Commercial and residential real estate, both of which constitute “Section 1250 property,” are depreciable over 39 and 27.5 years, respectively. However, many building improvements, known as “Section 1245 property,” may be reclassified for depreciation purposes as personal property or land improvements, thereby acquiring substantially shorter cost recovery periods.
To take advantage of reclassification, a “cost segregation” study performed by an engineer is required. Although total depreciation deductions allowed over time will remain unchanged, reclassification will accelerate and increase current deductions, perhaps producing a substantial tax benefit.
The Tax Court in Hospital Corp. of America, 109 T.C. 21 (1997), held that the definition of tangible personal property included many items attached to a building. Since that decision was issued (to which the IRS subsequently acquiesced) the Service has approved the use of cost-analysis studies to allocate costs to structural components and other tangible property to determine depreciable basis. Although significant tax benefits may obtain from a cost segregation analysis, the cost of the study, which depends on the real estate involved, may or may not justify reclassification in a particular case.
A successful cost segregation study would, for example, convert 27.5 year or 39 year Section 1250 property into Section 1245 property with much shorter depreciation periods. The negative aspects of reclassification are that (i) reclassified property may be more difficult to satisfy the “like-kind” exchange requirement in a later Section 1031 exchange; and (ii) even if a future like-kind exchange can proceed without taxable boot, burdensome depreciation recapture provisions may haunt that later exchange.
A cardinal rule of any Section 1031 exchange is that replacement property must be of “like-kind” to the relinquished property. If no reclassification has occurred, all Section 1250 real property would qualify as Section 1250 real property for purposes of the “like kind” definition in Section 1031, and would enjoy the expansive definition accorded to real property in the context of Section 1031 exchanges.
The result of reclassification is the birth, for depreciation purposes, of Section 1245 property. Some Section 1245 property, such as a barn, constitutes a “single purpose agricultural structure” under §1245(a)(3)(D), and would clearly be like-kind to other real property. However, some Section 1245 property, such as fixtures, might not constitute real property for purposes of satisfying the like-kind exchange requirement. Section 1031 largely defers to state law in determining whether property is real or personal for purposes of the like-kind exchange requirement of Section 1031. However, state law is often unclear and ambiguous as to what constitutes real property.
In any event, although it is certainly disadvantageous if the formerly reclassified property is determined not to constitute real property under local law, and is therefore not considered “like kind” to replacement real estate, the Section 1031 exchange may nonetheless proceed, since the like-kind requirement of Section 1031, though granting vast preference to real property, does also apply to exchanges of personal property.
Much stricter like-kind exchange definitions are applicable to personal property. For example, personal property is required to be of “like class” as defined in the regulations, or to be “similar or related in use.” If a portion of the replacement property is not of like-kind to relinquished property, being not of “like class,” or not similar or related in use, then not only will realized gain be recognized as taxable boot, but a portion of the recognized gain attributable to depreciation recapture may be taxed as ordinary income.
[It seems doubtful from a policy standpoint that the IRS would undertake to penalize the taxpayer who chose not to reclassify property by arguing that even though the taxpayer did not benefit from accelerated depreciation deductions, not all of the exchange property qualifies as Section 1250 real property for purposes of the like-kind exchange requirements, since some of the property could have been reclassified as Section 1245 property, but was not. However, there is no theoretical reason why IRS could not argue that reclassification is not strictly elective, and the Service has shown no disinclination to take positions which are equally or even more aggressive than those taken by the taxpayer. Accordingly, a taxpayer who selectively reclassifies property could possibly arose IRS interest. Although attorneys fees can be awarded to a victorious taxpayer, the IRS position must be “substantially unjustified.”]
Even if the taxpayer is fortunate enough to be able to characterize the formerly reclassified Section 1245 property as real property, thereby avoiding the narrower definition of like-kind exchange property applicable to personal property and thereby avoiding taxable boot, the taxpayer is still not out of the woods: Section 1245 may require the taxpayer to report as ordinary income depreciation recapture, since Section 1245 recapture trumps Section 1031 nonrecognition. IRC § 1245(b)(4). Therefore, an exchange that would otherwise be fully tax-deferred may become subject to depreciation recapture under Section 1245. Depreciation recapture will ordinarily result when recovery periods shorter than straight-line have been utilized to compute depreciation.
In many circumstances the extent of depreciation recapture depends on the value of Section 1245 property relinquished versus the value of Section 1245 property received in the Section 1031 exchange. Anticipating efforts by the taxpayer to undervalue the amount of Section 1245 property relinquished in the exchange, Treas. Reg. § 1.1245-1(a)(5) requires that the total amount realized upon the disposition be allocated between the Section 1245 property and non-Section 1245 property in proportion to their respective fair market values. Where the buyer and seller have adverse interests, any arm’s length agreement will establish the allocation. In the absence of an agreement, however, the allocation is based upon a facts and circumstances approach.
Although Section 1250 recapture can also theoretically occur in a like-kind exchange, the Tax Reform Act of 1986 generally required that all both residential and commercial real property be depreciated on a straight-line basis. Therefore, Section 1250 recapture should no longer generally be an issue in most like-kind exchanges, even if the exchange involves property which has previously been reclassified for depreciation purposes.
In a like-kind exchange involving replacement property that is immediately reclassified for depreciation purposes, basis must be allocated to the replacement property. The replacement property will consist of both Section 1245 and Section 1250 property, depending upon the result of the cost segregation study. The aggregate basis of the replacement property will by definition equal the fair market value of the replacement property less the deferred gain. Treas. Reg. § 1.1245-5(a)(2) requires that basis first be allocated to non-Section 1245 property to the extent of its fair market value, with the residue being allocated to Section 1245 property. The effect of this forced allocation will be to produce longer depreciation periods.