Cost Segregation Analysis for primary residence

[Patrick Fricchione]

I have an investment property in an LLC acquired through a 1031 exchange. Should I decide to demo the property in 4 years and rebuild, can I do a cost segregation analysis and use it as a primary residence or will the 1031 disallow it? I hate to miss out on the accelerated depreciation with the CSA.

[Greg Scott]

You can't take depreciation deductions on a primary residence.

I have a feeling that converting this rental to a primary will also unleash a huge tax bill in the form of depreciation recapture.  I'd consult a qualified CPA.

[Patrick Fricchione]

Quote from @Greg Scott:

You can't take depreciation deductions on a primary residence.

I have a feeling that converting this rental to a primary will also unleash a huge tax bill in the form of depreciation recapture.  I'd consult a qualified CPA.

[Account Closed]

Quote from @Patrick Fricchione:

I have an investment property in an LLC acquired through a 1031 exchange. Should I decide to demo the property in 4 years and rebuild, can I do a cost segregation analysis and use it as a primary residence or will the 1031 disallow it? I hate to miss out on the accelerated depreciation with the CSA.

Hey Patrick, 

To make things smoother, you may just want to make the newly constructed residence a rental for two years and then move in after. Ive seen this work well, as its not exactly clearly defined how long the IRS wants the holding period. We need to show we are trying to make it work as an investment 

[Basit Siddiqi]

Be mindful when you do the cost segregation study, the basis will be based on the carryover basis factoring in the deferred gain via 1031 exchange.

[Patrick Fricchione]

I thought the same regarding the CSS and primary residence. I wasn’t quite sure on the 1031 if I did the rebuild and waited a year or two to qualify for the accelerated depreciation while still under the 1031. Hoping for a creative solution, but doubtful.

I have been renting the property and thus the reason I'm giving it several years rather than waiting the proverbial 1 year and 1 day. Your comment mirrors what I was thinking. I will need to discuss with my Exchange professional. Thank you for the comment.

[Patrick Fricchione]

Good thought regarding the basis. Thanks for the input.

[Sean O'Keefe]

@Patrick Fricchione

IRC section 121(d) now sets a specific holding period when a 1031 replacement property converts to a principal residence. That holding period is five years after the 1031 exchange.

For example, an individual buys a residential property as a 1031 replacement. After using the property as a for-rent vacation home for two years, the owner converts it to a principal residence. To qualify for ANY tax exclusion under IRC section 121, the taxpayer must convert to principal residence use hand hold for an additional three years (so the holding period is no shorter than five years). (IRC section 121(d))

@Dave Foster might have more to add here. 

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*This post does not create a CPA-client relationship. The information contained in this post is not to be relied upon. Readers are advised to seek professional advice.

[Account Closed]

Quote from @Patrick Fricchione:

I thought the same regarding the CSS and primary residence. I wasn’t quite sure on the 1031 if I did the rebuild and waited a year or two to qualify for the accelerated depreciation while still under the 1031. Hoping for a creative solution, but doubtful.

I have been renting the property and thus the reason I'm giving it several years rather than waiting the proverbial 1 year and 1 day. Your comment mirrors what I was thinking. I will need to discuss with my Exchange professional. Thank you for the comment.

 Of course, happy to help! 

[Dave Foster]

@Sean O'Keefe, appreciate that shout out!  @Patrick Fricchione, You will not create any tax consequences simply by converting the use of a property.  Only a sale will trigger the tax.

However there are a couple issues here.

1. When you demo and rebuild you'll need to hold it long enough to have it as an investment property in order for the cost seg to impact.  And there is also the issue of basis that @Basit Siddiqi mentioned.

2. If you convert to your primary you'll not have a tax event until you sell.  If you have owned it for 5 years and lived in it for 2 out of the 5 years prior to selling it then you will get a proration of the gain tax free for the period of time you lived in it.  the period of time it was investment you will pay tax on.  And you wil have to recapture all depreciation.  

conversions generally don't work great when combined with a cost seg.

[Malik Javed]

Quote from @Patrick Fricchione:

I have an investment property in an LLC acquired through a 1031 exchange. Should I decide to demo the property in 4 years and rebuild, can I do a cost segregation analysis and use it as a primary residence or will the 1031 disallow it? I hate to miss out on the accelerated depreciation with the CSA.

Yes, you can utilize a cost seg study on your acquisition via 1031. You and/or CPA should be able to provide the depreciable carryover and excess bases, if any. You also might want to consider using the general asset account (GAA) as a strategy to possibly continue depreciating the property before demolishing and rebuilding.

Obviously, once you convert the investment property into a personal residence, you lose out on any further deductions from a P&L standpoint.

Feel free to DM me if you have any further questions.

[Michael Plaks]

Quote from @Patrick Fricchione:

I have an investment property in an LLC acquired through a 1031 exchange. Should I decide to demo the property in 4 years and rebuild, can I do a cost segregation analysis and use it as a primary residence or will the 1031 disallow it? I hate to miss out on the accelerated depreciation with the CSA.

Congrats! I have never seen someone throwing every one of the fashionable strategies into a single short paragraph. The result sounds super cool but makes little sense.

Shall we try to untangle it?

1. You currently have a rental property. Can you do cost segregation on it? Yes. Whether or not you can generate tax savings out of it is not guaranteed without analyzing your situation. Also, if you can benefit from cost segregation, we do not know whether it will apply to the current year or to the year of acquisition. It's case by case.

2. Complication: the property was acquired through a 1031. You still can pursue cost segregation, but it will generate a smaller impact than if you purchased this property outright, due to basis rules.

3. You plan to later demolish the property and rebuild it. The cost of demolition and new construction will be added to your basis, whatever that basis is at the time. Remember that the basis will be lower as a result of 1031 and further reduced by cost segregation.

4. It is unclear whether you're thinking about doing ANOTHER cost segregation post-rebuild. If the rebuilt property will continue to be rented - then yes, you can do it. However, it's not really cost segregation at that time but more like careful sorting out of your actual rebuild costs.

5. If you move into your rebuilt property right away - cost segregation is pointless, because you do not depreciate your residence.

6. 1031 does not make any difference with your rebuild and your plan to use it as a residence until you decide to sell it. Then there is the 5-yr rule.

[Patrick Fricchione]

Michael, thank you for your insight. To add more clarity, My intent was to do the 1031 and rent it for 2 years, demo and rebuild, do the CSA and rent another 2 years before considering to make it a personal residence. I just wasn't sure how the CSA and accelerated depreciation would be impacted should I convert it to a personal residence 2 years after the rebuild.

[Michael Plaks]

Quote from @Patrick Fricchione:

Michael, thank you for your insight. To add more clarity, My intent was to do the 1031 and rent it for 2 years, demo and rebuild, do the CSA and rent another 2 years before considering to make it a personal residence. I just wasn't sure how the CSA and accelerated depreciation would be impacted should I convert it to a personal residence 2 years after the rebuild.

Sharing this clarification up front would have produced better targeted responses.

When you convert a rental property to a residence, nothing happens tax-wise. Its basis and depreciation get "frozen" until you sell. Whether it was regular depreciation or bonus depreciation from cost segregation - same treatment basically: no immediate tax consequences.