1031 exchange and depreciation recapture?

[Heidi Kenefick]

If you do a cost segregation study, and take the depreciation early, when you sell the property do you have to pay it back as depreciation recapture if you are doing a 1031 exchange?

Scenario: I have two Airbnb’s I want to cost seg for 2024. But I am thinking of selling in 2025, and would then want to 1031 into an apartment complex. Good idea or bad idea?

[Andrew Strauss]

Hi Heidi - When you sell a property, the IRS requires you to "recapture" the depreciation you’ve taken on that property but by doing a 1031 exchange, you can defer not just capital gains tax but also depreciation recapture tax.
If you believe apartment complex is a good investment, with the 1031 exchange process, this can be a beneficial strategy.

[Sang Ji]

Hi Andrew, thank you for your expertise! if you do that, can you do the cost segregation for the new apartment complex you buy through 1031 exchange? And defer the depreciation recapture indefinitely (if you continue to do 1031 exchanges and cost seg over and over)

[Michael Plaks]

Unfortunately, this is far more complicated than "you can defer depreciation recapture with a 1031." Without cost segregation it would be true. With cost segregation - very complex and controversial.

Sorry, no time right now for an explanation which would have to be very long. At some later point. Just be warned that it may not work the way you envision it.

[Andrew Strauss]

Quote from @Sang Ji:

Hi Andrew, thank you for your expertise! if you do that, can you do the cost segregation for the new apartment complex you buy through 1031 exchange? And defer the depreciation recapture indefinitely (if you continue to do 1031 exchanges and cost seg over and over)

Yes, you can do it. But remember this is not straight forward as the basis of the new property is derived from the adjusted basis of the relinquished property plus any amount you paid.

[Sang Ji]

Quote from @Andrew Strauss:

Quote from @Sang Ji:

Hi Andrew, thank you for your expertise! if you do that, can you do the cost segregation for the new apartment complex you buy through 1031 exchange? And defer the depreciation recapture indefinitely (if you continue to do 1031 exchanges and cost seg over and over)

Yes, you can do it. But remember this is not straight forward as the basis of the new property is derived from the adjusted basis of the relinquished property plus any amount you paid.

[Sang Ji]

Thank you so much!!

[Sean Graham]

@Heidi Kenefick @Sang Ji yes you can defer depreciation recapture in a 1031 exchange. 

The 1245 property (think personal property and bonus depreciation) is recaptured at ordinary tax rates though… so the new property must have an equal amount or more 1245 property. 

The 1250 property (think real property and straight-line depreciation) is recaptured at a max of 25%. The new property must have an equal amount or more 1250 property. 

If the new property has less of either asset class (1245 or 1250) then the difference is subject to tax at the rates mentioned above. 

Does that make sense? 

[Heidi Kenefick]

@Sean Graham

Yes it does and that’s super helpful.

I have a CPA I work with who I’m sure will sort all of it out, just didn’t want to do something if it would cause a huge tax headache later.

Do you know if you convert a STR to a LTR after a cost seg, will it cause a large repayment of taxes (I'm doing the cost segs to lower my W2 tax rate).

[Sean Graham]

Quote from @Heidi Kenefick:

@Sean Graham

Yes it does and that’s super helpful.

I have a CPA I work with who I’m sure will sort all of it out, just didn’t want to do something if it would cause a huge tax headache later.

Do you know if you convert a STR to a LTR after a cost seg, will it cause a large repayment of taxes (I'm doing the cost segs to lower my W2 tax rate).

You are allowed to switch strategies down the road. I would just make sure your intention is try to do STR. If LTR are a better option down the road, then there is nothing wrong with making a switch. Taxes won't come into play until you sell.

[Heidi Kenefick]

@Sean Graham my goal was STR. The one I recently purchased will also work as a LTR, and numbers wise may actually make more sense. Currently I'm operating it as a STR, but I need a new cleaner and the quotes I'm getting are in some cases double my nightly rate, and the amount it grosses is only slightly more than what it will do as a LTR. But as a LTR, there is less headache and less overhead.

