By Greg Bryant
As originally seen in the AICPA July 2020 newsletter
- Treasury’s proposed regs on Like-Kind Exchanges, released June 11, clarify a number of taxpayer issues and concerns that have lingered since TCJA was passed in late 2017.
- Proposed regs are generally good news for most property owners considering a 1031 Exchange, or who have conducted 1031 Exchanges effective January 2018.
- Key guidance in the proposed regulations provides a detailed list of what constitutes “real property.”
The recently-released Temporary Regulations pertaining to 1031 Exchanges provide much needed clarification for taxpayers who have conducted cost segregation studies on exchanged properties. The Tax Cuts and Jobs Act of 2017 (TCJA) disallowed Personal Property from being included as part of the preferential tax treatment related to 1031 Exchanges. While most people understood the intent of such an edict, it created some unintended consequences when property owners exchange real estate. Unless the exchange involved raw land, there was a high likelihood that there would be some level of personal property “embedded” in a building–something that might have been identified in a cost segregation study. Note: We are talking about Section 1245 property commonly broken out in a cost segregation study – not Furniture, Fixtures and Equipment (FF&E).
In an effort to circumvent the impact related to the disallowance of Personal Property being conveyed in a 1031 Exchange, some taxpayers and their advisors implemented “creative” and aggressive strategies to assign a significantly reduced basis of Section 1245 property. Those strategies often utilized a Fair Market Value (FMV) exercise without regard to the actual tax basis of the same assets calculated in a cost segregation study. This practice could prove to be problematic – especially under examination.
With respect to the Regs, the Treasury Department has introduced the concept of Incidental Personal Property, which provides much more clarity about handling Section 1245 Property related to a 1031 Exchange.
The Proposed Regs state:
“Personal property is incidental to real property acquired in an exchange if, in standard commercial transactions, the personal property is typically transferred together with the real property, and the aggregate fair market value of the incidental personal property transferred with the real property does not exceed 15 percent of the aggregate fair market value of the replacement real property.”
Generally speaking, this is good news for most property owners who might be considering a 1031 Exchange, or who have conducted 1031 Exchanges since January 2018. Certainly, there are property types that will have in excess of 15 percent allocated to personal property, but this is without a doubt a very positive development. Also, since most 1031 Exchanges involve a “trade up” to a property with a significantly higher tax basis, the FMV (most likely the purchase price of the replacement property) will drive any decisions with respect to what the actual limitations are, if any, for the personal property that is allowed to be included from the exchanged basis.
Real world example
Let’s assume the Relinquished Property (Property A) is a $6 million limited service hotel with a $5 million depreciable basis. A cost segregation study identified 19 percent ($950,000) in 5-year personal property and 10 percent ($500,000) in 15-year land improvements.
Let’s say the Replacement Property (Property B) is a $10 million limited service hotel with an $8 million depreciable basis. Assuming the same percentage allocation of 5- and 15-year property, the 5-year personal property would amount to $1.44 million.
RESULT: Since the personal property from A is approximately 11.8 percent of B, this enables the taxpayer to include all of the 5-year property identified in the cost segregation study as part the overall exchange since it falls under the 15 percent threshold.
It should be noted that while these are Proposed Regulations that are currently open for comment, taxpayers can rely on these Regulations for any transaction completed after December 31, 2017 until the date of issuance for the Final Regulations.
In light of these Proposed Regs, it’s key to have a well-qualified cost segregation consultant help you evaluate the type of replacement property with respect to projected allocations of incidental personal property as well as perform an actual study on the Replacement Property.
About the author
Greg Bryant is the Managing Partner of Bedford Cost Segregation and a Certified member and past president of the American Society of Cost Segregation Professionals (ASCSP).