Many investors know that they can shelter the capital gains on the sale of investment properties when they structure the sale as part of a Section 1031 like-kind exchange. However, they are typically unsure about the consequences of a transaction involving the sale of an investment property with little or no gain.
The Situation
Mike owns an investment property that he bought as part of a 1031 exchange at the height of the real estate market in 2006 for approximately $296,000. With the decline in the real estate market over the next few years, the property was worth only about $209,000 in 2012. Mike received an offer for $305,000 in 2020, and is not sure whether a 1031 exchange is the right course of action.
The Problem
Mike’s initial thoughts regarding the current house are that he paid $296,000 for the house and the current offer is $305,000. His analysis is:
Purchase $296,000
Sale $305,000
The amount received for a property, minus the property’s adjusted basis and transaction costs. Regardless of the adjusted basis of a property, there is no gain until the property is transferred. There are two types of gain: “realized gain” and “recognized gain.” Realized gain is the difference between the total consideration (cash and anything else of value) received for a piece of property and the adjusted basis. Realized gain is not taxable until it is recognized. Gain is usually, but not always, recognized in the year in which it is realized. If gain is not recognized in the year it is realized, it is said to be deferred. In an exchange under Section 1031, realized gain is recognized in part or in full to the extent that boot is received. See Boot. Where only like kind property is received, no gain is recognized at the time of the exchange. Gain $9,000
20% Fed Cap The amount received for a property, minus the property’s adjusted basis and transaction costs. Regardless of the adjusted basis of a property, there is no gain until the property is transferred. There are two types of gain: “realized gain” and “recognized gain.” Realized gain is the difference between the total consideration (cash and anything else of value) received for a piece of property and the adjusted basis. Realized gain is not taxable until it is recognized. Gain is usually, but not always, recognized in the year in which it is realized. If gain is not recognized in the year it is realized, it is said to be deferred. In an exchange under Section 1031, realized gain is recognized in part or in full to the extent that boot is received. See Boot. Where only like kind property is received, no gain is recognized at the time of the exchange. Gain s $1,800
5% State Cap The amount received for a property, minus the property’s adjusted basis and transaction costs. Regardless of the adjusted basis of a property, there is no gain until the property is transferred. There are two types of gain: “realized gain” and “recognized gain.” Realized gain is the difference between the total consideration (cash and anything else of value) received for a piece of property and the adjusted basis. Realized gain is not taxable until it is recognized. Gain is usually, but not always, recognized in the year in which it is realized. If gain is not recognized in the year it is realized, it is said to be deferred. In an exchange under Section 1031, realized gain is recognized in part or in full to the extent that boot is received. See Boot. Where only like kind property is received, no gain is recognized at the time of the exchange. Gain s $450
Total Tax Burden $2,250
However, Mike has forgotten a couple of critical facts. First, he acquired this property in 2006 as part of a 1031 exchange, in which he sheltered a substantial gain. Second, he neglected to account for the depreciation recapture on both transactions. The real math for Mike’s current exchange is:
Purchase #1 $223,000
Sale #1 $295,000 (5-year hold)
The amount received for a property, minus the property’s adjusted basis and transaction costs. Regardless of the adjusted basis of a property, there is no gain until the property is transferred. There are two types of gain: “realized gain” and “recognized gain.” Realized gain is the difference between the total consideration (cash and anything else of value) received for a piece of property and the adjusted basis. Realized gain is not taxable until it is recognized. Gain is usually, but not always, recognized in the year in which it is realized. If gain is not recognized in the year it is realized, it is said to be deferred. In an exchange under Section 1031, realized gain is recognized in part or in full to the extent that boot is received. See Boot. Where only like kind property is received, no gain is recognized at the time of the exchange. Gain #1 $72,000
20% Fed Cap The amount received for a property, minus the property’s adjusted basis and transaction costs. Regardless of the adjusted basis of a property, there is no gain until the property is transferred. There are two types of gain: “realized gain” and “recognized gain.” Realized gain is the difference between the total consideration (cash and anything else of value) received for a piece of property and the adjusted basis. Realized gain is not taxable until it is recognized. Gain is usually, but not always, recognized in the year in which it is realized. If gain is not recognized in the year it is realized, it is said to be deferred. In an exchange under Section 1031, realized gain is recognized in part or in full to the extent that boot is received. See Boot. Where only like kind property is received, no gain is recognized at the time of the exchange. Gain s $14,400*
