Like-Kind Exchanges and the Cost Segregation Study
 
Written by: Steven D. Beaucaire, MST
Director - Tax | Bedford Cost Segregation, LLC

Like-kind exchange is one of those areas in tax law that is commonly misunderstood in its relationship to a cost segregation study (CSS). Not fully grasping the complexity of a like-kind exchange has led many businesses down an unproductive path only to find out a CSS is not feasible. For that reason, this month’s edition of The Bottom Line addresses two main areas that we see people having problems with when it comes to using cost segregation together with 1031. A CSS does have its place in the sale of business property if you know where to apply it.

While like-kind exchange has been around for quite some time, it is still a mystery to many. In its simplest form, it is merely an exchange of the “old” property for the “new”, and indeed, it would be wonderful if it were truly that easy. A like-kind exchange is applied when a company sells a property to purchase another more suitable property. In general, §1031 provides that no gain or loss is recognized if certain qualifying property is exchanged solely for like-kind property. One of the most important facts to know about §1031 is, it is NOT elective. If you meet all the requirements, the transaction is subject to like-kind exchange.

As an example, if a printing company wanted to sell its building for $1 million and purchased a new building for $1.5 million, it could qualify as a like-kind exchange. A step-up is created when the sale price of the old building is subtracted from the purchase price of the new building. For the first $1 million, there is no real purchase and sale because in a like-kind exchange there is a presumption that there is no gain or loss. This apples-to-apples part of the transaction is the key of a like-kind exchange. Any gain in the value of the first property is deferred by §1031 and in return for that, the IRS requires that the taxpayer use a “carry-over” basis to depreciate the new property. This applies at the asset class level, so that if the old or relinquished property was all 39-year property, then the new must be too. In our example, this means that two-thirds of the new purchase cannot be part of a CSS; only the half million dollar difference is eligible. The half million difference in value is the “step-up” referred to above and is considered a new asset placed in service on the date of the exchange.

The second most important fact to consider in like-kind exchange is that there must be sufficient value in each asset class after the exchange to support the carry-over basis. For instance, if you had $100,000 of 5-year assets in the old property, you must have at least that much 5-year in the new property. If there is insufficient basis, the depreciation recapture provisions of §1245(b)(4) and §1250(d)(4) apply to the depreciation on the difference, which is considered income.

While it would be nice to have the CSS apply to the entire purchase, remember that deferring the gain can more than make up for the portion excluded from the cost segregation study. A cost segregation study can be very valuable in accelerating deductions on the step-up, and it can be done without disturbing the like-kind exchange. As usual, knowing the facts ahead of time sets the taxpayer in the most advantageous position.