Cost Segregation and the Recapture Issue

Overview

Earlier this spring I devoted two blog posts to the topic of cost segregation studies.  In those, I mentioned that the purpose of such a study is to generate greater depreciation deductions by parsing out tangible personal property (that is depreciated over a shorter recovery period) from real estate when depreciable real estate is acquired in a transaction.  But, one of the downsides of separating out tangible personal property from the real estate is the possibility of recapture – that dirty word in tax.

Cost segregation and the potential for recapture – that’s the topic of today’s post.  I would also like to acknowledge Ken Wright’s assistance with today’s post.  Ken is a lawyer in Chesterfield, MO and a lecturer on tax and estate planning topics.  He brought to my attention the very real problem of recapture when a cost segregation study has been utilized and provided commentary for today’s post.

Cost Segregation Study - Why Do It?

According to the American Society of Cost Segregation Professionals, a cost segregation is "the process of identifying property components that are considered "personal property" or "land improvements" under the federal tax code."   Cost segregation is the engineering and accounting process of identifying those items of personal property that are contained within real property, and separating out the items of personal property for MACRS purposes.  Land is not depreciable, but structures associated with land are. From a depreciation standpoint, that means that there may be opportunities to allocate costs to personal property or land improvements that are depreciable.

A primary emphasis of a cost segregation study is to classify assets as depreciable personal property rather than as depreciable real estate (or classify depreciable personal property (e.g., structures) separate from non-depreciable real estate).  In tax lingo, a cost segregation study often results in the construction of rather detailed lists of individual assets that distinguish I.R.C. §1245 property with shorter depreciable recovery periods from I.R.C. §1250 property that has a longer recovery period. See, e.g., Hospital Corporation of America & Subsidiaries, 109 T.C. 21 (1997), acq. and non-acq. 1999-35 I.R.B. 314, as corrected by Ann. 99-116, 1999-52 I.R.B. 763.  But see, Amerisouth XXXII, Ltd. v. Comr., T.C. Memo. 2012-67 (involving residential rental property).  That is what generates larger depreciation deductions in any particular tax year. 

The Tax Cuts and Jobs Act (TCJA) of late 2017, at least indirectly, makes the practice of cost segregation more beneficial by providing for the immediate expensing of up to $1 million ($1,020,000 for 2019) of most personal property that is found on commercial and business property (including property found on a farm or ranch), and also by allowing first-year 100 percent “bonus” depreciation on used (in addition to new) assets.  These changes make it more likely that a cost segregation study will provide additional tax benefits.  

Potential Recapture Issue

When a component of I.R.C. §1250 property is reclassified as I.R.C. §1245 property, the total depreciation allowable on the reclassified item is the same.  The benefit comes from the present value of the tax savings resulting from the acceleration of the depreciation deduction.  However, depreciation recapture can occur on disposition.  Depreciation on an I.R.C. §1245 asset is subject to ordinary income recapture in accordance with I.R.C. §1245 and is ineligible for long-term capital gain treatment under I.R.C. §1231.  The impact of this result depends on the particular taxpayer’s marginal tax bracket at the time the recaptured amount is taxed. If the item of property had not been reclassified, gain on it would have been subject to a maximum rate of 25 percent as unrecaptured I.R.C. §1250 depreciation.  Thus, the ordinary income penalty could be de minimis or it could be as much as 37 percent for individuals (but only 21% for C corporations).

The recapture issue may be more problematic if the disposition of the reclassified asset is via installment sale, like-kind exchange or involuntary conversion.  Although gain from a sale of I.R.C. §1231 property can be reported on the installment basis, installment reporting is not permitted for I.R.C.§1245 depreciation recapture. Instead, all I.R.C. §1245 recapture is treated as cash received in the year of sale and must be reported.  IRC § 453(i).  The taxpayer’s basis in the property for purposes of calculating the gross profit ratio (part of the procedure for computing taxable gain on an installment sale transaction) is then increased by the amount of depreciation recapture and any remaining gain is taxed each year using the recomputed gross profit ratio.

