Yon Regan
Many are asking how the new tax law will affect cost segregation and 1031 exchanges. We should all note that due to some of the rule changes there are conflicts that will need to be addressed. Presently there is a lack of clarity on this matter. There are no definitive rules, and there is no IRS guidance at this time. The service will need to clarify this and several other items where these conflicts exist. What is outlined below are several possible outcomes and my prediction as to what is likely to happen.
The new law says 1031 exchanges only apply to real property. The challenge arises because, with the sale of commercial and multi-family real estate, personal property and real property are co-mingled. One of the central reasons (while not the only reason) we do a cost segregation study is to identify IRS §1245 – personal property, which, cannot be exchanged under the new 1031 rules. So, what do we do? Because the personal property and real property are intermingled in a 1031 exchange of commercial real estate, this point has become muddy.
With regard to 1031s, I see four possible scenarios. Three of them would benefit from a cost segregation study and one might not. I would point out however that in the last scenario, the person or group doing the exchange probably should reconsider doing an exchange at all.
1. No segregation of personal property was made on a relinquished property.
In this scenario, little if anything changes from the way things are now. We can only segregate the residual basis, same as before. The one difference being that everything we can identify and segregate in the acquired property with a class life of fewer than 20 years can be immediately expensed under the 100% bonus depreciation rules.
2. The relinquished property was segregated and the IRS reverts to prior rules.
The service has indicated they may backtrack on the issue of including personal property in the exchange of real estate. If this happens, little changes from the current methods used. As above, the major difference between how we handle things now vs. how we handled things in the past is the bonus depreciation being applied to the short life assets.
3. The relinquished property was segregated and personal property is excluded.
The person or group in the exchange will have to determine the sale value of the short life property they had segregated and then determine if there is any recapture on that property. Remember that the recapture of real property is not the same as with real estate. Unlike recapture on real property depreciation, you only pay recapture on the difference between the non-depreciated remaining basis (on a straight line calculation) and what you sell it for. So with a little planning, there should be little if any recapture if an exchange was part of the owner’s original plan. Same as above on the cost seg of the residual basis post exchange.
4. Segregation of personal property was made on the relinquished property but there is little difference in values between relinquished and acquired property.
This is one where the owner can potentially be exposed to recapture on personal property and no way to make it up with the acquired property. Imagine a situation where the owner was aggressive with declining balance treatment of the segregated assets on the relinquished property and, where they constituted a significant percentage of the building basis. Because recapture here is calculated on the nondepreciated remaining basis using a straight line depreciation convention, it is possible that even if the property is sold at that value, the owner will have to recapture the amount of depreciation that was accelerated. This is were 200 DB can work against you. The assumption here is that the residual basis is negligible and so the benefit of even the bonus depreciation on the acquired property is not enough to justify the cost of doing another cost segregation study. Not a completely horrible situation but one might ask why bother going through the exchange in the first place.
At the moment, everyone is at the mercy of the IRS and what the final rules will actually look like. So, the best we can do is operate reasonably, with sound data and solid methodology.
As for me, I am putting my money on option #3 because it is consistent with the core or general direction of the new law. It will complicate things a little for the owner but will wind up giving us a little more to work with on the acquired property side. In the short term, we will also be able to take significant advantage of the generous bonus depreciation rules. While there will be a small downside for owners who exchange property they have not owned for very long, longer-term owners will realize that much of their recapture fears were no more real than the monster under the bed.