1031 exchanges and cost segregation

Two tools, two different jobs

Cost segregation accelerates depreciation while you own a property. A §1031 like-kind exchange defers gain when you sell it and reinvest in replacement property. One brings deductions forward; the other pushes tax on the sale into the future. Used together they can be a strong combination, but the classifications a study creates follow the property into the exchange, and they affect how the exchange is taxed.

Only real property is exchanged

Since the 2017 tax law changes, §1031 applies only to exchanges of real property. Personal property no longer qualifies on its own.

Here is the complication. Whether an item is real property for §1031 purposes is decided under the §1031 regulations, which look at state and local law and at how the item is attached to, and functions with, the land or building. That is a different test from the depreciation classification a cost segregation study applies. As a result, some components a study places in the 5- or 7-year class can still count as real property in an exchange, while others are personal property and fall outside it. Which is which depends on the specific components and the facts.

Where recapture can surface

Depreciation taken on §1245 property is subject to recapture as ordinary income when the property is disposed of. In an exchange, that recapture is generally deferred only to the extent the replacement property includes enough §1245 property to absorb it. Where the §1245 property you give up is not matched on the replacement side, recapture can be triggered even though the rest of the exchange is tax-deferred.

That is not a reason to avoid cost segregation. It is a reason to know, before you sell, how much §1245 property is on your books, how those components will be treated in the exchange, and what the replacement property is likely to contain. A study on the property you are selling gives your CPA the component detail to run that analysis. A pre-acquisition estimate on the replacement property shows what it is likely to hold before you close.

Studying the replacement property

Basis in replacement property acquired in an exchange is generally made up of two parts: the basis carried over from the property you gave up, and any additional basis from new cash or debt. The regulations set out how each part is depreciated, including elections that change how the carried-over basis is treated, and whether bonus depreciation can apply depends on the facts of the acquisition.

A study on the replacement property classifies its components so your CPA can apply those rules correctly, rather than defaulting the whole basis to the structure. If you completed an exchange in a prior year without a study on the replacement property, a look-back study may still capture the missed depreciation through Form 3115. Your CPA files and signs the form; we prepare the narrative, the form, the calculations and the supporting schedules.

Who does what

• Your CPA decides how the exchange is reported, applies the recapture and basis rules on the return, and signs it.
• Your qualified intermediary holds the sale proceeds and documents the exchange under the §1031 identification and timing rules.
• We provide the engineering: component detail on the property you are selling, a pre-acquisition estimate or full study on the replacement, and coordination with your CPA throughout.

Common situations

• You studied the property you are selling. Bring the study to your CPA early, so the §1245 property on the books is known before the replacement property is chosen.
• You never studied the property you are selling. Depreciation that was allowable still affects your basis and your gain. Talk to your CPA about whether a study before the sale changes the picture. How recapture works.
• You are buying replacement property. An estimate before closing shows what the replacement property is likely to contain, and a full study after closing classifies it.
• You exchange across a portfolio or fund. The same principles apply property by property. Our portfolio and fund programs keep the deliverables consistent with one coordinator.

How the pieces fit over a hold

For an investor who expects to exchange rather than cash out, cost segregation and §1031 planning work best as one plan that runs from acquisition to exit:

• Before you buy. A pre-acquisition estimate shows what the property is likely to contain, so the depreciation can be underwritten with the deal.
• When you close. A study classifies the property's components in the year it is placed in service, when the benefit of bonus depreciation on the short-life classes is greatest.
• While you hold. Renovations are studied as they happen, and retired components are written off through partial asset dispositions rather than left on the books.
• Before you sell. Your CPA reviews the component picture on the property you are selling, including the §1245 property on the books, and the likely mix on the replacement side.
• After the exchange. The replacement property is studied, and the cycle starts again on the new asset.

Each step is easier when the one before it was documented. That is the practical argument for an engineered study at the start of every hold: it is the record the exit will be planned from.