5% State Cap The amount received for a property, minus the property’s adjusted basis and transaction costs. Regardless of the adjusted basis of a property, there is no gain until the property is transferred. There are two types of gain: “realized gain” and “recognized gain.” Realized gain is the difference between the total consideration (cash and anything else of value) received for a piece of property and the adjusted basis. Realized gain is not taxable until it is recognized. Gain is usually, but not always, recognized in the year in which it is realized. If gain is not recognized in the year it is realized, it is said to be deferred. In an exchange under Section 1031, realized gain is recognized in part or in full to the extent that boot is received. See Boot. Where only like kind property is received, no gain is recognized at the time of the exchange. Gain s $3,600*
5 Years The gradual reduction in value of an asset over time. The IRS requires investors to depreciate real estate (and certain other assets) over a specified period of time. Residential real estate uses a 27.5 year schedule, and commercial real estate uses a 39 year schedule. Depreciation $40,505
Fed Recapture (25%) $10,126*
State Recapture (5%) $2,025*
Purchase #2 $296,000
Sale #2 $305,000 (14-year hold)
The amount received for a property, minus the property’s adjusted basis and transaction costs. Regardless of the adjusted basis of a property, there is no gain until the property is transferred. There are two types of gain: “realized gain” and “recognized gain.” Realized gain is the difference between the total consideration (cash and anything else of value) received for a piece of property and the adjusted basis. Realized gain is not taxable until it is recognized. Gain is usually, but not always, recognized in the year in which it is realized. If gain is not recognized in the year it is realized, it is said to be deferred. In an exchange under Section 1031, realized gain is recognized in part or in full to the extent that boot is received. See Boot. Where only like kind property is received, no gain is recognized at the time of the exchange. Gain #2 $9,000
20% Fed Cap The amount received for a property, minus the property’s adjusted basis and transaction costs. Regardless of the adjusted basis of a property, there is no gain until the property is transferred. There are two types of gain: “realized gain” and “recognized gain.” Realized gain is the difference between the total consideration (cash and anything else of value) received for a piece of property and the adjusted basis. Realized gain is not taxable until it is recognized. Gain is usually, but not always, recognized in the year in which it is realized. If gain is not recognized in the year it is realized, it is said to be deferred. In an exchange under Section 1031, realized gain is recognized in part or in full to the extent that boot is received. See Boot. Where only like kind property is received, no gain is recognized at the time of the exchange. Gain s $1,800
5% State Cap The amount received for a property, minus the property’s adjusted basis and transaction costs. Regardless of the adjusted basis of a property, there is no gain until the property is transferred. There are two types of gain: “realized gain” and “recognized gain.” Realized gain is the difference between the total consideration (cash and anything else of value) received for a piece of property and the adjusted basis. Realized gain is not taxable until it is recognized. Gain is usually, but not always, recognized in the year in which it is realized. If gain is not recognized in the year it is realized, it is said to be deferred. In an exchange under Section 1031, realized gain is recognized in part or in full to the extent that boot is received. See Boot. Where only like kind property is received, no gain is recognized at the time of the exchange. Gain s $450*
14 Years The gradual reduction in value of an asset over time. The IRS requires investors to depreciate real estate (and certain other assets) over a specified period of time. Residential real estate uses a 27.5 year schedule, and commercial real estate uses a 39 year schedule. Depreciation $150,690
Fed Recapture (25%) $37,673*
State Recapture (5%) $7,535*
TAXES OWED WITHOUT EXCHANGE
Property 1
20% Fed Cap The amount received for a property, minus the property’s adjusted basis and transaction costs. Regardless of the adjusted basis of a property, there is no gain until the property is transferred. There are two types of gain: “realized gain” and “recognized gain.” Realized gain is the difference between the total consideration (cash and anything else of value) received for a piece of property and the adjusted basis. Realized gain is not taxable until it is recognized. Gain is usually, but not always, recognized in the year in which it is realized. If gain is not recognized in the year it is realized, it is said to be deferred. In an exchange under Section 1031, realized gain is recognized in part or in full to the extent that boot is received. See Boot. Where only like kind property is received, no gain is recognized at the time of the exchange. Gain s $14,400*
