Doing a 1031 Exchange on a Short Term Rental that is Cost Segregated

Member since 2022 · 5 posts · 3 votes

I have a short term rental that I self manage and am considered a real estate professional based on material participation rules. I did a cost segregation on the property 2 years ago and am now in the process of selling the home to purchase a long term rental. Based on the expected sale price, I am not expecting a capital gains hit as the sale price is only $15k more than purchase price. My question is: Since there is such a small capital gains tax hit, is there still a benefit to 1031 exchange to transfer any of that depreciation with the sale so I don't get a big tax hit on this sale? Or is cost segregation not transferable with the 1031 exchange? Thanks of any advice.

2 Reply

78 views

Most Popular Reply

Jon Taylor

Pasadena, CA · Member since 2019 · 136 posts · 148 votes

@Cameron Nordin

A cost segregation study accelerates depreciation by classifying certain building components as personal property or land improvements, allowing them to be depreciated over shorter recovery periods (e.g., 5, 7, or 15 years instead of 27.5 or 39 years).

By accelerating depreciation, cost segregation lowers your tax basis more quickly than standard straight-line depreciation. This means that when you sell the property, your adjusted tax basis is lower, which increases the capital gain you must recognize.

Additionally, any accelerated depreciation taken is subject to depreciation recapture at a higher tax rate (up to 25% for real estate assets) rather than being taxed as long-term capital gains.

So, while cost segregation provides significant upfront tax savings, it also increases your capital gains tax liability upon sale unless you use a 1031 exchange or other tax-deferral strategies.

You can find your current tax basis by reviewing your depreciation schedule (Form 4562) and prior years’ tax returns, specifically looking at your adjusted basis on Form 4797 (for sales of business property) or Schedule D (for capital gains and losses).

Your CPA should be consulted prior to making any decisions.

6 Reply

See this reply in the discussion

13 Replies

Jump to latestLatest

Sort by

Jon Taylor
Pasadena, CA · Member since 2019 · 136 posts · 148 votes
1y
@Cameron Nordin
A cost segregation study accelerates depreciation by classifying certain building components as personal property or land improvements, allowing them to be depreciated over shorter recovery periods (e.g., 5, 7, or 15 years instead of 27.5 or 39 years).

By accelerating depreciation, cost segregation lowers your tax basis more quickly than standard straight-line depreciation. This means that when you sell the property, your adjusted tax basis is lower, which increases the capital gain you must recognize.

Additionally, any accelerated depreciation taken is subject to depreciation recapture at a higher tax rate (up to 25% for real estate assets) rather than being taxed as long-term capital gains.

So, while cost segregation provides significant upfront tax savings, it also increases your capital gains tax liability upon sale unless you use a 1031 exchange or other tax-deferral strategies.
You can find your current tax basis by reviewing your depreciation schedule (Form 4562) and prior years’ tax returns, specifically looking at your adjusted basis on Form 4797 (for sales of business property) or Schedule D (for capital gains and losses).
Your CPA should be consulted prior to making any decisions.

6 Reply
Cameron Nordin
OP
Member since 2022 · 5 posts · 3 votes
1y
@Jon Taylor, this is a great explanation. Thanks so much for breaking that down for me.
1 Reply
Steve WoltermanBusiness Member
Attorney / Qualified Intermediary · Cincinnati, OH · Member since 2022 · 49 posts · 26 votes
1y
@Jon Taylor explained it l well. Yes, a 1031 will probably still make sense.
1031 Federal Exchange
Website View Page
1 Reply
Daniel Osman
Accountant · 1031 Exchange Qualified Intermediary | Nationwide · Member since 2024 · 53 posts · 32 votes
1y
@Jon Taylor provided a masterful breakdown.

To add to it. Your capital gain is calculated as the amount realized from the sale minus your adjusted basis. Due to the accelerated depreciation you've taken, your adjusted basis will be lower than your original purchase price. In your situation, the primary concern is the potential tax impact from depreciation recapture, rather than capital gains. When you sell a property, the IRS requires you to recapture the depreciation you've taken, which is taxed at a higher rate than capital gains. This includes any accelerated depreciation from a cost segregation study.

Many investors are unaware of the depreciation recapture tax and only consider potential capital gains. I've included an example of the taxes you might incur in an image below.

A 1031 exchange can be beneficial in your case because it allows you to defer not only capital gains taxes but also the depreciation recapture tax, thus avoiding the immediate tax hit. The basis of the replacement property will be adjusted to reflect the deferred gain and depreciation recapture, meaning the deferred depreciation will continue to impact your tax situation in the future.

As always, consult with your CPA before making any decisions to ensure the best strategy for your specific situation.

0 Reply
Dave FosterBusiness Member
Qualified Intermediary for 1031 Exchanges · St. Petersburg, FL · Member since 2013 · 9k+ posts · 9k+ votes
1y
@Cameron Nordin, @Jon Taylor's explanation was spot on. The 1031 is going to reap you a large net benefit even if there isn't a lot of capital gain. The depreciation on the cost seg will bit you pretty good.
The 1031 Investor5137 Reviews
Website View Page
0 Reply
Bill B.
Investor · Las Vegas, NV · Member since 2013 · 8k+ posts · 10k+ votes
1y
Short answer is you’ll owe as much or more taxes than you saved with your cost segregation if you don’t do a 1031. So, If you don’t do a 1031 you shouldn’t have done the cost segregation. If you thought that was worthwhile this should be too.
1 Reply
Jon Taylor
Pasadena, CA · Member since 2019 · 136 posts · 148 votes
1y
@Bill B. - This is a great point of view.
1 Reply
Basit SiddiqiBusiness Member
Accountant · New York, NY · Member since 2015 · 8k+ posts · 3k+ votes
1y
Your gain may be more than just the $15,000 increase in price since you did the cost segregation study.

