2018 Tax Law Impact on 1031 Exchanges/Cost Segregation

[Brian Schmelzlen]

The new tax law made it so that the gain on the sale of personal property can no longer be deferred through a 1031 exchange (1031s can now only be used for real property).

Likewise, the new tax law made cost segregation studies far more valuable in the short-term by increasing bonus depreciation from 50% to 100% on property with a useful life of less than 20 years.

However, in essence what cost segregation studies do is transform a portion of real property into personal property.  This is a great short-term benefit, but what impact will it have on future 1031 exchanges.  Do you think the IRS is going to rule that the personal property components affixed to the real estate in a 1031 exchange are "other property" and thus boot, or ignore it?

Some of my REI clients are grappling with this, and I am still of the opinion that they should still do the cost seg studies if there are large enough short-term savings and they are planning on holding the property for an indefinite amount of time, but I am curious about other views on this.

[Michael Plaks]

Let's take an example of what would happen if there's no future exception.

I buy a $500k property and cost-seg $100k of it as personal 5-yr property and bonus-depreciate 100% of it.

I now have $400k basis in the building and $0 basis in the personal property.

Fast-forward 5 years, and the property is worth $1 mil. I have to allocate the sales price between the two classes, but by now the personal property is probably not worth the original $100k. Let's be conservative and assume it is still worth $100k. What do we have?

Gain of $100k on the 1245 property (depreciation recapture) which is not eligible for 1031 and $500k gain on the building which is eligible for 1031. (Yeah, ignoring building depreciation, other classes, land etc.)

So my worst case scenario is having to return the deduction I got upfront from the cost seg.  I still win a little bit with time value of money. But in reality, the value goes down, so I won't have to recapture the entire value of the personal property.

As far as boot - I think it only matters if the value of 1245 received in the exchange is also segregated and exceeds the value of 1245 given up.

Bottom line: cost seg is much less beneficial if it cannot be rolled into a 1031 - but still beneficial, as @Brian Schmelzlen says. (Sorry, @Natalie Kolodij, I tried my best to be under 13 pages)