5% State Cap The amount received for a property, minus the property’s adjusted basis and transaction costs. Regardless of the adjusted basis of a property, there is no gain until the property is transferred. There are two types of gain: “realized gain” and “recognized gain.” Realized gain is the difference between the total consideration (cash and anything else of value) received for a piece of property and the adjusted basis. Realized gain is not taxable until it is recognized. Gain is usually, but not always, recognized in the year in which it is realized. If gain is not recognized in the year it is realized, it is said to be deferred. In an exchange under Section 1031, realized gain is recognized in part or in full to the extent that boot is received. See Boot. Where only like kind property is received, no gain is recognized at the time of the exchange. Gain s $3,600*
Fed Recapture (25%) $10,126*
State Recapture (5%) $2,025*
Property 2
20% Fed Cap The amount received for a property, minus the property’s adjusted basis and transaction costs. Regardless of the adjusted basis of a property, there is no gain until the property is transferred. There are two types of gain: “realized gain” and “recognized gain.” Realized gain is the difference between the total consideration (cash and anything else of value) received for a piece of property and the adjusted basis. Realized gain is not taxable until it is recognized. Gain is usually, but not always, recognized in the year in which it is realized. If gain is not recognized in the year it is realized, it is said to be deferred. In an exchange under Section 1031, realized gain is recognized in part or in full to the extent that boot is received. See Boot. Where only like kind property is received, no gain is recognized at the time of the exchange. Gain s $1,800
5% State Cap The amount received for a property, minus the property’s adjusted basis and transaction costs. Regardless of the adjusted basis of a property, there is no gain until the property is transferred. There are two types of gain: “realized gain” and “recognized gain.” Realized gain is the difference between the total consideration (cash and anything else of value) received for a piece of property and the adjusted basis. Realized gain is not taxable until it is recognized. Gain is usually, but not always, recognized in the year in which it is realized. If gain is not recognized in the year it is realized, it is said to be deferred. In an exchange under Section 1031, realized gain is recognized in part or in full to the extent that boot is received. See Boot. Where only like kind property is received, no gain is recognized at the time of the exchange. Gain s $450*
Fed Recapture (25%) $37,673*
State Recapture (5%) $7,535*
TOTAL TAXES DUE $77,609
When Mike overlooked the previous 1031 exchange, he neglected to account for the deferred taxes from that transaction. He also overlooked the significant depreciation he had taken during the time he owned this current property. While the gain on this current property is nominal, the potential tax liability in an outright sale would be substantial due to the need to recognize previously deferred taxes as well as the depreciation recapture.
The Solution: 1031 Exchange
Mike will sell this property as part of another 1031 exchange. After consulting with his attorney and a Qualified Intermediary (QI) like Accruit, Mike now understands that a Internal Revenue Code Section 1031 states that "no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held for productive use in a trade or business or for investment." 1031 Exchange is a tax deferral strategy, and that he would need to recognize those previously deferred taxes upon a sale. Mike visited the Capital Gains Calculator on the Accruit website to get a better understanding of the tax ramifications of a sale without another 1031 exchange.
Upon the sale of the mixed-use property, the exchange proceeds were sent directly to Mike’s QI to be held on his behalf until the purchase of his replacement property. This is necessary because a person doing an exchange cannot come in actual or constructive receipt of the net sale proceeds while the exchange is pending.
Within 45 days after the closing on the sale, Mike identified suitable replacement property (learn more about Identification rules in 1031 exchanges). Mike completed the acquisition of that property approximately sixty days later, well within 180 days of the sale of his relinquished property, utilizing the exchange proceeds held by his QI. Mike has now relocated his investment to a more investor friendly town.
The Result
Mike has successfully completed a 1031 exchange from a single-family home in a town that imposes heavy regulatory burdens on landlords to a neighboring town that is more investor friendly. He exchanged equal or up in value, using all of his equity, and thereby fully deferred the capital gain and depreciation recapture taxes on this property, as well as from his previous investment property.
Remember, a properly structured 1031 exchange can fully shelter both the depreciation recapture and capital gains taxes, at the Federal level, and usually at the state and local level as well.
As always, taxpayers are encouraged to discuss their plans with their tax and legal advisors before they embark on the path toward the sale of an investment property, and to engage the services of Accruit before closing on the sale of the relinquished property.
