Submitted by: Gian Pazzia CCSP- Past President ASCSP.
KBKG Tax Insight: Proposed 1031 Regs Should Not Materially Impact Cost Segregation Benefits
Last week, the IRS has issued proposed regs that define what real property is for purposes of 1031 exchanges. This became necessary due to changes in the Tax Cuts and Jobs Act (TCJA) that no longer allows personal property from being eligible for 1031 exchange. To address complications due to the inherent personal property included in a real property exchange (e.g., from cost segregation studies), the proposed regs provide a rule addressing personal property that is incidental to the purchase of real property received in the exchange.
KBKG Insight:The definition of personal property and real property for Section 1031 purposes has been a source of confusion for many years for taxpayers who conduct cost segregation studies of real property. Most cost segregation experts have historically interpreted the definition of real property and personal property for 1031 rules are different than definitions under depreciation rules. These proposed regs offer clarity by indicating these definitions for 1031 purposes should not rely on the definitions used for deprecation purposes.
As many tax professionals read the proposed regs, it may first appear that cost segregation studies may cause problems if a taxpayer intends to exchange the property in the future. However, upon deeper analysis, this is not the case. The proposed regs provide that personal property which is incidental to replacement real property is disregarded. Personal property is incidental to real property acquired in an exchange if, in standard commercial transactions, the personal property is typically transferred together with the real property, and the aggregate fair market value of the incidental personal property transferred does not exceed 15 percent of the aggregate fair market value of the replacement real property.
KBKG Case Study: A property is sold in a Sec. 1031 exchange for $10 million with a corresponding land value of $3 million and building value of $7 million. A cost segregation study was performed on that building resulting in the following allocations:
5 & 7-year property $1.4 million (20%)
15-year land improvements $1.05 million (15%)
39-year property $4.55 million (65%)
15-year land improvements $1.05 million (15%)
39-year property $4.55 million (65%)
The replacement property is purchased for $10 million. The “incidental” rule would disregard any personal property up to 15% of the total purchase price of the new property, or $1.5 million, making this a valid exchange under the proposed 1031 regulations.
KBKG Insight: Even though this is considered a valid exchange under the proposed regulations, taxpayers must still match or exceed personal property values in the new property in order to avoid 1245(b)(4) recapture tax. This has been an issue for many years before these proposed regulations and can be avoided with careful planning.
When considering that most taxpayers tend to “exchange up,” meaning their replacement property is generally purchased for more than the sale price of relinquished property, there is… » READ MORE