What Does 1031 Depreciation Recapture?
1031 depreciation recapture is the deferred tax liability on depreciation deductions taken on a potential investment property. In a 1031 exchange, both capital gains tax and depreciation recapture are deferred to the replacement property. These tax liabilities are deferred, not eliminated — they come due upon something else happening in the future which makes the property taxable, like selling the replacement property without another 1031 exchange.
Depreciation Recapture in a 1031 Exchange
- Beginning depreciation: You can take a depreciation deduction every year that you own an investment property, reducing the cost basis.
- Disposal of the Property: When sold or exchanged, previously taken depreciation must be recaptured and is taxed at rates up to 25%.
- 1031 Exchange Deferral: A 1031 exchange defers capital gains and depreciation recapture taxes, carrying those to the replacement property and adjusting its cost basis.
- Delayed Tax Bill: Depreciation recapture is postponed as opposed to avoided. Recaptured depreciation will be recaptured only if the replacement property is sold without another 1031 exchange.
Example: How 1031 Depreciation Recapture Works
|
Scenario |
Calculation |
Tax Implications |
|
Original Property |
Purchase price: $500,000 |
Claimed depreciation: $200,000 |
|
Adjusted Cost Basis |
$500,000 – $200,000 = $300,000 |
|
|
Sale Price |
$700,000 |
Gain: $400,000 |
|
Depreciation Recapture Amount |
$200,000 (Taxed at up to 25%) |
|
|
Remaining Capital Gain |
$200,000 (Taxed at applicable capital gains rate) |
|
|
1031 Exchange |
Gain and depreciation recapture deferred |
Deferred to new property |
Differences Between Depreciation Recapture and Capital Gains Tax in a 1031 Exchange
- Tax Rates: While depreciation recapture is taxed as ordinary income, capital gains are taxed at more favorable rates up to a maximum of 25%
- Deferability: While both can be deferred via a 1031 exchange, both are ultimately due.
- Calculation Differences: Depreciation Vs The Appreciation
Important Things to Know about Depreciation Recapture in a 1031 Exchange
- Maximum Depreciation Recapture Rate: 25% top tax rate.
- Deferral, Not Elimination: This means that deferred taxes must be paid at some time unless another 1031 exchange is completed.
- Record keeping: You must maintain proper records of depreciation to compute recapture taxes.
How to Reduce Depreciation Recapture in a 1031 Exchange
- Use of Cost Segregation Studies: This is beneficial (ideally at the time of purchase) for breaking out individual assets to maximize depreciation as well as future recapture tax.
- Investing in High-Value Replacement Property: Purchasing High-Value Replacement Property
- Leveraging Installment Sales: Spreads recapture tax over several years, potentially reducing the immediate tax impact.
Common Mistakes In A 1031 Exchange
Avoid these common pitfalls to maximize the benefits of a 1031 exchange:
- Failure to Meet Deadlines: You must adhere to the 45-day identification period and the 180-day exchange completion period in order for a valid exchange to be completed.
- Incorrect Property Classification: You can only launch a 1031 exchange with like-kind properties: personal residence is never qualified.
- Underestimating Depreciation Recapture: This may also be coming as an unforeseen hit to the pocketbook if you do not prepare for the fact that NOT all depreciation counted on your tax return is yours to keep.
- Inadequate Record Keeping: Keep appropriate records of depreciation, asset valuations, and transactions to prevent compliance issues.
- Lack of Professional Guidance: Inaccurate 1031 exchange can be a very expensive error to make without professional support.
Pros and Cons of Deferring Depreciation Recapture Through 1031 Exchange
- Pros: Tax deferral, reinvestment opportunities, improved cash flow
- Cons: Because you pay taxes later, those taxes will still need to be paid eventually; uneven planning for future liabilities may result in cash flow crunches.
Our Services for 1031 Depreciation Recapture
Dimov CPA offers specialized guidance for managing 1031 exchanges and depreciation recapture, including:
- Tax Guidance on 1031 Exchanges: In-depth consulting services.
- A depreciable property analysis of how much one needs to pay as recapture taxes in order to prepare
- Tax Deferral Strategies: Identifying ways to defer taxes effectively.
- Replacement Property Assistance: Helping you select qualified like-kind properties.
- Filing support and compliance: Coordinating all documentation needed for filing to comply with IRS regulations.
Conclusion
Otherwise known as depreciation recapture, 1031 depreciation is an important factor to consider in the tax liabilities of those involved in real estate investing. Although the 1031 exchanges provide relief from capital gains and depreciation recapture taxes, these liabilities are only deferred over time, not forgiven. However, you can only enjoy the most tax benefit of your investment based on proper planning and expert advice from professionals in this field.
Frequently Asked Questions
Is it possible to defer depreciation recapture in a 1031 exchange?
No, depreciation recapture cannot be avoided; it is simply deferred. If the property has to be sold eventually without any other exchange, taxes will apply.
If I do not do a 1031 exchange, what occurs?
If a 1031 exchange is not executed, both capital gains and depreciation recapture taxes are due upon sale.
What Is Depreciation Recapture?
Since depreciation recapture is based on the total depreciation taken, you should know that it will be taxed at 25%, maximum.
Which properties can be included in a 1031 exchange?
Properties must be held for investment or business use and be of the like-kind to the replacement property—not personal residences.
What is the impact of depreciation on my tax basis in a 1031 exchange?
Tax depreciation lowers the property tax basis, which will impact the profit or loss when sold. The number follows its original property to the replacement property in a 1031 exchange with a smaller basis.
