Why the depreciation that makes a short-term rental attractive can resurface as ordinary income in a 1031 exchange, and how the replacement contract decides how much.
Ask anyone pitching the short-term rental strategy what happens when you eventually sell, and you'll get the clean answer: run a 1031 exchange and defer everything. That answer is correct and, for an owner who commissioned a cost segregation study, dangerously incomplete.
Here is what the clean answer skips: a cost segregation study splits one property into assets that §1031 treats differently, and the depreciation on some of them comes due at the exchange no matter how carefully the rest is deferred.
The pitch shows you the year-one deduction. It rarely shows you the exit.
The strategy works like this. You buy a property, operate it as a short-term rental, and commission a cost segregation study that reclassifies part of the purchase price out of the building and into shorter-lived assets. With 100% bonus depreciation available again for property acquired after January 19, 2025 (§168(k)), those reclassified assets can be written off in year one. If the rental qualifies as nonpassive, the deduction offsets wages and business income.
The deduction is real. But the study has quietly divided the property into three groups, and each one leaves differently.
Land and the building shell are real property for every purpose. Depreciation on the building is recovered over 27.5 years and, on a taxable sale, is generally taxed as unrecaptured §1250 gain at a maximum rate of 25% (§1(h)(1)(E)).
Reclassified components such as built-in cabinetry, permanent floor coverings, and dedicated electrical and plumbing are §1245 property for depreciation purposes, but many of them remain real property for §1031 purposes. The exchange regulations define real property to include structural components integrated into an inherently permanent structure, including permanent coverings of walls, floors, and ceilings, as well as anything classified as real property under state or local law (Treas. Reg. §1.1031(a)-3(a)).
True personal property such as furniture, freestanding appliances, televisions, and décor is §1245 property for depreciation and personal property for §1031 purposes. It is the most heavily furnished part of a short-term rental, and it is the part the exchange cannot reach.
Since 2018, §1031 applies only to real property (§1031(a)(1); Treas. Reg. §1.1031(a)-1(a)(3)). When personal property is transferred alongside real property, nonrecognition does not extend to it (Treas. Reg. §1.1031(a)-1(a)(2)). The furnishings are treated as sold, not exchanged.
Because they were written off in year one, their adjusted basis is zero, and the gain is §1245 recapture taxed as ordinary income. Section 1245 is explicit that this gain is recognized "notwithstanding any other provision of this subtitle" (§1245(a)(1)). No replacement property cures it.
The same rule runs in the other direction. Exchange proceeds spent on the replacement property's furnishings buy non-like-kind property, which is taxable boot to that extent (§1031(b)). The clean approach is to sell and buy furnishings under separate bills of sale, funded outside the exchange.
The reclassified components are the more interesting group. They qualify as like-kind real property, so their gain can be deferred. But their depreciation is §1245 recapture, and §1245(b)(4) limits the shelter an exchange provides: recapture is deferred only to the extent the owner receives §1245 property in return. Any shortfall filled with non-§1245 property (the replacement building and land) is recaptured.
The regulations apply this as a matching exercise. The amount realized on the relinquished §1245 property is deemed to consist first of the fair market value of §1245 property acquired, and only the remainder of non-§1245 property (Treas. Reg. §1.1245-4(d)(4)). A parallel rule governs §1250 property (Treas. Reg. §1.1250-3(d)(6)).
Three consequences follow. The match is measured by fair market value at the exchange, not by what the original study reclassified. The replacement property needs components of its own, identified and valued, which usually means a cost segregation analysis on the replacement before closing rather than after. And the allocation belongs in both purchase contracts, because an arm's length allocation between parties with adverse interests is generally respected, while an undocumented one is left to a facts-and-circumstances determination (Treas. Reg. §1.1245-1(a)(5)).
The line between the second and third groups is not drawn by federal law alone. The exchange regulations add a second path: property that is real property under the law of the state where it is located, on the date it is transferred, is real property for §1031 purposes (Treas. Reg. §1.1031(a)-3(a)(6)). The path runs one way. State law can bring into the exchange an item that fails the federal structural component factors, but it cannot remove one that satisfies them.
That puts Florida fixture law directly into the analysis, and Florida fixture law does not turn on whether an appliance is built in. Florida courts weigh actual annexation to the realty, adaptation to the use of the realty, and the intention that the item become a permanent part of the freehold (Commercial Finance Co. v. Brooksville Hotel Co., 98 Fla. 410, 123 So. 814 (1929)), and they treat the intention of the party making the annexation as a primary test. In First Federal Savings & Loan Ass'n of Okaloosa County v. Stovall, 289 So. 2d 32 (Fla. 1st DCA 1974), a dishwasher, disposal, drop-in range, range hood, cabinets, countertop, and sink installed in a residence under a title-retention contract were held to be personalty, because there was no evidence of intent to make them a permanent accession to the freehold. In Maas Brothers, Inc. v. Guaranty Federal Savings & Loan Ass'n, 157 So. 2d 528 (Fla. 2d DCA 1963), custom-cut wall-to-wall carpeting hooked onto tack strips remained personalty.
