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John Hoffman, Baker Tilly Capital, LLC Joyce Welch, Deloitte Tax LLP

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1 John Hoffman, Baker Tilly Capital, LLC Joyce Welch, Deloitte Tax LLP
INTERACTION of LIKE-KIND EXCHANGES and COST SEGREGATION STUDIES John Hoffman, Baker Tilly Capital, LLC Joyce Welch, Deloitte Tax LLP

2 Agenda Introduction Like-Kind Exchange Basics Cost Segregation and LKE
Deferred Gain Examples How to Depreciate LKE Property Risks Associated with Cost Segs on 1031 Property Questions

3 Speakers John P. Hoffman, CPA Baker Tilly Capital, LLC Director
Specializes in real estate and fixed asset tax consulting including credits and incentives Leadership roles in historic tax credits and cost segregation Past President of ASCSP Joyce L. Welch Managing Director Deloitte Tax LLP Washington National Tax Specializes in like-kind exchanges and other tax deferral property transactions Over 25 years of tax planning experience Member of American Institute of Certified Public Accountants

4 Like-Kind Exchange IRC §1031(a)(1): “No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business, or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment.” 1

5 What is Like-Kind Property?
Replacement Property must be like-kind or like class to the Relinquished Property Like-Kind – refers to nature or character, not grade or quality Most real property assets will be like-kind to other real property, regardless of quality, and whether depreciable or non-depreciable Real property is not like-kind to personal property Like Class – safe harbor test for tangible personal property Within same “General Asset Class” or within same “Product Class” A property classified within any General Asset Class may not be classified within a Product Class Goodwill can never be like kind or like class 2

6 Like-Class Property for Personal Property Exchanges
General Asset Class (I) Office FF&E (asset class 00.11); (II) Information systems (asset class 00.12); (III) Data-handling equipment (asset class 00.13); (IV) Airplanes (asset class 00.21) (V) Automobiles, taxis (asset class 00.22); (VI) Buses (asset class 00.23); (VII) Light general-purpose trucks (asset class ); (VIII) Heavy general-purpose trucks (asset class ); (IX) Railroad cars and locomotives (asset class 00.25); (X) Tractors for use over the road (asset class 00.26); (XI) Trailers & trailer-mounted containers (asset class ); (XII) Vessels, barges, tugs, & similar water transportation equipment, (asset class 00.28); and (XIII) Industrial steam and electric generation and/or distribution systems (asset class 00.4). Product Class 6-digit North American Industry Classification System (NAICS) codes for determining product classes for purposes of LKE of depreciable personal tangible property If property in more than one class, it can be treated in any one of the classes NAICS codes to not apply to all assets 3

7 What is NOT Like-Kind Property?
Personal use or property held for sale (inventory) Held for development Acquired for conversion, then sale (e.g. condo conversions) Acquired to fix-up and sell (flip) Securities Stock of Real Estate Investment Trusts (REITs) (except via an up REIT) Interests in an Entity (LLC or Partnership) SMLLC is not treated as regarded entity 4

8 Incidental Personal Property
If personal property is "incidental" to a larger exchange of real property, it is not treated as a separate property for identification purposes, and does not need to be specifically identified - Reg (k)-1(c)(5)(B) Property is incidental: (i) in standard commercial transactions, the property is typically transferred together with the larger item of property, and (ii) the aggregate fair market value of all the incidental property does not exceed 15% of the aggregate fair market value of the larger item of property. Examples: furniture, appliances, laundry machines, and other miscellaneous items of personal property will not be treated as separate property from the sale of an apartment building, nursing home, motel, etc., if the fair market value of personal property does not exceed 15% of the total sale price. 5

9 Cost Segregation: Additional Information Needed
Deferred gain calculation spreadsheet Relinquished property Depreciation schedule – was a cost seg completed? Type of property, address Original purchase date and purchase price Sales price and date Replacement property Purchase date and purchase price Get CPA involved Depreciating exchanged basis can be extremely complicated 6

10 Deferred Gain Basis Considerations
Ask CPA for their calculations Is there enough basis to make cost segregation study worthwhile? In relinquished property or trade-up in replacement property What are the alternatives for depreciation methods? Bonus depreciation on FF&E Qualified leasehold improvement property Are you better off paying the tax and accelerating write offs on the acquisition property especially with a cost segregation study? 7

