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Understanding The 1031 Exchange Depreciation Recapture

July 5, 2023

A 1031 exchange is a real estate investing strategy which involves exchanging ownership of a property for suitable replacement properties while avoiding capital gains tax and depreciation recapture on the sale.

Depreciation recapture comes into play when you are selling an asset (most likely a property) that you have previously deducted taxes on. The government wants to make sure that you don’t get a tax benefit by deducting the full cost of an asset’s depreciation and then selling it for a profit without paying taxes on the deducted amount. In this case, the recaptured depreciation is taxed as ordinary income.

However, depreciation recapture taxes can be deferred with a 1031 exchange. In this article, we discuss everything you need to know about 1031 exchanges and depreciation recapture so that you can successfully defer paying any capital gains taxes or depreciation recapture when exchanging your property.

Depreciation Recapture in 1031 Exchanges

Depreciation Recapture in 1031 Exchanges

Now that you have an understanding on what depreciation recapture is, let’s go over its application to 1031 exchanges.

While you can avoid paying depreciation recapture taxes with a 1031 exchange, that doesn’t mean that the depreciation recapture is not entirely eliminated. A 1031 exchange allows you to defer depreciation recapture, however, the accumulated depreciation on the relinquished property gets carried over to the replacement property. This allows you to avoid paying the tax as ordinary income tax during the time of the exchange.

If you decide to sell your new property at a later date without a 1031 exchange, the deferred depreciation recapture will be taxed at ordinary income rates. This is why many real estate investors do a 1031 exchange every time they would like to buy or sell a property.

Lower Depreciation Basis on Replacement Property

When you acquire a replacement property in a 1031 exchange, its tax basis is adjusted to reflect the accumulated depreciation from the relinquished property. This means that the replacement property will have a lower depreciation basis and you will not be able to deduct as much from the property compared to having acquired it directly without a 1031 exchange.

Calculation of Depreciation Recapture

Calculation of Depreciation Recapture

Overview of the Formula Used to Calculate Depreciation Recapture

Depreciation Recapture = (Adjusted Basis of the Property) – (Original Cost of the Property – Total Depreciation Deductions)

Breaking it down:

Determine the Adjusted Basis of the Property: This is the original cost of the property plus any capital improvements made, minus any deductions for casualty losses or other adjustments as per tax laws.

Calculate the Total Depreciation Deductions: Add up all the depreciation deductions claimed over the years for the property. This amount represents the cumulative depreciation that has been deducted from the property owner’s cost or basis.

Subtract the Total Depreciation Deductions from the Original Cost of the Property: This step calculates the remaining adjusted basis of the property after accounting for the depreciation deductions.

Understanding the recaptured amount and its impact on taxable gain

Understanding the recaptured amount and its impact on taxable gain

The resulting amount from the formula represents the depreciation recapture, which is the portion of the accumulated depreciation that will be subject to taxation upon the sale or disposition of the property.

If the calculation process still seems a but confusing, here’s a real life example:

Suppose you purchased a property for $1,000,000 and have claimed $200,000 in depreciation deductions over the years. Let’s say there were no capital improvements or adjustments made to the property, so the adjusted basis remains the same as the original cost: $1,000,000. In this example, you’ve claimed $200,000 in depreciation deductions so $1,000,000 – ($1,000,000 – $200,000) = $200,000. The resulting amount of $200,000 represents the depreciation recapture, which is the portion of the accumulated depreciation subject to taxation upon the sale or disposition of the property.

Tax Implications of Depreciation Recapture

Tax rates applied to recaptured depreciation

The depreciation recapture tax is 25% for real estate owned for more than one year and can be up to 37% (same as regular income tax) for real estate owned for less than one year.

This figures explain why it could be so beneficial to defer these taxes by using a 1031 exchange. In fact, the most popular method of avoiding depreciation recapture tax is through 1031 exchanges.

If you or anyone you know is looking to do a 1031 exchange, please contact us at Universal Pacific 1031 Exchange. Our team of experienced professionals is ready to assist and guide you every step of the way.

Reporting Depreciation Recapture

Before we get into the steps of reporting depreciation recapture, it’s important to note that it is required by law to report all recaptured depreciation to the IRS.

Steps To Take

Reporting Depreciation Recapture

Form 4797: Start by reporting the sale or disposition of the property on IRS Form 4797, “Sales of Business Property.” This form is used to report the depreciation recapture and capital gains or losses from the sale of rental property.

Gather property information: Collect all relevant information about the property, including the original cost, date of acquisition, date of sale, and the amount of accumulated depreciation claimed over the years.

Determine the adjusted basis: Calculate the adjusted basis of the property, which is the original cost plus any improvements or adjustments, minus any previous depreciation deductions. This adjusted cost basis will be used to determine the depreciation recapture amount.

