Many real estate investors take annual depreciation expense, a non-cash flow reduction in income. However, the depreciation expense isn't a free lunch. Once the property is sold, the IRS will tax the depreciation. This is known as depreciation recapture. But does this same taxation apply under a 1031 exchange? Read on to find out.
What Is Depreciation Recapture?
When a property is sold, depreciation taken during its holding period is taxed. This is called depreciation recapture. It can account for up to 25% of total depreciation taken.
Depreciation recapture is an imputed tax. Regardless of whether the investor took depreciation, the recapture tax still applies.
Depreciation recapture is a capital gain but is actually taxed at an investor's ordinary income tax rate. What makes this tax unique is that it is capped at 25%. For investors with higher incomes, this is a welcome gift from the IRS. Those with lower incomes may not reach the 25% cap.
Let's look at an example of two investors to see how depreciation recapture affects different income levels. This example will use Section 1231 gains, which means gains in the sale of a trade or business held for more than one year. Investment real estate falls under this category.
The benefit of Section 1231 gains is that they are treated as long-term capital gains and taxed at a lower rate than ordinary income. Additionally, any losses are considered ordinary losses. A component of Section 1231 gains is unrecaptured Section 1250 (if applicable), which applies to depreciation expense.
Two investors purchased properties for $200,000 in 2017 and sold them in 2020 for $300,000. These are two different transactions. Total depreciation expense was $21,000. There were $2,500 in selling expenses. The adjusted basis on the date of the sale was ($200,000 + $2,500 - $21,000) $181,500. The net gain was $118,500.
The $118,500 is a Section 1231 gain. The depreciation expense of $21,000 is a Section 1250 gain. Making the long-term capital gain portion $97,500.
Investor A makes $85,000 annually and has $118,500 in section 1231 gains. The investor’s long-term capital gain rate on the $97,500 is 15%. The unrecaptured section 1250 gain of $21,000 is subject to the investor’s ordinary income tax rate or 22%. In this case, the $21,000 will just roll into the investor’s total income and be taxed at 22%.
Investor B makes $500,000 a year, putting him in the 35% tax bracket. This investor's long-term capital gains rate is 20%, which is the rate his $97,500 gain will be taxed. The unrecaptured section 1250 gain of $21,000 will be taxed at 25%.
With an understanding of how depreciation recapture works, what happens to it in a 1031 exchange?
Depreciation Recapture in a 1031 Exchange
The answer here is easy, and it's the same as what happens to capital gains in a 1031. Both capital gains and depreciation recapture taxes are deferred. These taxes will not be owed until the property is sold outright. At that time, the unrecaptured Section 1250 gain will be taxed at a maximum rate of 25%.
Additionally, the cost basis is carried over into the replacement property. The IRS doesn’t allow investors to start a new depreciation schedule.
If the taxpayer receives boot in the 1031 exchange, the process can become complex. Either way, it is best to work with a tax professional when deferring unrecaptured Section 1250 gains under a 1031 exchange.
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.
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.
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.
Hypothetical examples shown are for illustrative purposes only.
