Written by Dustin Peck, CPA
1031 exchanges and cost segregation studies are both powerful strategies for real estate investors. However, what happens when they are used in conjunction with each other? In this article, we will explore the opportunities and benefits of pairing these two strategies, as well as some potential pitfalls. In previous blog posts, we covered 1031 exchanges and Cost Segregation fundamentals. We recommend reviewing those articles first for a deeper understanding of these concepts.
Maximizing Depreciation:
Investors who have decided to utilize a 1031 exchange may also want to consider a cost segregation study on the replacement property in order to maximize accelerated depreciation on that new property. However, what is the basis in the new property that is available for cost segregation? The basis of the replacement property is broken up into two parts: the carryover basis and the excess basis (if any). Under the default rules for depreciation following a 1031 exchange, the carryover basis from the relinquished property continues depreciating; it does not restart. It generally continues to depreciate over the remaining life of the relinquished property, unless the replacement property has a longer depreciable life, in which case it extends to the longer life but still starts from the original depreciation schedule of the relinquished property. If there is any excess basis from the 1031 exchange, this portion starts depreciation based on the depreciable life of the replacement property. Under this default method, only the excess basis would be eligible for cost segregation. With only the excess basis available, this limits the impact of a cost segregation study.
However, the taxpayer can make an election under Treas. Reg. § 1.168(i)-6(i)(1) to restart the depreciation on the carryover basis of the property based on the depreciable life of the replacement property. Making this election allows the full basis (both the carryover and excess basis) to be eligible for cost segregation. This has the potential to significantly increase the tax benefit of a cost segregation study on a replacement property. However, this requires careful cost versus benefit analysis. It is possible in some cases that the acceleration of depreciation from the cost segregation after making this election would not result in increased depreciation versus continuing depreciation over the remaining life of the relinquished property. This can depend on how long the relinquished property has been held and the makeup of tax lives existing in each property. One key factor in this determination may be the ability to take bonus depreciation. The excess basis of the property is always eligible for bonus depreciation (based on the portion of bonus-qualifying assets identified in the cost segregation study). However, the carryover basis would only be eligible for bonus depreciation if the replacement property is brand new and unused. For example, if an investor purchased a brand-new home directly from a home builder, then the carryover basis would be eligible for bonus deprecation; however, if they purchased an existing home that was being rented out or lived in by the previous owner, then the carryover basis would not be bonus eligible.
Example: John owns a property he purchased for $500,000 and has taken $100,000 of depreciation on the property, leaving him with an adjusted tax basis of $400,000. Through a qualifying fully deferred 1031 exchange transaction, he sells the property for $800,000 and purchases a replacement property for $900,000. His carryover basis is $400,000, and his excess basis is $100,000. Without making the election noted in the previous paragraph, only the $100,000 of excess basis is eligible for cost segregation. With the election, the entire $500,000 basis is eligible for cost segregation.
Personal Property Issues:
Performing a cost segregation study on a replacement property in a 1031 exchange can illuminate a potential issue in your 1031 exchange. A cost segregation study aims to identify property components that are eligible for accelerated depreciation or shorter tax lives. Often, some of these components identified are considered personal property under depreciation regulations. Current 1031 exchange regulations only allow for like-kind exchange of real property. Personal property is not eligible for like-kind exchange. Fortunately, there are two factors that help reduce the potential for this issue to cause a 1031 exchange to be invalid. One is that the definition of real property under the 1031 regulations includes certain types of property that would be considered personal property under the depreciation regulations. The second is that the IRS allows a safe harbor for “incidental” personal property. Personal property can be included in a like-kind exchange transaction if: 1) it is typically transferred together with real property in standard commercial transactions; and 2) it does not exceed 15% of the value of the replacement real property. However, even though this “incidental” personal property does not invalidate the exchange, it could still result in boot.
Example: Jane owns a property worth $900,000 with an adjusted basis of 400,000. She wishes to sell the property by performing a 1031 exchange transaction and purchase a replacement property for $900,000. The relinquished property’s $900,000 value comprises all qualifying real property under 1031 regulations. The replacement property is made up of $800,000 of real property value and $100,000 of office furniture that does not qualify as real property under 1031 regulations. The personal property value does not exceed 15% of the value of the replacement real property. Therefore, this personal property is considered “incidental” and is disregarded in determining the validity of the 1031 exchange. However, because the $100,000 of personal property received in the exchange is non-like kind property, this is considered “boot” and Jane would recognize $100,000 of taxable gain, reducing her deferred gain.
What if a taxpayer had a cost segregation study done on a property and then later wished to dispose of that property in a 1031 exchange? In this case, the relinquished property may have components that were depreciated under accelerated depreciation methods, some of which may also be personal property. The 15% rule for “incidental” personal property still applies to protect from invalidating the exchange. However, even in a complete exchange without any boot, there still is a potential for ordinary gain on depreciation recapture. 1031 exchanges generally allow for the deferral of capital gain and gain on straight-line depreciation on real property. Depreciation on personal property and accelerated depreciation on real property is generally subject to ordinary income recapture, just as it would be if sold separately from a 1031 exchange. This ordinary recapture may be avoided in some situations if the replacement property has the same value or greater of qualifying like-kind property in the same property type. This is one reason it may be beneficial to perform cost segregation on the replacement property in these situations.
Example: Joe performed a cost segregation study on his residential rental property. The cost segregation study determined that the property included $50,000 of 5 year personal property under depreciation regulations, although it is considered real property under 1031 regulations. He later wishes to sell the property and acquire a new property. The 5 year property is fully depreciated but still worth $30,000; therefore, if he sold the property, he would be subject to $30,000 of taxable ordinary income recapture. Instead, he performs a 1031 exchange and acquires a replacement property worth $900,000. Joe performs a cost segregation study on his replacement property, which identified $50,000 of 5 year property that qualifies as real property under 1031 regulations. See the table below for the full details of the allocation of values in each property.
Result: All property in the exchange is considered like-kind, and there is no boot. The depreciation on the 5 year property is not subject to ordinary income recapture because a greater value of the 5-year property was acquired in the fully deferred 1031 exchange.
In conclusion, utilizing 1031 exchanges and cost segregations together can produce significant tax benefits for real estate investors; however, it can also produce unintended results. When combining these two strategies, it is crucial to work with knowledgeable professionals to develop a strategic approach to maximize tax benefits while avoiding potential pitfalls.
Dustin joined Trout CPA in 2018 after graduating from Messiah College (summa cum laude) with a Bachelor of Science degree in Accounting with a minor in Economics. Dustin serves on the firm’s Construction & Real Estate and Consumer Services Industry Groups. He also serves on the firm’s Multistate Taxation Industry Group. In his free time, Dustin enjoys spending time with his family and friends and participating in outdoor activities such as hiking, biking, and hunting. He lives in Lancaster County with his wife.