Like Kind Exchange Wrinkle With Cost Segregation

By Jason Watson, CPA
Posted Thursday, July 16, 2026

With the Tax Cuts and Jobs Act, IRC Section 1031 was generally limited to exchanges of real property. Personal property no longer gets its own tax-deferred exchange treatment.

Why do you care? With many real estate transactions, there is personal property transferred along with the real estate. Furniture, televisions, appliances and other movable items are easy examples. However, a cost segregation study can also create several Section 1245 buckets within what normal humans would otherwise view as immovable and part of one big piece of real estate.

Most humans. Or mostly normal humans. We all know a few.

Let’s say you bought a $500,000 short-term rental and the cost segregation report came up with $80,000 in 5-, 7- and 15-year property. Naturally, you accelerate depreciation of these items with bonus depreciation. Later, you enter into a 1031 like-kind exchange involving another real estate investment property. Neat.

However, before calculating the tax consequences, you need to slow down and separate three concepts that are often mashed together:

• Section 1245 property for depreciation recapture purposes.
• Real property for Section 1031 purposes.
• True personal property that is not eligible for Section 1031 treatment.

Those three buckets can overlap, but they are not synonymous.

True Personal Property

Let’s start with the easy stuff. Furniture, televisions, movable appliances and similar items are generally personal property and are no longer eligible for Section 1031 nonrecognition.
Suppose $20,000 of the $80,000 cost segregation allocation relates to furniture and movable appliances. You fully depreciated those items, leaving a zero adjusted tax basis. At the time of the exchange, their fair market value is $8,000 resulting in an $8,000 gain.

Since the property was previously depreciated under Section 1245, the $8,000 gain would generally be ordinary income depreciation recapture. And no, we cannot pretend they are worth $38 because that produces a better tax return.

This is one reason we generally recommend keeping furniture, televisions, freestanding appliances and other separately identifiable personal property out of the cost segregation study. You do not need an engineer to tell you that a sofa is not part of the building. These items can be separately listed and depreciated based on their actual cost.

Keeping them separate also makes the eventual disposition much cleaner. You can identify the original cost, accumulated depreciation, adjusted tax basis and fair market value of each item without trying to reverse-engineer those amounts from a broader cost segregation allocation.

Section 1250 Land Improvements

Now consider another piece of the $80,000 cost segregation allocation. Let’s say $25,000 relates to 15-year land improvements such as driveways, landscaping, drainage, sidewalks, fencing or similar improvements connected to the rental property.

For a typical rental property, these assets are generally Section 1250 property, not Section 1245 property. That can work in your favor during a Section 1031 exchange.

Why? Because these land improvements are generally real property. If they are real property, they can generally participate in the Section 1031 exchange along with the building and land. In that case, some or all of the gain recognition and depreciation recapture concern might remain deferred when sufficient replacement Section 1250 property is received.

This gives you a nice result- accelerated depreciation now and potentially delayed gain recognition later. Best of both worlds as Van Halen would sing. Yes, we are counting the Sammy era.

Section 1245 Does Not Always Mean Personal Property

Now let’s deal with the remaining $35,000 from the cost segregation study. In our example, this amount is 5-year and 7-year Section 1245 property.

It is tempting to say that all Section 1245 property is personal property and therefore cannot qualify for Section 1031 nonrecognition. That is not quite right.

An asset can be Section 1245 property for depreciation and recapture purposes while also being real property for Section 1031 purposes. Whoa! Different tax rules. Different definitions. Different headaches. But this is good!

Treasury Regulations Section 1.1031(a)-3 provides the special definition of real property for a like-kind exchange. Generally, tangible property can qualify as real property if-

• It is classified as real property under the state or local law where the property is located.
• It is specifically listed as real property in the Section 1031 regulations.
• It qualifies as an inherently permanent structure or as a structural component of one based on the facts and circumstances.

Each distinct asset is analyzed separately. Yes, that can be a pain, but a good previous cost segregation report should be your rubric. Unless you bought the one from a Cracker Jack box.

An inherently permanent structure is generally property that is permanently affixed to real property and ordinarily expected to remain in place for an indefinite period. For assets that are not specifically listed, the regulations consider factors such as how the asset is affixed, whether it was designed to remain in place, the damage removal would cause, the time and expense required for removal, and the parties’ circumstances.

This all makes sense, right? Sure.

For a rental property, this might include odd-duck items such as dedicated electrical wiring, outlet receptacles, appliance branch circuits, dryer vent hookups, gas connectors, water lines, drain lines, specialty plumbing connections, decorative or specialty lighting, removable floor coverings, window treatments or other components that are not loose furniture, TVs or freestanding appliances.

Some of these assets might remain Section 1245 property for depreciation and recapture purposes while still qualifying as real property for Section 1031. Others might not. The cost segregation label starts the conversation; it does not finish it.

The current Form 8824 instructions illustrate this exact result with Section 1245 assets that also qualify as real property for Section 1031. However, even when the assets qualify for Section 1031 nonrecognition, the Section 1245 recapture analysis does not simply disappear. And we burst that bubble in a bit.

