1031 Exchanges & Recaptured Depreciation

When you own real estate and make improvements to it, you can take a deduction on your tax return for the theoretical wear-and-tear on the property. This is one of the great benefits of owning real estate. In this article, we are going to talk about recaptured depreciation and 1031 exchanges.

Residential vs. Commercial Property

Residential rental property is depreciated over 27.5 years, and commercial property is depreciated over 39 years. That means that even if your property increases in value, you can take a deduction for the wear-and-tear on the property.

However, the disadvantage is that your basis is reduced incrementally each year. If you own an apartment building for 27 years, your property will have a zero basis on the improvements because you have run out the clock on your depreciation.

When you go to sell your property, all of your depreciation related gain is taxed at a higher rate than standard capital gains tax rates. Thankfully, you can do a 1031 exchange and defer all of those capital gains taxes.

1031 Exchange Professionals

Considering deferring taxes with a 1031 exchange? Be sure to consult with a 1031 exchange professional about the details of your exchange before you start the process. At CPEC1031, our intermediaries have over twenty years of experience facilitating exchanges of real estate. With offices located in downtown Minneapolis and around the country, we are well equipped to help you with your 1031 exchange no matter where your property is located. Contact us today to set up a time to speak with one of our 1031 exchange professionals about your transaction.

• Start Your 1031 Exchange: If you have questions about 1031 exchanges, feel free to call me at 612-643-1031.

Defer the tax. Maximize your gain.

© 2018 Copyright Jeffrey R. Peterson All Rights Reserved

Tips for Dealing with 1031 Property Received in a Divorce Settlement

When a spouse purchases property in a 1031 exchange, they have a lower basis (than a normal cost basis) in the property to the extent that they have deferred gains and rolled over into the new replacement property. This may be called a substituted basis or reduced basis due to the taxes that were deferred in the exchange.

Depreciation Deductions

If, in addition to starting with a lowered basis, the spouse then took depreciation deductions for the wear, tear, and exhaustion of the property, then the remaining basis would have been further reduced each year incrementally as these depreciation deductions were taken.

Section 1041

Years later, if the spouse gets divorced and transfers the replacement property to their ex-wife/husband (former spouse) as part of a divorce property settlement, then the former spouse will take the property with a straight carry-over basis under IRC Section 1041 (transfers of property between spouses or incident to divorce), so they get the property with a super low basis, being whatever remaining basis the transferor had left in the property. Section 1041 makes transfers between spouses tax-neutral, in that the receiving spouse just takes the transferred property subject to the other spouses basis.

Section 121 Exclusion

If the former spouse moves into the property and makes it their principle residence, they may be able to take a partial exclusion under IRC Section 121 once they have owned and lived in the property for two years; however, the amount of the exclusion allowed is a fraction based upon the ratio of the time the property was used as a rental and the amount of time it was used as a principle residence. Further, IRC Section 121 is inapplicable to deprecation recapture. So, the former spouse will only get to use a fraction of the principle residence as it relates to the appreciation (or natural increase in value over time), but will not be able to exclude any gains attributable to the past depreciation that was taken by either or both spouses.

Unrecaptured Depreciation

Unrecaptured depreciation may be taxed at a maximum rate of 25% on most US real property. While normal long term capital gains are taxed at a maximum rate of only 20%.

In summary, if you receive property in a divorce property settlement that was originally purchased to complete a 1031 like-kind exchange…you may be receiving the property with an unexpectedly low basis and additional potential tax complications. These tax complication may be compounded by the limitations imposed in Section 121 for the principle residence exclusion that carve-out from the exclusion the deprecation recapture

PROTIP:  Let the entrepreneurial spouse keep the old low basis property, and have the other spouse receive cash!  Cash is king.

• Start Your Exchange: If you have questions about tax implications of property in a divorce, feel free to call me at 612-643-1031.

Defer the tax. Maximize your gain.

© 2017 Copyright Jeffrey R. Peterson All Rights Reserved

How to Offset Depreciation Recapture in a 1031 Exchange

If someone wanted to do a 1031 exchange strictly to offset depreciation recapture, is that allowed? That's our topic for this 1031 education article.

Depreciation Recapture Example

In this example - the person would be selling a property for $250,000 and basically have no excess cash once existing mortgages were paid off.

If the taxpayer did the 1031 exchange and identified/purchased properties of at least $250K or greater within the allowed time (and put $250K or more of mortgages on them) the taxpayer would just be able to carry forward his basis without any tax consequence? The qualified intermediary would sign the huds, but wouldn't really hold or transfer any cash in this scenario. Would this work?

Using 1031 to Recapture Depreciation

The short answer is yes. 1031 works for both gain from appreciation and also deprecation recapture.

The amount of debt they have is not necessarily related to the basis that they have for tax purposes, so even if they have little or no cash proceeds at closing, they may still have a big gain...and need to do a 1031 exchange.

• Start Your 1031 Exchange: If you have questions about 1031 exchange depreciation recapture, or anything regarding 1031, feel free to call me at 612-643-1031.

Defer the tax. Maximize your gain.

© 2017 Copyright Jeffrey R. Peterson All Rights Reserved