My other one does really well as a STR, doing double or sometimes 2.5x what it will do as a LTR. The overhead is high though, so considering selling as it really just breaks even at the end of the day. The tax benefit however, will tip it favorable.

[Austin Cheatham]

They have answered your question pretty well here, but I would just be sure to track your basis very carefully when looking to doing multiple 1031 exchanges with depreciation. This can get pretty complex, pretty quickly, so just keep that piece in check for audit documentation and make sure you have good records on all of it.

[Sean Graham]

Quote from @Heidi Kenefick:

@Sean Graham my goal was STR. The one I recently purchased will also work as a LTR, and numbers wise may actually make more sense. Currently I'm operating it as a STR, but I need a new cleaner and the quotes I'm getting are in some cases double my nightly rate, and the amount it grosses is only slightly more than what it will do as a LTR. But as a LTR, there is less headache and less overhead.

My other one does really well as a STR, doing double or sometimes 2.5x what it will do as a LTR. The overhead is high though, so considering selling as it really just breaks even at the end of the day. The tax benefit however, will tip it favorable.

@Heidi Kenefick ok I sent you a DM / connection as well

[Michael Plaks]

"yes you can defer depreciation recapture in a 1031 exchange."

@Heidi Kenefick  @Sang Ji

As attractive as this answer sounds, it is both incomplete and incorrect. I will have to debate my colleagues on what they said here, just not today.

[Michael Plaks]

As attractive as this answer sounds, it is both incomplete and incorrect. I will have to debate my colleagues on what they said here, just not today.

[Michael Plaks]

Apology for multiple posts - a forum software glitch apparently

[Michael Plaks]

@Ashish Acharya, @Nicholas Aiola, @Dave Foster, @David Orr, @Jason Watson, @Natalie Kolodij, @Bernard Reisz

Friends, based on my prior failed attempts to address this issue offline, nobody really wanted to hold this hot potato in their hands. I don't blame you, it's a really big and hot potato.  

I guess it's time we face the music. First, it's after 10/15, and most of us have a little more time. Second, as you can see on this thread, some of our colleagues take a rather cowboy approach, and I disagree with their position. I assume you disagree, as well.

I do plan a long post going down this rabbit hole, but it will take a few days, as my own tax season is not over. Meanwhile, please chime in. If you have time to elaborate - by all means, do. If you don't have time, at least say whether you agree that depreciation recapture after cost segregation is automatically avoided/deferred in a 1031. Thank you, colleagues!

[Dave Foster]

@Michael Plaks Didn't you say you were buying coffee for us at the next one of these "sessions"?

I say yes it can be deferred.  No, it is not automatic!!  I like how @Sean Graham parsed it.

[Sean Graham]

Quote from @Dave Foster:

@Michael Plaks Didn't you say you were buying coffee for us at the next one of these "sessions"?

I say yes it can be deferred.  No, it is not automatic!!  I like how @Sean Graham parsed it.

@Dave Foster thank you! Much appreciated. 

As we both said, "yes it can be deferred." No one said was automatic. Yes, you need to do a cost segregation study

[Michael Plaks]

Quote from @Sean Graham:

Quote from @Dave Foster:

I say yes it can be deferred.  No, it is not automatic!!  I like how @Sean Graham parsed it.

As we both said, "yes it can be deferred." No one said was automatic. Yes, you need to do a cost segregation study

"As we both said, "yes it can be deferred." No one said was automatic. Yes, you need to do a cost segregation study"

Don't you two have a vested interest in defending this position?  ;)

Where we disagree is your statement that "so the new property must have an equal amount or more 1245 property."  This assumes that one can exchange 1245 property for 1245 property, and the current version of 1031 does NOT allow that. But, like I said, it's a much longer debate.

[Dave Foster]

I'm only vested in getting free coffee from you @Michael Plaks.

