2018 Tax Law Impact on 1031 Exchanges/Cost Segregation

13 Replies

The new tax law made it so that the gain on the sale of personal property can no longer be deferred through a 1031 exchange (1031s can now only be used for real property).

Likewise, the new tax law made cost segregation studies far more valuable in the short-term by increasing bonus depreciation from 50% to 100% on property with a useful life of less than 20 years.

However, in essence what cost segregation studies do is transform a portion of real property into personal property.  This is a great short-term benefit, but what impact will it have on future 1031 exchanges.  Do you think the IRS is going to rule that the personal property components affixed to the real estate in a 1031 exchange are "other property" and thus boot, or ignore it?

Some of my REI clients are grappling with this, and I am still of the opinion that they should still do the cost seg studies if there are large enough short-term savings and they are planning on holding the property for an indefinite amount of time, but I am curious about other views on this.

I'm waiting for the IRS to issue further guidance- a handful of issuance is anticipated in August. 

The way I now see it 1245 (personal) property isn't allowed to be 1031 exchanged. So how can we just ignore that we got the benefit of qualifying it as such AND still get the 1031? 

The entire time it was kind of jumbled I felt since you could still just 1031 in one lump- you didn't have to match your 1245/1250 in old and new properties. 

So my instinct says : No it will trigger boot. 


My experience with how tax guidance tends to go: They'll find some magical exception to somehow make this allowable in spite of tax code stating it shouldn't be. 

This is an interesting question. Here is an article where a law professor discusses a lot of the uncertainties surrounding 1031 exchanges after the tax law changes. The author here suggests that a cost seg. study merely identifies what is 1250 property, 1245 property, etc. and presumably these categories exist even without the cost seg. study.

Many questions exist currently.. I think everyone is looking forward to new regulations!

Link to the article:

https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3179003

Originally posted by @Michael Torhan :

This is an interesting question. Here is an article where a law professor discusses a lot of the uncertainties surrounding 1031 exchanges after the tax law changes. The author here suggests that a cost seg. study merely identifies what is 1250 property, 1245 property, etc. and presumably these categories exist even without the cost seg. study.

Many questions exist currently.. I think everyone is looking forward to new regulations!

Link to the article:

https://papers.ssrn.com/sol3/papers.cfm?abstract_i...

Oh boy I did not have time to read a 13 page paper but based on the summary it seems his basis is code section 1031 doesn't specifically identify real property....but other sections of IRC do. 

I'll wait to see what kind of guidance is issued. This is 13 pages of my life I won't get  back if the IRS says the opposite tomorrow lol

Let's take an example of what would happen if there's no future exception.

I buy a $500k property and cost-seg $100k of it as personal 5-yr property and bonus-depreciate 100% of it.

I now have $400k basis in the building and $0 basis in the personal property.

Fast-forward 5 years, and the property is worth $1 mil. I have to allocate the sales price between the two classes, but by now the personal property is probably not worth the original $100k. Let's be conservative and assume it is still worth $100k. What do we have?

Gain of $100k on the 1245 property (depreciation recapture) which is not eligible for 1031 and $500k gain on the building which is eligible for 1031. (Yeah, ignoring building depreciation, other classes, land etc.)

So my worst case scenario is having to return the deduction I got upfront from the cost seg.  I still win a little bit with time value of money. But in reality, the value goes down, so I won't have to recapture the entire value of the personal property.

As far as boot - I think it only matters if the value of 1245 received in the exchange is also segregated and exceeds the value of 1245 given up.

Bottom line: cost seg is much less beneficial if it cannot be rolled into a 1031 - but still beneficial, as @Brian Schmelzlen says. (Sorry, @Natalie Kolodij , I tried my best to be under 13 pages)

Great post @Brian Schmelzlen , this was a hot topic in our office this week as well.

@Michael Plaks , good break down of real life example. 

Here's my two cents on an additional strategy to help both 1031's while having done cost seg. This is an old strategy, not my own:

If you do cost segregation, thereby identifying personal property (1245 to make @Natalie Kolodij happy), you can no longer 1031 that property. BUT, the depreciation recapture of that 5-year property is not taxed as capital gains, rather regular income tax rates.

Now when you 1031 exchange into your new property, you can utilize 50% or 100% bonus depreciation of the personal property (1245) , and defer your taxes!!!

Any thoughts?

Disclaimer, I am not a CPA or EA like you guys.

Hello All, 

Very interesting discussion, although  a bit complex for us relative newbies ;-)

One thing I have read else where and also kind of mentioned above is about the tax rate on the 'depreciation recapture tax'. I usually see it referred to as being a 25% rate, with no reference to what tax bracket the taxpayer is in. Above, and a few times elsewhere I have seen it referred to as 'taxed at ordinary income tax rate', which I tax as meaning if I am in the 12% bracket, it would be at that rate. 

Am I misunderstanding something here?

Related to this tax and capital gains, in what order are they applied? Meaning if I have say 30K of ordinary income and in the 12% bracket, and I then sell a property where I have say 10K of recapture and 10K of capital gains for a total of 50K. 1) Does my ordinary income tax rate stay at the 12% 2) Is recapture taxed at 12%, or added to #1 and then 22% (rate for single @ 40K), or the 25% we hear so much about 3) Does capital gains tax stay at 0% since my regular ordinary income, not counting the recapture amount, is in the 12% bracket?

Thanks to all of you who so willingly share your knowledge here, 

Dan Dietz

Hey @Daniel Dietz  

So something to keep in mind is that the income from the sale of the property will account into what tax bracket you fall into. 