Care should be taken in an installment sale transaction by a taxpayer who has reclassified a significant portion of a property’s basis as I.R.C. §1245 tangible personal property to get enough cash down to pay the tax liability resulting from the recapture along with any first-year payments. (This may also lead to some creative purchase price allocations in sales contracts.)

Ordinary income recapture under I.R.C.§1245 applies to any disposition of I.R.C. §1245 property notwithstanding any other provision of the Code unless there is an express exception contained in I.R.C. §1245.  I.R.C. § 1245(a)(1).  I.R.C. §1245(b)(4) provides a limited exception from the recapture rules for like-kind exchanges under I.R.C. §1031 and involuntary conversions under I.R.C. §1033. Under the exceptions, if property is disposed of and there is nonrecognition of gain under I.R.C. §1031 or I.R.C. §1033, then the amount of gain to be taken into account under I.R.C. §1245 by the seller is not to exceed the sum of the amount of gain recognized on the disposition determined without regard to I.R.C. §1245 (effectively boot received under I.R.C. §1031 and proceeds not reinvested under §1033), plus the fair market value of any property that is received and which is not I.R.C. §1245 property and has not already been taken into account as gain.

The application of the application rules in the event a portion of the real property is reclassified as §1245 property is illustrated by the following example that is based on Treas. Reg. §1.1245-4(d)(5).

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Example

Sam Sung owns I.R.C. §1245 property, with an adjusted basis of $100,000 and a recomputed basis of $116,000. The property is destroyed by fire and Sam receives $117,000 of insurance proceeds that triggers $16,000 of recapture.

Sam uses $105,000 of the proceeds to purchase I.R.C. §1245 property similar or related in service or use to his original property, and $9,000 of the proceeds to purchase stock in the acquisition of control of a corporation owning property similar or related in service or use to Sam’s original property. Both acquisitions qualify under the involuntary conversion rules. Sam properly elects to limit recognition of gain to the amount by which the amount realized from the involuntary conversion exceeds the cost of the stock and other property acquired to replace the converted property.

Since $3,000 of the gain is recognized (without regard to the I.R.C. §1245 recapture rules) under the involuntary conversion rules for failure to purchase sufficient replacement property (that is, $117,000 minus $114,000), and since the stock purchased for $9,000 is not I.R.C. §1245 property and was not taken into account in determining the gain under the involuntary conversion rules, the amount of the gain taken into account as I.R.C. §1245 recapture is limited to $12,000 (that is, $3,000 plus $9,000).

If, instead of purchasing $9,000 in stock, Sam purchases $9,000 worth of property which is I.R.C. §1245 property similar or related in use to the destroyed property, the recapture amount would be limited to $3,000.  The result would have been the same had the transaction been structured as an I.R.C. §1031 exchange.

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As noted above, a building containing items that have been reclassified as I.R.C. §1245 tangible personal property for MACRS purposes as the result of a cost segregation study does not change the classification of the property for purposes of the like-kind exchange provisions of I.R.C. §1031 or the involuntary conversion rules of I.R.C. §1033.  Consider the following example:

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Example 

Ray Ovac reclassifies 25 percent of the basis of items in a building as being 7-year MACRS property and claims accelerated depreciation. All of the items are otherwise structural components of the building and therefore classified as real property under state law.  Ray later trades the building and associated land in a like-kind exchange for unimproved land. For purposes of applying the like-kind exchange rules of I.R.C. §1031, Ray is treated as having traded real property for real property. Ray will recognize gain under I.R.C. §1245, however, unless the FMV of the 25 percent of the basis that was reclassified as I.R.C. §1245 property is replaced by an equal or greater FMV of I.R.C. §1245 property. The point of this is to ensure that the I.R.C. §1245 recapture carries over to the replacement I.R.C. §1245 property and is not subsumed by the replacement I.R.C. §1250 property.

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Conclusion

The recapture potential as the result of a cost segregation study should always be kept in mind.