11 Is cost segregation worthwhile?
Relinquished Property Warehouse Office Totals Sales Price $ ,000,000 $ ,500,000 $ 9,500,000 Deferred Gain $ ,950,000 $ ,460,000 $ 9,410,000 Adjusted Tax Basis $ ,000 $ ,000 $ ,000 Replacement Property Cinema Acquisition Cost $ 9,600,000 $ 9,600,000 Additional Basis (trade-up) $ ,000 Due to small Additional Basis cost segregation analysis may not be worthwhile 8

12 Real v Personal Property in §1031
Real Property must be replaced with Real Property to defer the gain Definition of Real Property is determined by state law – Varies by state Definition of Real and Personal Property for tax-depreciation purposes is determined under federal law. State law tends to classify fixtures in a building as real property. Sample Real Property for state purposes: Casework Millwork Carpeting Dedicated electric and plumbing 9

13 Sample Exchange – Example One Exchanged Properties
Relinquished Property - Retail Sales Price $12M Replacement Property - Industrial Purchase Price $20M 10

14 Sample Exchange – Example One Relinquished Property Step Up
Building Land Totals Sales Price (FMV) $9.0M $3.0M $12M Relinquished Property 5 Year 15 Year 39 Year Land Totals Original Purchase Price $600K $1.2M $6.2M $2.0M $10M Depreciation <$425K> <$275K> <$325K> <$1.02M> Adjusted Basis $175K $925K $5.88M $8.98M Step up: Adjusted Basis to FMV Building Land Totals Adjusted Basis $6.98M $2.0M $8.98M Sales Price (FMV) $9.0M $3.0M $12M Step Up to FMV (w Land) 134% Step Up to FMV (w/o land) 129% 11

15 Sample Exchange – Example One Boot Test – Version #1
Replacement Property – Post Cost Segregation 5 Year 15 Year 39 Year Land Totals Purchase Price (FMV) $1.5M $2.0M $12.5M $4M $20M Life Relinquished Property Adjusted Basis FMV Step Up FMV Relinquished Property Replacement Property Boot Check 5 Year $175K 134% $235K $1.5M Pass 15 Year $925K $1.24M $2.0M 39 Year $5.88M $7.88M $12.5M Land $2.68M $4.0M Total $8.98M $12M $20M TRANSACTION DOES NOT TRIGGER BOOT 12

16 Sample Exchange – Example One Boot Test - Version #2
Replacement Property – Post Cost Segregation 5 Year 15 Year 39 Year Land Totals Purchase Price (FMV) $0 $2.0M $12.5M $5.5M $20M Life Relinquished Property Adjusted Basis FMV Step Up FMV Relinquished Property Replacement Property Boot Check 5 Year $175K 134% $235K $0 Fail 15 Year $925K $1.24M $2.0M Pass 39 Year $5.88M $7.88M $12.5M NDP $2.68M $5.5M Total $8.98M $12M $20M TRANSACTION TRIGGERS BOOT IN 5 YR PROPERTY 13

17 Sample Exchange – Example One Replacement Property Net Basis
Purchase Price Allocation Relinquished Property Sales Price Relinquished Property Adjusted Basis Allocated Deferred Tax Gain Replacement Property Net Basis $20M 100% $12M $8.98M $3.02M $17.0M Building Total $16M 80% $2.4M $13.6M Land Total $4M 20% $604K $3.4M Basis of depreciable property for cost segregation analysis is $13.6M 14

18 Sample Exchange – Example Two Exchanged Properties
Relinquished Property - Apartments Sales Price $12M Replacement Property - Industrial Purchase Price $12M 15

19 Sample Exchange – Example Two Relinquished Property Step Up
Building Land Totals Sales Price (FMV) $9.0M $3.0M $12M Relinquished Property 5 Year 15 Year 27.5 Year Land Totals Original Purchase Price $3.0M $1.2M $4.3M $1.5M $10M Depreciation <$2.4M> <$275K> <$781.8K> <$3.46M> Adjusted Basis $600K $925K $3.52M $6.54M Step up: Adjusted Basis to FMV Building Land Totals Adjusted Basis $5.04M $1.5M $6.54M Sales Price (FMV) $9.0M $3.0M $12M Step Up to FMV (w Land) 183% Step Up to FMV (w/o land) 178% 16

