Deferring Gains from Depreciation Recapture in a 1031 Exchange

A crucial consideration real estate investors face when selling property is what their capital gains tax liability will be. Deferring these capital gains is a primary reason an investor might enter into a 1031 exchange at the sale. Another issue that is at times overlooked, but in many cases equally important to consider, is the taxable result of depreciation taken during ownership of the property.

What is depreciation?

Taxpayers can recognize a reduction in the value of their assets over time by taking depreciation on those assets over their estimated economic life. The amount of depreciation taken each year is equivalent to value lost each year, or depreciation expense to the taxpayer. Typically, the “straight line” method of depreciation is used. This means that the value of the asset is divided by a number of years (27.5 for residential rental property, and 39 years for commercial property), and the resultant amount is taken as depreciation each year. Note that land value cannot be depreciated – only improvements. In some cases, accelerated depreciation or bonus depreciation can be taken, which allows the taxpayer to depreciate the property by a greater amount than allowed under the straight line method, in a shorter period of time. To the extent a taxpayer has taken a greater amount of depreciation on a property at the sale than they would have had they used the straight line method, the difference between the two values is referred to as “additional depreciation.”

Dreaded “depreciation recapture” – why and when does it occur?

When real property is disposed of in a taxable sale, the total amount of straight line depreciation taken by the taxpayer, up to the extent of gain recognized in the sale, is taxed as ordinary income (up to 25%). In other words, the tax benefit during the taxpayer’s ownership of the property is recouped, or “recaptured,” by the IRS. Additional depreciation is recaptured at the applicable income rate, without a 25% cap.

In a 1031 exchange, depreciation is recaptured to the extent the value of depreciable property acquired as replacement property is of a lesser value. What this means is that when utilizing a 1031 exchange, a taxpayer must acquire real property of equal or greater value to the property sold, and the property must also contain depreciable property (i.e. improvements) of equal or greater value to the depreciable property sold, in order to defer both capital gains and avoid depreciation recapture.

It is important for taxpayers to be aware that they can fully defer their capital gains by acquiring property of an equal or greater value to the property they sold, while not deferring all of their depreciation tax liability, because the replacement property did not have a sufficient value of depreciable property. In other words, depreciation recapture can trigger tax liability, even if a taxpayer acquires like-kind property of an equal or greater value to their relinquished property in a 1031 exchange.

Example:

A taxpayer purchases real property for $500,000 that includes improvements with a value of $250,000. They later sell the property for $1,000,000, having taken depreciation of $250,000 using the straight line method over the course of their ownership. The adjusted basis in the property is $250,000 (the purchase price, less the depreciation taken). Total gains are $750,000 (sales price of $1M less the adjusted basis), and without an exchange, would be taxed at 25% on the $250,000 depreciation deductions (depreciation recapture) and at the applicable capital gains rate on the other $500,000 of gains. The taxpayer decides to do a 1031 exchange and acquires a replacement property of equal value for $1,000,000. However, it only contains $150,000 of depreciable property. There are no capital gains recognized for purposes of Section 1031 because the taxpayer exchanged into a property of equal value. However, the taxpayer will have depreciation recapture on $100,000 because they acquired a property with only $150,000 of depreciable property, a trade down from the $250,000 of depreciable property that was part of the relinquished property.

The Bottom Line

One of the most important takeaways from the above example is that an investor can have a taxable event when completing a 1031 exchange, even if they reinvest all their proceeds and buy up in value, because their transaction triggers depreciation recapture. Most often, this is seen where a taxpayer exchanges out of improved property, into unimproved property that has no depreciable improvements (i.e. vacant land). In such a case, there may be depreciation recapture, depending on the type and amount of depreciable property that was owned as part of the relinquished property, and the amount and type of depreciation that was taken. It is essential that when planning a 1031 exchange, investors consult with their tax advisor early on in the process to analyze their tax liability, and what replacement property must be acquired in order to fully defer all gains (both capital gains and depreciation).