Cost Seg vs. 1031 Exchange | Real Estate Tax Strategy 2025
The 2025 Tax Landscape
The golden age of 100% bonus depreciation is fading. In 2025, we drop to 40% if purchased before January 20, 2025 and the OBBA is restored to 100%, making cost segregation and 1031 exchanges even more valuable for real estate investors who want to manage taxes strategically.
Cost Segregation: Accelerate Depreciation, Boost Cash Flow
Cost segregation reclassifies components of your property into shorter depreciation lives — often unlocking 20–35% of your building’s value in year-one deductions.
Use it when you:
Plan to hold for several years.
Want immediate tax savings.
Need cash flow to reinvest.
1031 Exchange: Defer Capital Gains and Keep Equity Working
A 1031 exchange lets you defer capital gains tax by reinvesting proceeds into a new property.
Use it when you:
Sell an appreciated property.
Want to avoid capital gains recognition.
Are you repositioning your portfolio?
The Hybrid Strategy
Smart investors use both.
Perform a cost seg before selling → take partial depreciation → then roll proceeds into a new property via 1031. Done right, it’s the best of both worlds.
Common Mistakes to Avoid
Running cost seg too close to a 1031 closing (recapture risk).
Not coordinating depreciation schedules.
Failing to plan the entity structure in advance.
Understanding Cost Segregation and 1031 Exchanges for Modern Multifamily PropertiesModern multifamily properties—like sleek apartment complexes with amenities such as rooftop decks, fitness centers, and smart tech integrations—represent prime opportunities for real estate investors to leverage tax strategies. These properties often involve significant capital outlays, making tools like cost segregation studies and Section 1031 exchanges essential for optimizing cash flow, deferring taxes, and building long-term wealth. Below, I'll break down each strategy, their interplay, and specific considerations for multifamily assets, drawing on established IRS guidelines and expert insights. What is Cost Segregation? Cost segregation is an IRS-approved engineering-based analysis that accelerates depreciation deductions by reclassifying portions of a property's cost basis into shorter-lived assets (e.g., 5, 7, or 15 years instead of the standard 27.5 years for residential rental property like multifamily buildings).
How it works: A study dissects the building into components—such as carpeting, lighting fixtures, landscaping, or HVAC systems—and identifies those eligible for quicker depreciation. This can front-load deductions, potentially reducing taxable income by 20-40% in the early years.
Benefits for multifamily properties: These assets often have high-value personal property (e.g., appliances in units, pool equipment) that qualifies for acceleration. Bonus depreciation (up to 60% in 2025, phasing down further) can apply to qualifying elements, enhancing cash flow for renovations or distributions.
Example: On a $10M multifamily acquisition, a study might reallocate $2-4M to shorter lives, yielding $500K+ in first-year deductions.
Studies are most effective post-purchase or renovation and can be applied to new builds, acquisitions, or even leased spaces. What is a 1031 Exchange? Under IRC Section 1031, investors can defer capital gains taxes by "exchanging" one investment property (the "relinquished" property) for another of "like-kind" (broadly, any U.S. real estate held for investment). This applies seamlessly to multifamily properties, allowing upgrades from smaller apartments to larger complexes without immediate tax hits.
Key rules (as of 2025): Proceeds must go through a qualified intermediary; identify replacement properties within 45 days; close within 180 days. Post-TCJA (2017), exchanges are limited to real property only—no personal property or intangibles.
Benefits for multifamily: Enables scaling—e.g., trading a 20-unit building for a 50-unit one—while preserving equity. No limit on transaction size, but strict timelines apply.
Example: Selling a multifamily property with $2M in deferred gains lets you roll the full proceeds into a larger asset, deferring taxes indefinitely (or until a non-1031 sale).
Synergy: Combining Cost Segregation and 1031 ExchangesThese strategies complement each other powerfully for multifamily investors, but require careful basis management to avoid pitfalls like depreciation recapture (taxed at ordinary rates up to 25%). The Tax Cuts and Jobs Act (TCJA) enhanced their pairing by excluding personal property from 1031 basis carryover, making cost segregation more viable on replacement properties.
Aspect
Cost Segregation Alone
1031 Exchange Alone
Combined Strategy
Primary Goal
Accelerate depreciation for immediate tax savings
Defer capital gains on sale
Defer gains + accelerate deductions on new property
Tax Impact
Increases deductions (e.g., 25-50% reclassification)
Defers 15-20% federal + state gains tax
Maximizes both; bonus depreciation on "excess basis"
Multifamily Fit
Ideal for amenities-heavy builds (e.g., gyms, elevators)
Enables portfolio growth (e.g., single- to multi-unit)
Study on replacement unlocks cash flow for scaling
Potential Drawback
Recapture on sale if not exchanged
Low carryover basis limits new deductions
Requires election to depreciate full basis; complicates future exchanges
ROI Boost Example
$300K/year extra deductions on $5M property
Defer $500K taxes on $3M gain
$400K combined savings Year 1 post-exchange
Basis Mechanics: In a 1031, the replacement property inherits the relinquished property's adjusted basis (carryover basis). Any "excess basis" (from added debt or cash) starts fresh and qualifies fully for cost segregation and bonus depreciation. By default, only excess basis accelerates—but you can elect under Treas. Reg. §1.168(i)-6(i) to depreciate the entire basis over the replacement's life, enabling a full study.
Process for Multifamily:
Sell relinquished property via 1031 (e.g., older apartments).
Acquire replacement (e.g., modern complex with blueprint-planned efficiencies).
Post-closing: Commission a cost segregation study on the new asset to identify short-life components like unit fixtures or site improvements.
File your return to claim deductions.
Multifamily-Specific Tips: These properties often yield high reclassification rates (30-50%) due to interior elements. Use studies to support Tangible Property Regulations for repairs vs. improvements. For scaling from single-family to multifamily, 1031 defers gains while cost segregation offsets rental income.
Considerations and Caveats
Timing: Start the study soon after acquisition to align with tax filing; 1031 basis must be finalized first.
Costs: Studies run $5K-$20K (ROI often 5-10x); 1031 fees ~$1K-$2K.
Risks: Noncompliance (e.g., missing timelines) triggers full taxes + penalties. Prior segregation can lead to ordinary income recapture on unexchanged gains. Always consult a tax advisor or CPA specializing in real estate.
2025 Updates: Bonus depreciation phases to 40%; no major 1031 changes, but monitor IRS guidance.
By overlaying these strategies—like a blueprint on your aerial-view multifamily asset—you can visualize and realize deferred growth. For personalized advice, reach out to a professional; this isn't tax advice. If you'd like me to expand on examples, calculations, or related visuals (e.g., confirming an image generation for that aerial blueprint concept), just let me know!
Internal Link Prompt: Learn more about our Tax Planning Services → /services/tax-planning]
CTA:
Ready to see which strategy saves you the most?
Book your Strategic Tax Blueprint Session with Strategic Planning Advisors today.
Results. Expertise. Integrity.
About the Author:
Frank Alcini, CPA, founder of Strategic Planning Advisors, helps real estate investors and construction professionals implement strategic tax plans that build wealth and protect assets.