I think that's why we typically use 25% for dep recapture (even though it's up to 25%) - because if you're selling a property with big enough gains to be really worried, there's a good chance you'll hit that spot any way. 

You may be in a lower bracket normally- but add in $200k of income from selling a house and you climb fast. 

Originally posted by @Daniel Dietz :

Hello All, 

Very interesting discussion, although  a bit complex for us relative newbies ;-)

One thing I have read else where and also kind of mentioned above is about the tax rate on the 'depreciation recapture tax'. I usually see it referred to as being a 25% rate, with no reference to what tax bracket the taxpayer is in. Above, and a few times elsewhere I have seen it referred to as 'taxed at ordinary income tax rate', which I tax as meaning if I am in the 12% bracket, it would be at that rate. 

Am I misunderstanding something here?

Related to this tax and capital gains, in what order are they applied? Meaning if I have say 30K of ordinary income and in the 12% bracket, and I then sell a property where I have say 10K of recapture and 10K of capital gains for a total of 50K. 1) Does my ordinary income tax rate stay at the 12% 2) Is recapture taxed at 12%, or added to #1 and then 22% (rate for single @ 40K), or the 25% we hear so much about 3) Does capital gains tax stay at 0% since my regular ordinary income, not counting the recapture amount, is in the 12% bracket?

Thanks to all of you who so willingly share your knowledge here, 

Dan Dietz

 Since all of that depreciation expense while you own the property reduces your taxable income, when you "recapture" it, it will be taxed at regular income tax rates.

Originally posted by @Thomas Rutkowski :
Originally posted by @Daniel Dietz:

Hello All, 

Very interesting discussion, although  a bit complex for us relative newbies ;-)

One thing I have read else where and also kind of mentioned above is about the tax rate on the 'depreciation recapture tax'. I usually see it referred to as being a 25% rate, with no reference to what tax bracket the taxpayer is in. Above, and a few times elsewhere I have seen it referred to as 'taxed at ordinary income tax rate', which I tax as meaning if I am in the 12% bracket, it would be at that rate. 

Am I misunderstanding something here?

Related to this tax and capital gains, in what order are they applied? Meaning if I have say 30K of ordinary income and in the 12% bracket, and I then sell a property where I have say 10K of recapture and 10K of capital gains for a total of 50K. 1) Does my ordinary income tax rate stay at the 12% 2) Is recapture taxed at 12%, or added to #1 and then 22% (rate for single @ 40K), or the 25% we hear so much about 3) Does capital gains tax stay at 0% since my regular ordinary income, not counting the recapture amount, is in the 12% bracket?

Thanks to all of you who so willingly share your knowledge here, 

Dan Dietz

 Since all of that depreciation expense while you own the property reduces your taxable income, when you "recapture" it, it will be taxed at regular income tax rates.

Depreciation Recapture tax for real property (1250) is taxed at capital gains rates. That can be anywhere from 0-25%. However, the personal property that was depreciated (1245) is taxed at one's personal income tax rate, whatever that may be.

Originally posted by @Yonah Weiss :
Originally posted by @Thomas Rutkowski:
Originally posted by @Daniel Dietz:

Hello All, 

Very interesting discussion, although  a bit complex for us relative newbies ;-)

One thing I have read else where and also kind of mentioned above is about the tax rate on the 'depreciation recapture tax'. I usually see it referred to as being a 25% rate, with no reference to what tax bracket the taxpayer is in. Above, and a few times elsewhere I have seen it referred to as 'taxed at ordinary income tax rate', which I tax as meaning if I am in the 12% bracket, it would be at that rate. 

Am I misunderstanding something here?

Related to this tax and capital gains, in what order are they applied? Meaning if I have say 30K of ordinary income and in the 12% bracket, and I then sell a property where I have say 10K of recapture and 10K of capital gains for a total of 50K. 1) Does my ordinary income tax rate stay at the 12% 2) Is recapture taxed at 12%, or added to #1 and then 22% (rate for single @ 40K), or the 25% we hear so much about 3) Does capital gains tax stay at 0% since my regular ordinary income, not counting the recapture amount, is in the 12% bracket?

Thanks to all of you who so willingly share your knowledge here, 

Dan Dietz

 Since all of that depreciation expense while you own the property reduces your taxable income, when you "recapture" it, it will be taxed at regular income tax rates.

Depreciation Recapture tax for real property (1250) is taxed at capital gains rates. That can be anywhere from 0-25%. However, the personal property that was depreciated (1245) is taxed at one's personal income tax rate, whatever that may be.

 Its taxed as regular income. The rate is capped at 25%.

It's calculated via the 1250 recapture worksheet as part of schedule D- it's capital gains rates. 

It may be based on ordinary interest if held less than one year. 

https://www.irs.gov/publications/p544#en_US_2017_p...

https://www.irs.gov/taxtopics/tc409

https://www.law.cornell.edu/uscode/text/26/1#h

Thanks for all the feedback from everyone. I have only bought properties so far, so the taxes upon selling are new to me, and probaby a few year off, but I want to plan ahead. 

So I can understand fully, in a simplfied scenario, if I have 30K of ordinary income, and I sell a property or stock or what ever and have say a 40K gain (let's leave recapture out of it for now) . So my 30K of ordinary income is taxed at 12%, and so far I am in the 0% capital gains group. Once I add the 40K in capital gains, is the first 8K taxed at 0% UP TO the next bracket (about 38K I think), and then the other 32K of capital gains would be taxed at the 15% capital gains rate? 

Thanks, Dan Dietz