20 Sample Exchange – Example Two Boot Test – Version #1
Replacement Property – Post Cost Segregation 5 Year 15 Year 39 Year Land Totals Purchase Price (FMV) $1.0M $2.0M $7.0M $2M $12M Life Relinquished Property Adjusted Basis FMV Step Up FMV Relinquished Property Replacement Property Boot Check 5 Year $600K 183% $1.10M $1.M Fail 15 Year $925K $1.70M $2.0M Pass 39 Year $3.52M $6.45M $7.0M Land $1.5M $2.75M Total $6.54M $12M TRANSACTION TRIGGERS BOOT IN 5 YR PROPERTY 17

21 How to Depreciate Property Acquired in a Like-Kind Exchange
General rule for depreciating exchanged basis: Remaining Life and Method Applies when Replacement Property has: Same or Shorter Recovery Period; or Same or Faster Depreciation Method Exchanged Basis amount is depreciated over the remaining recovery period of the Relinquished Property using the same depreciation method (200%, straight- line, etc.) and the same depreciation convention (half- year, mid-quarter, etc.) 18

22 How to Depreciate Property Acquired in a Like-Kind Exchange
In order of favorability to Taxpayer: Personal Property 5 – 7 yrs; Double Declining Land Improvements 15 yrs; 150% Declining Balance Residential Property 27 ½ yrs; straight-line Commercial Property 39 yrs; straight-line Land – no depreciation 19

23 Opting out of General Rules - §1.168(i)-6(i)(1) Election
§1.168(i)-6(i)(1) allows taxpayer to elect out of the remaining life and method general rule Relinquished property is treated as if you sold it on date of exchange Adjusted basis of relinquished property can be depreciated same as replacement property Can be beneficial if recovery periods of replacement property are shorter (trading 39 year property for 27 ½ year) Must be made in year of replacement on timely filed return Can only be revoked with consent of IRS (in extraordinary circumstances) Election is made on Form 4562 20

24 Opting Out of General Rules - Example
Relinquished Property Building & Land Sales Price $ ,000,000 Adjusted Basis $ 1,000,000 Replacement Property Purchase Price $ 6,000,000 Excess Basis Building Land Allocation $ 2,000,000 $1,700,000 $300,000 The Adjusted Basis of the building ($1M), is depreciated under the prior method unless Owner elects out $1.7M Excess Basis may be depreciated under an accelerated method as determined through the cost segregation study 21

25 Risk of Cost Segregation and §1031
Relinquished Property classified into 5 or 7 year categories, Replacement Property must conform or risk: Recapture Boot treatment on failure to acquire qualifying like-kind replacement property. An exchange that otherwise qualifies for §1031 non-recognition treatment may still trigger depreciation recapture under §1245 but exchange of §1250 property does not 22

26 Triggering Gain Tax payer acquires $300,000 of non like-kind property
Relinquished Property Replacement Property Type Raw Land Warehouse FMV $2MM Basis $800K Land $1.0M Building $700K Personal Property $300K Tax payer acquires $300,000 of non like-kind property Triggers $300,000 in gain 23

27 Recapture Calculation
Relinquished Property Replacement Property Type Office Warehouse Land $200,000 §1245 Property $900,000 $500,000 §1250 Property $2,900,000 $3,300,000 Total FMV $4,000,000 §1245 Property trade down from $900,000 to $500,000 Creates ordinary income recapture Taxable gain will never exceed the gain realized 24

28 This presentation contains general information only and the respective speakers and their firms are not, by means of this presentation, rendering accounting, business, financial, investment, legal, tax, or other professional advice or services. This presentation is not a substitute for such professional advice or services, nor should it be used as a basis for any decision or action that may affect your business. Before making any decision or taking any action that may affect your business, you should consult a qualified professional advisor. The respective speakers and their firms shall not be responsible for any loss sustained by any person who relies on this presentation.

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