The cost segregation study reduced your basis when you applied it 2 years ago. Therefore, you may have a sizable gain without doing a 1031.

Discuss with your accountant what the tax ramifications are with and without a 1031 exchange.
[email protected]917-280-8544
Basit Siddiqi CPA4.979 Reviews
View Page
0 Reply
Sean GrahamBusiness Member
Investor , CPA · Detroit, MI · Member since 2016 · 582 posts · 248 votes
1y
Quote from @Bill B.:

Short answer is you’ll owe as much or more taxes than you saved with your cost segregation if you don’t do a 1031. So, If you don’t do a 1031 you shouldn’t have done the cost segregation. If you thought that was worthwhile this should be too.
I disagree. Cost segregation can still be beneficial without a 1031 exchange.
Think about the "lazy 1031 exchange". Ex. You use the depreciation losses from Property B to offset the depreciation recapture & capital gains from the sale of Property A.
Maven Cost Segregation Tax Advisors555 Reviews
Website View Page
1 Reply
Bill B.
Investor · Las Vegas, NV · Member since 2013 · 8k+ posts · 10k+ votes
1y
@Sean Graham isn’t your example paying for another cost segregation, which will cost more than a 1031, just to break even on taxes? As opposed to either doing the cheaper 1031 and being ahead on taxes. Or doing the 1031 and a cost segregation and being way ahead? It seems like the worst choice.
I'm probably just coming at it from a bad angle as I'm not a big cost seg fan on SFR. I like having my depreciation expenses being available against just my highest taxes every year rather than use too much in year one. Of course I never had a really high w-2 income to offset. So I went almost 7 years paying zero taxes, until I started paying properties off. Now as my income accelerates I'm happy to have the depreciation.
I was simply trying to make the best of his bad situation. I don’t make any money whatever he chooses to do. It’s all good. :-)
0 Reply
- Sean GrahamBusiness Member
  Investor , CPA · Detroit, MI · Member since 2016 · 582 posts · 248 votes
  1y
  Quote from @Bill B.:
  
  @Sean Graham isn’t your example paying for another cost segregation, which will cost more than a 1031, just to break even on taxes? As opposed to either doing the cheaper 1031 and being ahead on taxes. Or doing the 1031 and a cost segregation and being way ahead? It seems like the worst choice.
  I'm probably just coming at it from a bad angle as I'm not a big cost seg fan on SFR. I like having my depreciation expenses being available against just my highest taxes every year rather than use too much in year one. Of course I never had a really high w-2 income to offset. So I went almost 7 years paying zero taxes, until I started paying properties off. Now as my income accelerates I'm happy to have the depreciation.
  I was simply trying to make the best of his bad situation. I don’t make any money whatever he chooses to do. It’s all good. :-)
  Let's connect on this! It's just another option if 1031 exchange isn't an option. Both a viable strategies.
  Maven Cost Segregation Tax Advisors555 Reviews
  Website View Page
  1 Reply
Ashish AcharyaBusiness Member
CPA, CFP®, PFS · FL · Member since 2017 · 5k+ posts · 3k+ votes
1y
@Cameron Nordin A 1031 exchange allows you to defer capital gains taxes and depreciation recapture, but it does not transfer previously taken cost segregation depreciation to the new property. Instead, depreciation recapture is deferred along with any capital gains when using a 1031 exchange. Since you claimed accelerated depreciation through cost segregation, a sale without a 1031 exchange would trigger recapture tax on the depreciation taken.

Even though your capital gain is small ($15K), the main tax concern is depreciation recapture, not just capital gains. If you don't do a 1031 exchange, you’ll owe tax on the portion of depreciation claimed, even if the sale price is close to the original purchase price. By completing a 1031 exchange, you can roll over both your gains and deferred depreciation into the new long-term rental, avoiding an immediate tax hit.

However, consider whether deferring recapture is worth it if you plan to hold the new property long-term and take additional depreciation. If you anticipate selling the replacement property in a few years without another exchange, the tax deferral may only be temporary.

This post does not create a CPA-Client relationship. The information contained in this post is not to be relied upon. Readers should seek professional advice.
[email protected]941-914-7779
INVESTOR FRIENDLY CPA®5241 Reviews
Website View Page
TaxMD™ | AI-Powered Tax Planning
Website View Page
0 Reply
Stephen Nelson
Accountant , CPA, MBA in Finance, MS in Taxation · Redmond, WA · Member since 2025 · 172 posts · 135 votes
1y
Quote from @Cameron Nordin:

I have a short term rental that I self manage and am considered a real estate professional based on material participation rules.
Being a real estate professional would not matter for a short-term rental if by STR you mean the tax law definition (which is a property where the average rental interval is 7 days or less).

Also just to be clear, to deduct STR losses you'd need to materially participate in the STR.

Note: STRs can work well for real estate investors because tax law says they aren't considered rentals. Here's the actual rule from the regs:

(ii) Exceptions. For purposes of this paragraph (e)(3), an activity involving the use of tangible property is not a rental activity for a taxable year if for such taxable year—
(A) The average period of customer use for such property is seven days or less;

0 Reply

Join the conversationCreate a free account to reply, vote on answers and follow this thread.