Real estate investments can generate many benefits, not the least of which is property appreciation. This means that when you sell that appreciated property, you could realize a profit from that sale. One potential downside could be capital gains taxes. Another is depreciation recapture taxes.
One way to defer capital gains taxes is through a 1031 exchange. But do you have to recapture depreciation in a 1031 exchange? The answer is no.
Depreciation Recapture in Brief
Depreciation recapture taxes are based on the concept of depreciation. This concept assumes that your property has a finite period during which it will have a “useful life.” According to the IRS, that useful life is 27.5 years for residential properties and 39 years for commercial properties. The IRS supports income tax deductions through depreciation to account for a property’s loss of functionality. This is the allocation of your real estate’s cost over its useful life.
This can be a nice perk while you own the real estate. But the IRS wants some of that money back when you sell it. This comes as depreciation recapture, which equals 25% of the depreciation allowance taken over your investment’s holding period.
Depreciation recapture can whittle the profit you earn from selling your investment or business real estate. The federal capital gains tax can compound the issue. Plus, if you’re in a state that assesses its capital gain tax, you could lose much of the profit from your sale.
Deferring Depreciation Recapture
When you exchange into another property using the like-kind exchange, you could defer capital gains and depreciation recapture taxes and potentially avoid paying them immediately. Through the like-kind exchange, your original non-depreciated cost basis plus the gain in value carries over to that replacement property. You won’t owe depreciation recapture taxes until you dispose of that replacement property through a regular sale. Or you could continue deferring those taxes through another 1031 exchange.
Meanwhile, you could still take depreciation on the replacement property. If you use the single-schedule depreciation method, you’ll use the replacement property’s new adjusted cost basis and divide it by either 27.5 years or 39 years to determine the depreciation amount.
Remember that the 1031 exchange can only defer that depreciation recapture tax. It doesn’t eliminate it. You’ll likely still have to pay it down the road.
Taxes and Exchanges
Though the like-kind exchange could be one solution to depreciation recapture, it carries with it multiple rules. Because of this, be sure you work with a professional familiar with the 1031 exchange deadlines and requirements and how taxes can be deferred.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.
The income stream and depreciation schedule for any investment property may affect the property owner’s income bracket and/or tax status. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities.
Costs associated with a 1031 transaction may impact investor’s returns and may outweigh the tax benefits. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities.
Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.
