The recently released proposed regulations on Sec. 1031 like-kind exchanges (REG-117589-18) provide much needed clarification for taxpayers who have conducted cost segregation studies on exchanged properties. The law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, removed personal property from part of the preferential deferred tax treatment for like-kind exchanges.
While most people understood the intent of that edict, it created some unintended consequences when property owners exchange real estate. Unless the exchange involved raw land, it was highly likely that some level of personal property would be “embedded” in a building — something that might have been identified in a cost segregation study. Note: Usually Sec. 1245 property (tangible personal property that may be depreciated) is broken out in a cost segregation study — not furniture, fixtures, and equipment.
To circumvent the disallowance of personal property being conveyed in a like-kind exchange, some taxpayers and their advisers implemented aggressive strategies to assign a significantly reduced basis of Sec. 1245 property. Those strategies often used a fair market value (FMV) 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 IRS examination.
In the new proposed regulations, the Treasury Department makes reference to “incidental personal property,” providing much more clarity about handling Sec. 1245 property in a like-kind exchange.
The preamble to the proposed regulations states:
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.
The incidental property rule itself is found in Prop. Regs. Sec. 1.1031(k)-1(g)(7)(iii). If the personal property qualifies as incidental, the like-kind exchange will be valid; however, gain will be recognized based on the FMV of the personal property. Generally speaking, this is good news for most property owners who might be considering a like-kind exchange, or who have conducted them since January 2018. Certainly, there are property types that will have in excess of 15% allocated to personal property, but this is without a doubt a very positive development. Also, since most like-kind 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% ($950,000) in five-year personal property and 10% ($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 five- and 15-year property, the five-year personal property would amount to $1.44 million.
Result: Because the personal property component of Property A is approximately 11.8% of the basis of Property B, this enables the taxpayer to include all of the five-year property identified in the cost segregation study as part the overall exchange since it falls under the 15% threshold.
It should be noted that while the IRS is accepting comments on the proposed regulations through Aug. 11, taxpayers can rely on them for any transaction completed after Dec. 31, 2017, until the final regulations are issued, if they follow them consistently and completely.
Cost segregation can help
In light of these proposed regs, it’s key to have a well-qualified cost segregation consultant help evaluate the type of replacement property that can qualify as incidental personal property as well as perform an actual study on the replacement property.
— 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). To comment on this article or to suggest an idea for another article, contact Sally Schreiber, senior editor, at Sally.Schreiber@aicpa-cima.com.