Balancing 1245 Rapid Depreciation in a 1031 Exchange

The IRS is changing the way it looks at personal property that’s embedded in real property in 1031 exchanges. For a long time (roughly three decades), the IRS took the position that if the state of Minnesota considers the water heater that’s plumbed in as a permanent fixture and a component of the real estate, then they would go along with that and conform to the state standard.

Recently, some new treasury regulations were released defining what exactly constitutes real estate for purposes of 1031 exchange. Generally speaking, fixtures are still considered components of the real estate and can be 1031 exchanged for other real estate. That said, there can be some exceptions when it comes to things like specialty HVACs or water heaters that are for a special use over and above the standard infrastructure of the building.

1245 Rapid Depreciation

Some people engage in cost-seg studies where they parse out the various components for accelerated depreciation, creating what we call 1245 gain. You need to be cautious in those situations and make sure that your replacement property has a sufficient amount of 1245 components so you can match up your 1245 gains with 1245 replacement.

Assemble Your Team of Advisors

We always recommend surrounding yourself with the best and brightest advisors. Bring in your accountant, attorney, qualified intermediary, and banker in early on during the process to ensure you’re setting yourself up for success. Reach out to the like-kind exchange professionals at CPEC1031 today to learn more about our services and how we can help you execute a successful 1031 exchange.

• 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.

© 2022 Copyright Jeffrey R. Peterson All Rights Reserved

The Impact of Recaptured Depreciation on a 1031 Exchange

One of the joys of owning real estate with improvements is that you get to take a non-cash loss or deduction on your tax return for the theoretical wear and tear on the property. A residential rental property or apartment building is depreciated over 27 and a half years, and a commercial building is depreciated over 39 years. Every year, even if the property is going up in value, you get to take a tax deduction for the wear and tear.

The Downside

The downside to recaptured depreciation is that incrementally each year your basis is being reduced in the property. So at the end of that 27 and a half years, your apartment building will have a zero basis on the improvements because you depreciated it down to zero (unless you add basis by making capital improvements).

Impact on a 1031 Exchange

So how does this impact a 1031 exchange? The answer is that if you weren’t to do a 1031 exchange, all of that gain that’s attributable to the depreciation is taxed at a higher rate than normal capital gains rates. The maximum depreciation rate is 25% federal (compared to the maximum normal capital gains rate of 20%), so you pay the piper at a higher rate for all of that depreciation you’ve taken.

The good news is you can defer that gain, even the depreciation gain, by doing a 1031 exchange and keep all of your hard earned equity working for you by rolling it into a replacement property to defer the gain.

1031 Exchange Practice Tip

Most real property is Section 1250, however, if you have some components of your relinquished property that are classified as 1245 property for more rapid deprecation such as sheds, out-buildings, barns, agricultural storage bins, pens and silos then you need to be careful to match up enough like-kind 1245 replacement property to fully defer all of your gains.

• 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.

© 2021 Copyright Jeffrey R. Peterson All Rights Reserved

Unexpected Recapture In a 1031 Exchange

Normally in a 1031 exchange, you defer all of your capital gains (both from appreciation in value and depreciation deductions taken over the years) by acquiring a like-kind replacement of equal of more value; and equal of more equity.

In Tax Law Nobody Wants Surprises

There are some situations when the relinquished property will have some tax complications (snakes in the grass) that could cause you to unexpectedly recognize gain.  To make matters worse, the surprise gains could be characterized as ordinary income and taxed at higher rates than mere capital gains rates.

What Do You Need to Check Out?

Here are some things to check out with your CPA, accountant or tax attorney:

Tax Credits

When Congress wants to encourage investors to do something they provide tax incentives.  One of the most effective tax incentive is to offer tax credits.  Tax credits are more valuable than mere deductions because they off-set your tax liability dollar-for-dollar. The problem is that tax credits on your relinquished property for either rehabilitation expenditures under Section 47; or from low income housing under Section 42 may be recaptured. Both of these Tax Code Sections allow for recapture of the amount of the tax credits. It is always prudent to check with your accountant BEFORE you sell just to make sure you do not have any problems with old tax credits.

Special Recapture for Rapid Deprecation

If you were able to take rapid deprecation under Section 179 or you qualified for bonus deprecation for investment in the Gulf Opportunity (GO) Zone areas impacted by hurricanes Katrina, Rita, and Wilma, then you need to check into the recapture provisions of those specific programs if your property ceases to be Qualified GO Zone Property.

Section 1245 Gain

Cost segregation engineering studies are often used by property owner to peel out those components of a piece of real estate that can be more rapidly deprecated.  A typical commercial building is deprecated over 39 years.  That is a long deprecation schedule.  A multi-family apartment building can be deprecated over 27.5 years.  Certain components of real-estate can be re-classified and more rapidly deprecated over a 5..10..15 year schedule. Those components can cause you to have recapture, unless you are mindful and when you buy your replacement property you buy qualifying property that matches up component for component with those Cost Segregation properties that were more rapidly deprecated.

•  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

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

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