Cost segregation does not limit Section 1031 exchanges
I’m in the specialty tax business, and I get calls on a daily basis from CPAs and real estate owners who are concerned that the reallocation of tax basis to “personal property” as part of a cost segregation study will limit the benefit of a Section 1031 exchange. This is not the case. The confusion stems from the different definitions of “personal property” for purposes of Sections 1245 and 1031.
By way of background, “cost segregation” is the process of identifying and separating personal property, which is Section 1245 property, that is grouped with real property, which is Section 1250 property. Put another way, cost segregation involves breaking down the components of a building and allocating the tax basis in the property between the “personal property” and “real property” that makes up the building.
Cost segregation looks to Section 1245 and 1250 for the definitions of what is personal and real property, respectively. The purpose is to be able to compute depreciation on the personal and real property correctly. This is needed as depreciation looks to the useful life of the item of property and allows the taxpayer to recover the cost of the property via depreciation deductions over the useful life of that property. If Section 1245 property is not separated from Section 1250 property, the taxpayer is not recovering the cost of the Section 1245 property over the correct useful life. Their actual Section 1245 property will be spread over a useful life that is beyond the economic useful life of the 1245 property because it is stuck in Section 1250 property and being depreciated over much longer class lives (27.5 years for residential and 39 years for commercial).
The purpose for identifying Section 1245 “personal” property for depreciation purposes is different than the purpose for identifying “personal property” for Section 1031 exchanges. A Section 1031 exchange involves exchanging real or personal investment property solely for other investment property that is of the same type or “like-kind.” Section 1031 allows taxpayers to defer reporting income tax on the exchange. Thus, the purpose of identifying real and personal property is to determine whether property is of like kind, which allows for the deferral of income tax. Given the changes in the Tax Cuts and Jobs Act, Section 1031 only applies to exchanges of real property and not to the exchange of personal property.
How can “personal property” mean one thing for depreciation and another thing for Section 1031 exchanges? The answer is found in the Tax Code, where the term “personal property” has different meanings.
Without getting into the technical language in the regulations, one can see this distinction directly on the IRS website. Per the IRS website regarding Section 1031 exchanges, the examples of personal property include “machinery, equipment, vehicles, artwork, collectibles … .” The items used in the definition on the IRS website are personal property within the meaning and intent of furniture, fixtures, and equipment (“FF&E”). Personal property, such as FF&E, is largely defined by reference to state law. It is generally tangible property that is subject to state or local property tax. It is property that cannot be separated from the structure without damaging the property.
Compare this to Section 1245 property identified in a cost segregation study. Section 1245 is referred to as personal property, but it is not the same as FF&E. Section 1245 property is typically not subject to the county personal property tax; it is only used for federal tax depreciation or amortization purposes. In a cost segregation study, Section 1245 property includes assets installed into a building, items such as carpeting, specialty electrical, specialty HVAC, specialty plumbing, etc. These items are distinct from FF&E-type personal property, such as furniture and artwork as in the description on the IRS webpage.
Thus, a cost segregation study only separates out Section 1245 property and not “personal property” within the meaning of that term for purposes of Section 1031. The cost segregation study results only impact the depreciation deduction, not whether property is of like-kind for purposes of Section 1031.