If you’ve done a cost segregation study on your property, you’ve likely accelerated depreciation by reclassifying portions of the building into shorter-lived components — things like carpet, lighting, cabinets, or parking lots. These are categorized as §1245 property, and they help boost early tax deductions.

But here’s the catch:
When you later sell the property and use a 1031 exchange, those deductions can come back to bite you if you don’t plan ahead.

Let’s break it down.

🧱 §1245 vs. §1250 Property: What’s the Difference?

In a cost segregation study, we reallocate a portion of a building’s value from §1250 to §1245 so it can be depreciated faster — generating huge tax savings upfront.

🔁 What Happens in a 1031 Exchange?

A 1031 exchange allows you to defer capital gains taxes when you sell an investment property and reinvest the proceeds into a like-kind property.

But here’s the key:

You can only defer depreciation recapture on §1245 property if you replace it with similar §1245 property in the new asset.

In contrast, §1250 gain can be deferred as long as you’re buying real property.

📊 Real-World Example

Let’s say:

• You own a building worth $2 million.
• After cost segregation, $600,000 (30%) is classified as §1245 and fully depreciated.
• The remaining $1.4 million (70%) is §1250.

Now you sell the property and exchange into a larger $3 million asset.

You’re thinking: “Great! I’ve traded up — I’m covered.”
But here’s the trap:
🔺 If the replacement property only includes $300,000 of §1245 property, then you’re short $300,000.

That shortfall will be recaptured and taxed as ordinary income, even though you did a 1031.

🎯 Why It Matters

Your cost segregation study helped you take bigger deductions early — but that also means there’s a bigger tax bill waiting unless you carefully plan your exchange.

To fully defer all taxes, especially on the accelerated depreciation, your replacement property must contain a similar mix of §1245 and §1250 assets.

✅ Planning Tips

Here’s how to protect your gains:

• Know Your Numbers: Understand how much §1245 property you’ve depreciated before the exchange.
• Analyze the Replacement Property: Conduct a cost segregation study early to see if the new property has enough §1245 to match.
• Use New Money Wisely: If you’re trading up, allocate new basis to §1245 components to fill the gap.
• Coordinate with Your Team: Tax advisor, QI, and cost seg provider should all be on the same page.

🔚 Bottom Line

Cost segregation and 1031 exchanges are two of the most powerful tax tools in real estate — but they don’t operate in separate silos. They work best together, with smart planning and a clear strategy.

If you’ve accelerated depreciation on your current property and plan to exchange it, you need to match those deductions carefully — or risk triggering a tax bill you thought you were deferring.

Need Help Navigating the Numbers?
At Tax Logic™, we help real estate investors and developers plan smarter 1031 exchanges with cost segregation strategies that maximize after-tax cash flow — and keep the IRS off your back.

📞 Let’s talk before your next deal closes. One conversation can save you six figures.