Generally cost segregations do not tip the scale in favor or not of a 1031 exchange.  The forced gain or appreciation and straightline 1250 depreciation are usually more than enough to motivate someone to contemplate a 1031.  Getting to include 1245 property back into the 1031 is just a happy bonus!

[Michael Plaks]

Quote from @Dave Foster:

I'm only vested in getting free coffee from you @Michael Plaks.

Coffee is not a like-kind property, not included  ;)

[Sean O'Keefe]

Good answers here from @Michael Plaks and @Sean Graham - couple more suggestions:

Keep in mind that you also have the option to Reverse 1031 Exchange. Other options that are rarely talked about, but also an options, is to sell property without 1031 Exchange and get cost seg on new property that reduces capital gains (this strategy depends on property type, level of participation, etc.). 

.

.

.

*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.

[Sean O'Keefe]

Quote from @Michael Plaks:

@Ashish Acharya, @Nicholas Aiola, @Dave Foster, @David Orr, @Jason Watson, @Natalie Kolodij, @Bernard Reisz

Friends, based on my prior failed attempts to address this issue offline, nobody really wanted to hold this hot potato in their hands. I don't blame you, it's a really big and hot potato.  

I guess it's time we face the music. First, it's after 10/15, and most of us have a little more time. Second, as you can see on this thread, some of our colleagues take a rather cowboy approach, and I disagree with their position. I assume you disagree, as well.

I do plan a long post going down this rabbit hole, but it will take a few days, as my own tax season is not over. Meanwhile, please chime in. If you have time to elaborate - by all means, do. If you don't have time, at least say whether you agree that depreciation recapture after cost segregation is automatically avoided/deferred in a 1031. Thank you, colleagues!

.

rather cowboy approach @Michael Plaks.

This is a great explanation!

[David Orr]

@Michael Plaks @Sean Graham

I had to do some research on this after reading the other replies in this thread because my understanding of the nuances of 1031s isn't as thorough as my understanding of some other real estate tax topics.  So my answer isn't entirely just off the top of my head, but this is my current understanding of it.  The article https://www.thetaxadviser.com/newsletters/2021/feb/final-sec... is one source of helpful info on this topic. 

A 1031 exchanged property can include 1245 components that are considered part of the "real property" for 1031 purposes if they're affixed to the building (and also up to 15% of the value can be personal property under an IRS rule, such as appliances). 

If the replacement property has at least as much value in 1245 components, then section 1245 recapture isn't a problem, you can defer the recapture of the 1245 depreciation.  But if the replacement property has less value in section 1245 items, you do have to compute the difference (which pretty much requires a cost seg study on the acquired property), and then you have 1245(b)(4) recapture on the difference.  

I am curious about how that is actually handled by other tax pros in real life scenarios.  If someone does a 1031 with a property that had a cost seg, do you consider it to be mandatory that they do a cost seg study on the replacement property to be sure the replacement property has at least as much 1245 and 1250 value as the exchanged property?  Or are you ok with looking at the replacement property, and if it's higher value and appears to likely have more value in both 1245 and 1250 property, do you figure there is reasonable basis to assume there isn't any recapture?  (And let the excess basis be depreciated over 27.5 or 39 years, as is typically done on real estate without a cost seg.)

About @Sang Ji's question "can you do the cost segregation for the new apartment complex you buy through 1031 exchange".  Yes, but you can only use bonus depreciation on the portion of the value of the property that isn't attributed to the value that came from the exchanged property.  So, don't expect to be able to do a cost seg study on the property and take a big bonus depreciation deduction, unless the new property has significantly higher value than the exchanged property.  

[Michael Plaks]

Quote from @David Orr:

@Michael Plaks @Sean Graham

Thanks, David, we will certainly continue this.

Quick note. I believe that the 15% rule is being misapplied by many. It says that up to 15% of non-real-estate property does not disqualify an exchange. It does NOT say that this 15% is rolled into an exchange. It is still NOT part of an exchange and creates boot problems. Besides, cost segregation typically exceeds 15%. Lots to unravel here.