Those were lien priority disputes, and their facts drove their results. That is the point. Whether a wall oven or a built-in refrigerator in a Florida short-term rental is a fixture is a factual question about intent, and in an exchange that intent is evidenced largely by documents the owner signs: the purchase contract, any bill of sale for furnishings, the closing statement, and the cost segregation report itself.
The standard Florida form does not settle it. The current Florida Realtors/Florida Bar AS IS contract includes "fixtures, including built-in appliances" in the Real Property in paragraph 1(c). It then lists the range, oven, refrigerator, dishwasher, disposal, ceiling fans, and light fixtures as Personal Property in paragraph 1(d), and recites that the Personal Property has no contributory value. A built-in dishwasher sits on both sides of that line, and the recital sits uneasily beside a cost segregation study that assigned the same items real dollars.
Two further points follow. First, Florida classification decides only whether an item is inside the exchange; the §1245 recapture rules still apply to it (Treas. Reg. §1.1031(a)-3(a)(7)). A built-in oven that Florida law makes real property still needs a §1245 match in the replacement property. Second, classification is tested on the date of transfer. An owner who replaces built-ins with freestanding units during the rental years, as short-term rental owners often do, may have changed the answer without knowing it.
This is a drafting problem as much as a tax problem. The classification of each appliance, the exclusions in paragraph 1(e), the terms of any separate furniture bill of sale, and the allocation in both contracts should be settled together, before either contract is signed, by counsel reading the cost segregation report and the purchase contract side by side.
An owner buys a furnished short-term rental for $1,000,000. The cost segregation study allocates $200,000 to land, $600,000 to the building shell, $100,000 to reclassified components that remain real property under §1.1031(a)-3, and $100,000 to furnishings and appliances. The owner takes $200,000 of bonus depreciation in year one.
Four years later the owner sells for $1,400,000, allocated $1,200,000 to land and building, $150,000 to the components, and $50,000 to the furnishings, and exchanges into a $1,600,000 replacement property with all proceeds reinvested.
The furnishings, in either case: $50,000 is recognized as §1245 ordinary income. The exchange never reaches it.
The components, without a matching allocation: The replacement contract states a single price, all of it building and land. The $150,000 realized on the components is deemed received entirely in non-§1245 property, so §1245(b)(4) provides no shelter and the full $100,000 of prior depreciation is recaptured as ordinary income. Total ordinary income: $150,000, on an exchange in which every dollar was reinvested.
The components, with a matching allocation: The replacement contract allocates $175,000 to comparable components, supported by a cost segregation analysis of the replacement property. The $150,000 realized is deemed received entirely in §1245 property, and no recapture is triggered on the components. Total ordinary income: $50,000.
In this example: the same sale, the same reinvestment, and a $100,000 swing in ordinary income, decided by one allocation line in a contract the owner's advisors may never have read.
Each professional in the transaction owns a piece and no one owns the whole. The agent sells the deduction. The cost segregation firm is engaged at purchase, not at sale. The qualified intermediary administers the exchange mechanics and does not advise on allocation. The replacement seller has no reason to break out components unless asked, and a single-price contract on a standard form is the default. The recapture problem sits in the gap between them, and it surfaces on the return for the year of the exchange.
There is a second-order issue here: the exit only matters if the entry worked. The deduction offsets nonpassive income only if the rental escapes the passive activity rules. That generally requires an average period of customer use of seven days or less, so the activity is not a "rental activity" at all (Treas. Reg. §1.469-1T(e)(3)(ii)(A)), and material participation by the owner under one of the tests in Treas. Reg. §1.469-5T(a), established year by year. An owner who hands the property to a full-service manager often fails the second condition. In that case the deduction is suspended as a passive loss, while the recapture exposure described above remains exactly the same.
Land improvements deserve a note as well. A pool, fencing, or paving reclassified to 15-year property is §1250 property, not §1245 property, but bonus depreciation exceeds straight-line recovery, and §1250(a) treats that excess as ordinary income on a taxable disposition. The matching logic above applies to it through its own regulation.
None of this makes the strategy improper, and none of it makes the deduction illusory. It is black-letter recapture law applied to an asset the study itself divided. What is rare is the discipline to plan the exit at the entrance: which reclassified assets are real property under the exchange regulations or state fixture law, what they will be worth at sale, how the replacement property will be analyzed and allocated before closing, and how furnishings will move outside the exchange. Even done well, the exchange defers recapture rather than eliminating it; the deferred amount carries into the replacement property's basis and follows the owner forward. The durable exit is the estate plan. Section 1245 recapture does not apply to a transfer at death (§1245(b)(2)), and the basis of property acquired from a decedent is generally stepped up to fair market value (§1014). An exchange strategy without that endpoint is a deferral with a bill attached.
If you own a short-term rental with a cost segregation study behind it and you cannot say, today, which of its components will qualify in an exchange under both federal and Florida law, what they are worth, and how the replacement contract will allocate them, that is a conversation worth having before you list the property, not after the exchange closes.
Summit Law Group, PLLC advises ultra-high-net-worth individuals, family offices, and founders on tax, trust, and structural planning across Florida, New York, and New Jersey. This article is for general information only and does not constitute legal or tax advice. The example above is hypothetical and illustrative; the treatment of any asset under §§1031, 1245, and 1250 depends on its classification under federal and state law, its value, and the terms of both purchase contracts.