000,000.

Years later, the investor sells the property in a deal where it is valued at $1,300,000. Let’s assume the amount of personal property is the same, which means the real property is $1,100,000 with $200,000 in depreciated assets. Without bonus depreciation, their gain would have been $300,000 (using the original $1,000,000 basis). But because they took bonus depreciation, the gain is $500,000.

Because of the increased gain, the taxpayer will eventually have a larger tax burden when they sell a property in a taxable sale. For the current exchange, they will have to replace the depreciable assets or pay depreciation recapture. Obviously, every situation is different, but taxpayers who are planning to exchange into a property type with fewer depreciable assets may elect not to take bonus depreciation. It all depends on whether you feel receiving a large deduction now is worth potentially reducing your flexibility down the road.

Taking bonus depreciation on a 1031 exchange replacement property

The above was a scenario where bonus depreciation was taken on a relinquished property, but it’s also possible to take bonus depreciation on a 1031 exchange replacement property. The exchanger would need to commission a cost segregation study on the replacement property to identify depreciable assets and assess whether any excess basis may qualify for additional deductions.

But what if you purchase a property, take bonus depreciation, then sell that property in an exchange? Can you take bonus depreciation on the replacement property after it’s already been taken on the relinquished property? The answer is yes, but only on the portion acquired with new cash or debt.

Michael Podesta, CPA and Audit Director for PP&CO, explains:

“Can bonus depreciation apply to replacement property in a 1031 exchange? In some cases, yes, but generally only with respect to the replacement property’s excess basis, not the carryover basis transferred from the relinquished property. In relative terms, that often means the portion attributable to additional cash invested or new debt incurred in acquiring the replacement property may be eligible for the accelerated deduction, assuming the assets involved otherwise qualify and the taxpayer meets the applicable requirements. Many CPAs analyze this issue by focusing on the replacement property’s excess basis in the 1031 exchange and whether the acquired assets otherwise qualify for bonus depreciation under current federal tax rules.”

So in our example above, where the replacement property is valued at $1.5 million and the relinquished property was sold at $1.3 million, only $200,000 of the new property could potentially qualify for accelerated depreciation treatment, but even that is not a certainty. As Podesta points out, “The final determination depends on basis calculations, asset classification, and the taxpayer’s overall tax circumstances.”

One question we often get is this: if personal property is not eligible under Section 1031, would identifying depreciable assets with a cost segregation study invalidate those portions of the property for future exchanges?

In CCA 200648026, it was determined that “the fact that electrical lines within a building might be classified, in whole or in part, as tangible personal property for purposes of the definition of § 1245 property does not determine whether these lines are tangible personal property or real property.”

In other words, whether a certain part of a property is included in a cost segregation study does not mean it can’t be included in a 1031 exchange. That said, if bonus depreciation is taken, it must be reflected in any future 1031 exchange, particularly when calculating depreciation recapture and the basis of the relinquished and replacement property. But since the cost segregation study doesn’t affect 1031 eligibility, there’s no reason not to see what kinds of deductions are possible right now.

Tips for avoiding mistakes when combining strategies

Having a cost segregation study performed early means getting all the facts so you can decide whether bonus depreciation is right for you. If you plan to hold the property for a long time, it can be very attractive. The tax savings are real, but so is the later risk of recapture, which is why those planning future 1031 exchanges need to look ahead.

A trusted CPA can help you understand the impact of bonus depreciation, basis reduction, and recapture based upon your unique situation. Your advisors can help you evaluate how these factors may affect a future 1031 exchange, so the earlier you speak with your tax and legal advisors, the better prepared you’ll be.

The same is true of a 1031 Qualified Intermediary (QI). You have to work with a QI when performing a like-kind exchange, so speak to one well in advance of your planned property sale so you can set up the exchange properly in order to defer all possible taxes.

Bonus depreciation can provide meaningful short-term tax savings, and a 1031 exchange can help defer taxes and support long-term reinvestment, but when these strategies overlap, the details matter. If you are considering a 1031 exchange and your property has been subject to bonus depreciation or cost segregation, it is important to review the tax implications with your CPA before moving forward, including how depreciation recapture, carryover basis and excess basis could affect your transaction. And when it’s time to perform your 1031 exchange, JTC’s team is here to help coordinate the exchange process and work alongside your advisors to support a smoother transaction.

Learn more about JTC’s QI services