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?

[Aus Smith]

Hey All, 

This is the exact question I was looking for an answer too. The best answer I found was looking at it from a tax and legal perspective. From a tax perspective, we have both section 1245 and 1250 assets. From a legal aspect, 100% of the assets is real estate property, regardless of how we look at it for tax purposes. Therefore, amounts separated for by a cost segregation study would not technically increase the "non-real-estate-property" for the purposes of the 15% test. The argument against this though, is that the audit technique guides suggest that the 1245 asset components have to be 'personal property', aka movable assets. Movable assets suggest they are 'non-real-estate property". Contradictory and perhaps more of a tax and law question in itself. Interested in getting more familiar with the legal realm myself anyway. 

I can understand the perspective, but I am not satisfied with this answer myself. If I remember where I found it I will share. I would say that any reduction of 1245 assets in a 1031 exchange with a cost segregation study would constitute boot, and the 15% rule should be considered. I am still not 100% on how it should be applied though. 

Thank you all for sharing your answers! I really anticipate to see the detailed response from Michael once he has time. I had the same realization as Michael when considering section 1245 assets in a 1031 exchange, and I really have been looking for a concrete answer ever since. 

Again thanks all and Cheers! 

[Jason Malabute]

Heidi, if you do a 1031 exchange, both the capital gains and depreciation recapture can be deferred, but the recapture isn’t eliminated—it just gets pushed to when you sell the new property. If you receive any boot (like cash or non-like-kind property), then some of that recapture could be triggered and taxed. Now, when it comes to cost segregation, it accelerates depreciation, which means more of it is subject to recapture when you sell. However, in a 1031 exchange, you can still defer that, but it gets tricky—just like Michael mentioned, it’s a complex situation, especially with cost segregation in the mix. It’s definitely something to discuss with a tax advisor who knows these ins and outs. As for your scenario of exchanging two Airbnbs into an apartment complex, it could be a good move if the complex is a strong investment. Just remember that all the deferred gains and depreciation recapture will carry over.

[Michael Plaks]

Quote from @Aus Smith:

 I had the same realization as Michael when considering section 1245 assets in a 1031 exchange, and I really have been looking for a concrete answer ever since. 

The reason you can't find a concrete answer is that there's none. Cost seg people and 1031 people predictably assure us that there's nothing to worry about. Guess who wrote the article linked by @David Orr? Yep, a cost seg guy. And I don't agree with his interpretation.

I would personally love if it was clear and simple and, most importantly, investor-friendly and 1031-friendly and cost seg-friendly. I don't think that it is though. And whatever controversy there is, it has not been tested in courts, as far as I know. 

<to be continued...>

[Ashish Acharya]

@Heidi Kenefick If you do a cost segregation study and take accelerated depreciation, depreciation recapture taxes apply when you sell. However, using a 1031 exchange allows you to defer both capital gains and Normal depreciation recapture in RE asset taxes by reinvesting in like-kind property.

For the assets that were segregated as non-real estate, you cannot do a 1031 exchange on Non-RE assets. That is why you have to recapture bonus-depreciated asset's depreciation. It can be managed with the right allocation.

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

[Julio Gonzalez]

@Heidi Kenefick Here's an article that you might find helpful regarding cost segregation studies, recapture and 1031 exchanges. Feel free to reach out if you have any questions!

Does recapture diminish the value of a cost segregation study?

[Chere Grunion]

Quote from @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?

[Chere Grunion]

If you do a 1031 exchange, you can defer depreciation recapture, but it doesn’t erase it; it just transfers to the new property. So, a 1031 can be a good move if you want to keep deferring taxes while upgrading to an apartment complex.

[Michael Lynch]

@Michael Plaks we need more regs and court cases. It hasn't been that long that 1245 property cannot be exchanged. You had a prior post that seemed reasonable.

To complicate matters, check your state. Some states still allow 1245 property exchanges.

[Bernard Reisz]

@Michael Plaks @Ashish Acharya @Nicholas Aiola, @Dave Foster, @David Orr, @Jason Watson, @Natalie Kolodij

Great discussions we've had and looking forward to continuing. 

This series of questions is where it all comes together: 1250, 1245, 1031, etc. and it really is such a confusing mess that even the IRS may have been misinterpreting it - which would not be a first! (Most notably, they've gotten REPS aggregation all mixed up in the past.)

Based on the regs seems that:

- 1245 ordinary income recapture applies to some forms of property that qualify as "real estate" for 1031 exchange purposes

- 1245 recapture on such "real estate" overrides 1031 deferral such that 1245 depreciation is recaptured to the extent there's a trade down in 1245 property in the exchange

@Heidi Kenefick There are many additional mitigating considerations worth discussing in conjunction a real estate tax accountant.