Things to Consider When Analyzing Tax Deferred Exchanges and Cost Segregation Studies After 2017

The TCJA modified Internal Revenue Code (“IRC”) Section 1031 to provide that, for transactions entered into after January 1, 2018, only the exchange of real property held for productive use in a trade or business or for investment will qualify for tax deferred treatment. This is a substantial change in the law, as prior to the Act, personal property could also be exchanged under Section 1031.

This change raises several questions, including:

  1. What is the definition of real property for purposes of Section 1031?
  2. What is the effect of a real estate exchange when some personal property (e.g. appliances, carpeting, certain flooring, etc.) is involved?
  3. Do the results of a cost segregation study impact what would otherwise be tax deferred?

While new Treasury regulations under Section 1031 would presumably help to answer these questions, the U.S. Treasury Department has not provided any indication that such regulations will be issued in the near future.  Therefore, it is necessary to consult existing sources to attempt to divine what would be considered “real property” for purposes of Section 1031, and how such definition will impact tax-free exchanges thereunder. 

What Is Considered Real Property for Purposes of Section 1031?

According to the Congressional Committee Report released in advance of the TCJA, Congress intended that the pre-TCJA definition of “real property” for purposes of a Section 1031 like-kind exchange continue to apply post-TCJA.[1]  Under this definition, property which is considered real property “by the highest court or statute of the State in which the [taxpayer] is organized” would be considered real property for purposes of Section 1031.[2]  In many states, property which is “fixed” to a building is considered to be real property.[3]

Generally, items that are considered “fixed” are items that cannot be separated or removed from the real property without causing significant damage to either the item or the property.[4]  However, the IRS has taken the position that, while informative, state law definitions are not dispositive, and that, for purposes of Section 1031, federal law controls.[5]  Furthermore, the IRS has taken the position that property classifications for purposes of one IRC section do not control when applying a different IRC provision.[6]   

What Is the Effect of a Real Estate Exchange When Some Personal Property is Involved?

As the TCJA has limited the application of Section 1031 to real property, it is now unclear how transactions in which fixtures are transferred will be treated.  Per the preamble to the final Treasury regulations under § 1.1031(k)-1, there is no de minimis exception with respect to non-like-kind property exchanged in a Section 1031 transaction.  Additionally, the Section 1031 regulations, which have not been amended to reflect changes made by the TCJA, maintain that a gain must be recognized on the receipt of any non-like-kind property.[7]  As such, it would track that any personal property transferred in a Section 1031 exchange would be treated as boot[8], regardless of how minimal the amount of personal property is with respect to the transaction as a whole.  Importantly, any recognized gain from the treatment of personal property as boot would be ordinary income to the extent of any previously taken depreciation with respect to such personal property.[9]  Therefore, it would seem that under the new TCJA modified Section 1031, any personal property exchanged must be treated as boot, and gain or loss must be recognized by the taxpayer.  This is in addition to any potential unrecaptured gain under Section 1250, which requires that certain previously taken real property depreciation must be recognized as gain in a Section 1031 transaction if the economics of the transaction would otherwise eliminate any future such recapture.[10]

Do the Results of a Cost Segregation Study Impact What Would Otherwise be Tax Deferred?

In a Section 1031 exchange, it is generally believed that performing a cost segregation study (“CSS”) is the best practice if the client wants to accelerate available depreciation of the received property. Before performing a CSS however, there are several factors for a taxpayer to consider.  Because a CSS identifies components of the real property that could be classified as tangible personal property, a future sale may subject the property to depreciation recapture under Section 1245, depending on the fair market value of the personal property at the time of the sale.  Such consideration is amplified by changes to Sections 179 and 168(k). 

Under Section 179, certain improvements to real property (defined as “Qualified Improvement Property”) and mechanical systems of a building can be expensed in the year the property is placed in service, subject to certain limitations. This would allow a recipient of property with a CSS breakdown to expense qualifying property under Section 179.  However, certain recapture rules exist for the sale of property for which a Section 179 deduction has been taken, which result in ordinary income recapture, regardless of whether the property is Section 1245 or Section 1250 property.[11] 

Additionally, certain qualifying property can be 100% depreciated in the year placed in service under Section 168(k) (“Bonus Depreciation”).  Qualifying property includes personal property, which is no longer eligible for Section 1031 exchanges, as well as land improvements, which may still be included.[12]  Due to a drafting error in the TCJA, Qualified Improvement Property is not currently eligible for Bonus Depreciation under Section 168(k).  While regulations under Section 168(k) make clear that the basis in property received in a Section 1031 exchange may be eligible for Bonus Depreciation, the limitation of Section 1031 to real property significantly diminishes the impact of these rules for 2018 going forward.[13]  Other than, potentially, land improvements, property with a transferred basis under Section 1031 would not be eligible for Bonus Depreciation under Section 168(k).  However, personal property received as boot may be eligible for Bonus Depreciation under Section 168(k), which would offset any gain recognized on the receipt. Also, bonus depreciation taken on Section 1250 assets is not considered a straight line method.[14]  

It is also important to note that not all states have conformed their treatment of Section 1031 or Section 168(k) transactions to the new federal rules.  As such, taxpayers should take care to note that the treatment of a transaction for federal purposes may not be the same at the state level.

To summarize, a CSS is advisable where the tax savings provide a sufficient economic benefit. Generally, for a property acquired for less than $2,000,000, a CSS is not feasible.  However, as personal property is likely no longer eligible for tax-free exchange treatment under Section 1031, it may be necessary to determine how much personal property is being exchanged in a Section 1031 transaction even if a full CSS is not performed.  As the receipt of personal property is likely to result in the recognition of gain, the use of Section 179 or 168(k) should be considered to offset the recognition of gain.

For questions about this article, please contact Perry Weinstein at PWeinstein@fgmk.com.

 

 

[1] H.R. Rep No. 115-466, at 396, FN 726 (2017).

[2] See Id.

[3] See CCA 201238047.

[4] For examples see Significant Features of Property Tax (by State). Datatoolkits.lincolninst.edu.

[5] CCA 201238027.

[6] See CCA 200648026.

[7] Treas. Reg. § 1.1031(j)-1(b)(3).

[8] Boot received in a 1031 exchange is money or the fair market value of property received by the taxpayer in the exchange, which may trigger the recognition of gain.

[9] See IRC § 1245.

[10] Treas. Reg. § 1.1250-(3)(d).

[11] See IRC § 1245.

[12] See IRC § 168 (k)(2).

[13] See Prop. Treas. Reg. § 1.168(k)-2.

[14] See Treas. Reg. § 1.168(k)-1(f)(3).

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