Section 1245 Recapture Can Still Sneak In

IRC Section 1245(b)(4) provides a special limitation for like-kind exchanges. In simplified terms, the amount of Section 1245 recapture recognized cannot exceed-

• The gain otherwise recognized in the exchange, plus
• The fair market value of replacement property received that is not Section 1245 property.

Why would the second item matter? Because the tax code generally does not want fully depreciated Section 1245 property disappearing into the replacement Section 1250 property ether without preserving the potential ordinary income recapture down the road.

The current Form 8824 instructions provide an example where the taxpayer relinquishes $55,000 of Section 1245 property that qualifies as real property for Section 1031. The taxpayer previously claimed $35,000 of depreciation on those assets.

However, the replacement real property contains no Section 1245 property. Since the Section 1245 assets have a fair market value of $55,000 and a zero adjusted basis, there is enough gain to recapture the full $35,000 of prior depreciation. Yuck.

Said differently, in the IRS example on Form 8824, the taxpayer received only Section 1250 replacement property, so there was no replacement Section 1245 property to carry the old recapture potential forward.

Replacement Section 1245 Property

The result can be different when the replacement property also contains Section 1245 real property.

Suppose the relinquished rental includes Section 1245 property that also qualifies as real property under Section 1031, such as the odd-duck electrical wiring, appliance branch circuits, gas supply piping, fixed dryer vent ducting and similar integrated components discussed just a bit ago. The replacement rental also includes qualifying Section 1245 real property.

In that situation, some or all of the Section 1245 recapture potential might remain deferred because the replacement Section 1245 property can continue carrying that recapture potential. The exact calculation depends on the gain otherwise recognized, the fair market value and tax classification of the replacement assets, and the amount of prior depreciation.

This is why a cost segregation study on the relinquished property is not always enough. You might also need an allocation or cost segregation analysis for the replacement property to determine what type of property was received.

Read that again. You might need a cost segregation study or another defensible allocation even if you don’t intend to accelerate depreciation, simply to calculate the replacement Section 1245 property. Otherwise, you know what went out the door but not what came back through it. A tough way to finish an exchange calculation.

Incidental Personal Property

What about the 15% incidental personal property rule? Treasury Regulations Section 1.1031(k)-1(g)(7)(iii) reads-

(iii) Personal property generally resulting in gain recognition under section 1031(b) that is incidental to real property acquired in an exchange. For purposes of this paragraph (g)(7), personal property is incidental to real property acquired in an exchange if—

(A) In standard commercial transactions, the personal property is typically transferred together with the real property; and

(B) The aggregate fair market value of the property described in paragraph (g)(7)(iii)(A) of this section transferred with the real property does not exceed 15 percent of the aggregate fair market value of the replacement real property or properties received in the exchange.

Cool. Let’s say your replacement rental property has a fair market value of $800,000. Fifteen percent of $800,000 is $120,000.

Therefore, up to $120,000 of personal property received with the replacement real estate might qualify as incidental, assuming that type of personal property is typically transferred with the real estate in standard commercial transactions.

However, incidental does not mean exchange eligible.

Why do we care or like this rule? The rule helps prevent a relatively small amount of personal property received with the replacement real estate from blowing up the qualified-intermediary safe harbor. It does not magically convert the personal property into real property, and it does not independently eliminate gain or Section 1245 recapture.

Additionally, the regulation’s heading describes the property as “personal property generally resulting in gain recognition under section 1031(b).” Treasury was kind enough to put the warning on the label.

Also, the 15% calculation looks at personal property received with the replacement real estate. It does not provide a 15% free pass for the personal property transferred with the relinquished property.

Read that again too. This does not mean you can take 15% of the replacement property and “like kind exchange” that for Section 1245 property sold with the relinquished property.

To Recap 1031 Cost Segregation Troubles

After the Tax Cuts and Jobs Act, Section 1031 is generally limited to real property. However, do not assume that every Section 1245 cost segregation bucket is automatically personal property and therefore exchange ineligible.

• Section 1245 property might still qualify as real property under the special Section 1031 definition if it is treated as real property under state or local law, is specifically listed in the regulations, qualifies as an inherently permanent structure, or is a structural component integrated into one.
• Furniture, televisions, freestanding appliances and other movable items generally remain true personal property. They do not receive Section 1031 nonrecognition, and gain can trigger Section 1245 depreciation recapture.
• Even when Section 1245 property qualifies as real property, some or all of the recapture might still be recognized if the replacement property does not include sufficient Section 1245 property to continue carrying that recapture potential.
• Finally, the 15% incidental personal property rule protects the deferred-exchange mechanics. It does not make personal property exchange eligible or make depreciation recapture disappear. And to reiterate, you cannot simply conflate the incidental exception as a cover for the Section 1245 property you sold.

But incidental does not mean tax-free. It just means incidental. Sounds so innocent.