EXPLAINED: Cost Segregation followed by 1031 exchange creates tax problems

[Michael Plaks]

@Bernard Reisz  @Natalie Kolodij  @David Orr  @Kory Reynolds  @Dave Foster  

A lengthy introduction.

This post has been promised for 2 years on various threads, and it's finally here. The result of tedious time-consuming research and peer brainstorming with my colleagues and friends (tagged at the top, thank you!): we finally arrived at a consensus, for the most part.

For my fellow tax professionals and other tax nerds: let's resist our natural temptation to debate the highly technical details here. Let's do it offline, to protect the innocent bystanders.

For investors: this is a very complex and highly technical stuff, and it is NOT necessary to understand all the details. But it's useful to be aware that these problems do exist. Leave the rest to your CPAs.

For everyone: in taxation, there is a huge gap between what the law and the rules prescribe and the real world. If you read this post and dismiss it by saying - but nobody does this in real life! - you won't be wrong. Yet these rules are here anyway. Ignoring them is your choice.

What is this whole thing about, the short version?

Cost segregation coupled with 1031 exchanges.

You buy an STR for $200,000. You do cost segregation. It says you can apply bonus depreciation to $50,000 of it. You get an immediate $50,000 tax write-off. You are happy.

By next year, you are tired of all the hassles of dealing with annoying demanding guests and the messes they leave behind and neighbors complaining about noise and parking. You decide to get rid of it.

Your investor friends and TikTok, ahem, experts and Bigger Pockets forum posters tell you: don't sell, do a 1031 exchange! There's no tax hit because it's an exchange!

Guess what? They are wrong. Not wrong about recommending a 1031 exchange, it could be a great move, depending on your situation. But wrong suggesting that it avoids all taxes. It doesn't. This is the point of this long post.

Doing a 1031 exchange after cost segregation does create tax problems!

You can stop reading now. The rest is the details.

Problem 1. Depreciation recapture on the furniture you give up.

Furniture, electronics, pictures and all the other moveable stuff that you leave in your old STR cannot be included in the exchange, contrary to what you've been told. No, the so-called 15% incidental rule doesn't apply here.

You have to figure out how much this stuff is worth at the time of your exchange. $5,000? Ok, you have $5,000 of taxable income, at ordinary rates (the bad kind).

Oh, it's completely worthless, you say, like $0 value? Well, if you can say it with a straight face, then you avoided recapture tax.

Problem 2. Depreciation recapture on the cabinetry in your house.

Your cost segregation report said that you could deduct cabinets, countertops, floating laminate floors and other items installed on the property. It was correct.

Your exchange facilitator told you that these items could be included in the exchange (unlike furniture). This was also correct.

Where is the problem then? To avoid depreciation recapture, you need to have corresponding items in the replacement property.

Example: if the cabinetry and fixtures and other similar items are worth $20,000 today, you need $20,000 worth of similar items in the property you're buying in the exchange. It only has $15,000? Then you have $5,000 of taxable depreciation recapture. It has none at all, like a white box warehouse or undeveloped land? Then the full $20,000 of the old property is taxed as depreciation recapture, and at the bad ordinary rates.

Disclosure: this is the only part of this post where we don't have a firm consensus between CPAs. Some of my colleagues doubt that this is a problem. I'm confident that it is.

Appliances and carpets.

You may have noticed that I didn't mention them before. There is a reason.

The fact that they are eligible for bonus depreciation is not debatable. Whether they can be included in the exchange is. As in - are they treated like furniture or like cabinetry?

The IRS specifically said that inclusion of carpets and appliances in a 1031 exchange is case by case. Sometimes yes, sometimes no.

But even if they are included (akin cabinetry), they can still trigger depreciation recapture at the time of exchange, as explained above. At least in my personal educated opinion.

Problem 3. Taxable "boot" on furniture received.

If your new property comes with furniture, electronics, fixtures and so on - they are not part of the exchange. They are what is called taxable boot. Ask your exchange facilitator or your CPA or even ChapGPT to explain what it means. It means possible tax on part of your exchange.

Oh, but you were told it's tax-free if within "15% incidental" allowance? You were told wrong, sorry. No such allowance. The 15% rule serves a very different purpose.

Problems 4-5-6...

There's room for more controversy and more obscured rules. But I think we had enough.

No to double- and triple- cascade of cost segregation followed by 1031.

It was suggested on this forum that you can supercharge this chain by doing it repeatedly. Nice try but you cannot, save for some rare situations. Unless you ignore the intricacies of the IRS rules of course.

Some reasons were discussed in the comments on the post that suggested this 2x/3x approach. The issues discussed by me in this post are additional reasons why that attractive idea does not work.

So, what should be done differently then?

Cost segregation reports, for starters. They should not stop at identifying "5-yr personal property." They should separate it into property qualifying as "real property" for 1031 purposes (cabinetry, countertops, wiring etc) and property that does not (furniture, curtains, pictures, TVs etc ). And make a call on those case-by-case things like appliances and carpets.

Tax planning. If you're considering a 1031 exchange for a property that has been cost segregated, especially if placed in service recently, and double so if it's an STR - advance planning can save you a pretty penny. In some special cases, you might even want to reconsider cost segregation or an exchange. Needless to say, you will need a tax accountant/advisor/strategist very well versed in this specialized area.

Tax preparation. If you have already done both cost seg and a subsequent 1031, it has to be correctly prepared. 9 out of 10 tax returns in this situation, and maybe even 10 out of 10, ignore these complications. What if you or your CPA decide to do it right? Then you have a very challenging project on your hands: mitigating these adverse tax consequences. Yes, it is possible, via things like price allocation for various exchange components. But it is the high end of tax preparation art, and you will need a high end expert.

Cost segregation on the new property. In view of these rules, cost segregation on the new property is not optional. If you cost segregated the old property, you pretty much have to do the same on your new property.

What will actually be done differently?

Probably nothing. We real estate people don't like rules, hassles and all that junk. We like checks at closings and tax refunds.