Calculate depreciation recapture: Use the formula below to calculate the depreciation recapture amount:

Depreciation Recapture = (Adjusted Basis of the Property) – (Original Cost of the Property – Total Depreciation Deductions)

Complete Form 4797: On Form 4797, enter the relevant information about the property sale, including the date of sale, proceeds from the sale, and the adjusted basis. Report the depreciation recapture amount on the appropriate lines of Form 4797.

Consult IRS publications: Refer to IRS publications, specifically Publication 946, “How to Depreciate Property,” and Publication 544, “Sales and Other Dispositions of Assets,” for detailed instructions and examples on reporting depreciation recapture.

Keep supporting documentation: Maintain accurate records and documentation to support your depreciation recapture calculations. This includes records of the original cost of the property, improvements made, depreciation deductions claimed, and any adjustments or relevant transactions related to the property.

Consult a tax advisor or professional: Given the complexity of depreciation recapture and tax reporting, it’s advisable to consult a tax professional or accountant who can guide you through the process, ensure compliance with IRS regulations, and help you accurately report depreciation recapture. Other Exceptions and Exemptions to Depreciation Recapture.

Other Exceptions and Exemptions to Depreciation Recapture

Other Exceptions and Exemptions to Depreciation Recapture

There are other exceptions and exemptions to depreciation recapture that can provide tax relief in certain situations.

One exemption is the Qualified Small Business Stock (QSBS) exemption. It allows eligible investors to exclude a portion or all of the capital gains tax from the sale of qualifying small business stock held for more than five years which results in significant tax savings.

Additionally, Section 179 expensing and bonus depreciation provisions allow businesses to deduct the full cost of qualifying assets upfront or take accelerated depreciation deductions. These provisions can help offset the impact of depreciation recapture by allowing businesses to deduct a larger portion of the asset’s cost in the year of purchase. Both individuals and businesses may be eligible for these exemptions, and they offer substantial benefits by reducing tax liability and encouraging investment in small businesses and capital assets.

However, specific eligibility criteria, limitations, and rules apply to each exemption, so it’s important to consult with a tax professional to determine if you qualify and to maximize the benefits available to you.

Planning Strategies to Manage Depreciation Recapture

Proactive tax planning is crucial when it comes to managing depreciation recapture. If you are considering a 1031 exchange, it’s important to engage in comprehensive tax planning to minimize the impact of depreciation recapture tax.

One effective strategy is to utilize cost segregation studies, which involve identifying and classifying various components of a property to accelerate depreciation deductions. This allows for more accurate tracking of depreciation and can potentially reduce the amount subject to recapture.

However, it’s essential to balance the short-term benefits of increased depreciation deductions with the long-term tax implications. Evaluating the potential recapture tax liability upon the eventual sale of the property is important to ensure the overall tax strategy aligns with your financial goals.

By carefully planning and considering these factors, you can effectively manage depreciation recapture and optimize your tax outcomes.

Professional Guidance for Depreciation Recapture

Qualified intermediaries play a vital role in facilitating 1031 exchanges and can provide guidance on the specific rules and requirements related to depreciation recapture. They can help structure the exchange transaction and ensure that the necessary documentation and forms are properly prepared.

Additionally, tax advisors who specialize in 1031 exchanges can provide valuable insights and strategies to manage depreciation recapture effectively. When selecting professionals, it is important to identify reputable individuals or firms with experience in 1031 exchanges, a strong understanding of tax laws, and a track record of providing reliable guidance. Consulting with professionals at Universal Pacific 1031 exchange is highly recommended for personalized guidance and planning when it comes to depreciation recapture.

Conclusion

Now that you’ve read through this article about 1031 exchange depreciation recapture, you should know exactly what actions to take in each situation and all considerations to take into account.

Now, let’s recap.

Depreciation recapture is a significant consideration when engaging in a 1031 exchange. While this strategy allows for the deferral of capital gains tax and depreciation recapture, it is important to understand the implications and plan accordingly.

Proper planning, including the use of cost segregation studies and evaluating long-term tax implications, can help minimize the impact of recaptured depreciation.

Seeking professional guidance from tax and legal professionals, as well as qualified intermediaries such as Universal Pacific 1031 Exchange, is highly recommended. These experts can provide valuable insights, ensure compliance with IRS regulations, and help structure successful 1031 exchanges with minimal tax implications.

By understanding the complexities of depreciation recapture and engaging in proactive tax planning, real estate investors can navigate the process with confidence and optimize their tax outcomes.

About The Author

Michael Bergman, CPA
Michael Bergman is a California licensed CPA and Real Estate Broker with over 32 years of experience in commercial real estate. Specializing in 1031 tax-deferred exchanges and financial oversight, his expertise is invaluable for complex real estate transactions. Michael’s unique blend of financial acumen and real estate knowledge positions him as a trusted advisor in the industry, offering sound advice and strategic insights for successful property management and investment.

Don’t let taxes hinder your property investment decisions. Connect with us today for a free, no-obligation 1031 exchange consultation. Let us help you navigate the process with ease.