Proposed 1031 Regulations – Impact on Cost Segregation Studies

The combination of 1031 like-kind exchanges and cost segregation studies have long been two of the better tax tools in construction and real estate owners’ toolboxes. The combination of tax deferrals and bonus depreciation created advantageous scenarios where capital gains were deferred, investments continued to grow, and personal property could be depreciated at an accelerated rate. When the Tax Cuts and Jobs Act (TCJA) was passed in 2017, it limited the use of 1031 exchanges to real property only. This created confusion for many Atlanta construction and real estate companies, where it is common for personal and real property to be sold or exchanged as a unit. Recent IRS proposed regulations sought to clarify the definition of real property, which could impact past or future cost segregation studies. To help clients, prospects and others, Wilson Lewis has provided a summary of key details below.

Background on 1031 Exchanges and Cost Segregation Studies

Like-kind exchanges have been utilized for years as an advantageous way for taxpayers to defer the cost of capital gains taxes on investment properties. In effect, taxpayers can swap out one type of investment for another (of similar type), and the investment continues to grow tax-free. There is no limit to how many times a qualified property can be exchanged, and gains can be rolled over until finally selling the property for cash and paying one long-term capital gains rate (currently 0, 15, and 20 percent, depending on taxable income).

The Tax Cuts and Jobs Act (TCJA) introduced more complexity with like-kind exchanges. Chief among the changes was the exclusion of personal property from like-kind exchange transactions. Since the change took effect, there have been questions about how to differentiate between personal and real property, especially within construction. For example, the sale of an apartment or hotel building became more complicated and the transaction required separate allocations for property type; furniture and fixtures would be considered personal property while the building itself real property.

This is where the value of cost segregation studies comes in. Using the above property structures in another example, while the building itself may be real property and deducted over 39 years, the personal property components like furniture, décor, appliances, and so on have shorter tax lives. Not only is separating the real and personal property a requirement under most like-kind exchanges, doing so can also save a significant amount of money in taxes using bonus depreciation.

After TCJA, there were limits placed on the scope of 1031 exchanges, in doing so it effectively created two definitions for personal property. In property exchanges, the purpose of separating personal and real property solely for 1031 is different than the purpose of separating the same types of property for cost segregation. The former is done for tax deferral, and the latter is done for bonus depreciation.

Proposed Regulations on 1031 Exchanges

In the summer of 2020, the IRS released proposed regulations clarifying the definition of real property and intangible assets. Under the proposed regulations, real property, in addition to the standard definition of structures and buildings, also includes:

• Land
• Improvements to land, including inherently permanent structures and their components (such as parking lots or fences)
• Unsevered natural products of the land (such as crops)
• Water and air space superjacent to land

Recognizing that in many cases, some level of personal property will exist with the real property, the IRS introduced the term incidental personal property. Incidental personal property is transferred together with the real property and can be considered along with the real property asset as long as it does not exceed 15 percent of the “aggregate fair market value of the replacement real property.” What this means is that it is entirely possible for taxpayers to include all, or at least some, personal property in 1031 exchanges.

The IRS specifically stated that machinery is not included in real property unless it qualifies as a structural component, serves the inherently permanent structure, and does not produce or contribute to income.

Other IRS guidance states that:

• Intangible real estate assets such as easements or permits should be treated as real property for 1031 purposes, except if they generate income
• State and local law does not control the definition of real property for 1031 exchanges.

Maximizing Bonus Depreciation – 1031 Exchanges

For property exchanges where it makes sense to combine a cost segregation study, taxpayers can realize significant tax savings. For buyers, the immediate benefit is 100 percent bonus depreciation of personal property. However, buyers also need to examine whether a previous cost segregation study was done on the property and evaluate the depreciation schedule and property categories. Not only may there be additional tax consequences for personal property not yet at the end of its tax life, but also reclassification under new proposed guidelines. It may be that some types of property that were previously classified as Section 1245 property under cost segregation that could be reclassified to 1031 property.

Additionally, consider the timeframe. For one, most elements of TJCA will expire at the end of 2025 and revert to pre-2018 levels. For long-term capital gains, that means losing the preferential treatment of a maximum 20 percent tax for high-income taxpayers. In addition, there is also the outcome of the 2020 presidential election. President Trump has expressed interest in lowering the capital gains tax, while Former Vice President Biden’s plan calls for reinstating the top ordinary tax rate for taxpayers with more than $1 million in income. In either scenario, nothing is likely to change quickly, but investors may need to have a back-up plan for tax impact in 2021 and beyond. 

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The recently issued IRS proposed rules on 1031 exchanges opens the door to new opportunities, especially when combined with a cost segregation study and bonus depreciation. The topic can be quite complex and for this reason, it is necessary to consult with a qualified tax advisor to guide your efforts. If you have questions about the information outlined above or need assistance with another tax or accounting issue, Wilson Lewis can help. For additional information call us at 770-476-1004 or click here to contact us. We look forward to speaking with you soon.