No Gain, No Exchange?

We are often asked to help a taxpayer understand the pros and cons of structuring a Section 1031 tax-deferred exchange. Sometimes during these conversations, the taxpayer indicates that they have little or no gain on the current property, and then jump to the conclusion that they have no need to structure a 1031 exchange.

Alas, they often have reached the conclusion in haste, without weighing all of the tax facts.

Assuming that this is the taxpayer’s first investment property, on which the taxpayer has little or no capital gain, the depreciation recapture taxes is often overlooked. Investment real estate is depreciated over its tax life (commercial investment property is depreciated over 39 years, and residential investment property over 27-½ years), and upon sale the depreciation is “recaptured” and taxed at 25% at the Federal level, plus state and local taxes. For example, Joe bought a residential investment property ten years ago for $100,000. During those ten years, he has taken approximately $3,636 in depreciation each year, for a total of $36,363 in depreciation. Upon sale, he will have to pay Federal depreciation recapture tax of $9,090. Even if Joe sells the property for $100,000 – no capital gains – he will have to pay this tax, plus potential state and local taxes.

Now assume that this is Joe’s third investment property, the result of two prior 1031 exchanges. Further assume that he bought his first property for $100,000 and sold it ten years later for $200,000. He then acquired Property 2 for $200,000 as part of a successful 1031 exchange, holding it for another ten years before selling it for $300,000. Joe is now selling Property 3, which he bought for $300,000 ten years ago, but he is selling it for the same $300,000. Notice that Joe has $200,000 in capital gains ($100,000 from each of the first two properties), plus the depreciation recapture on each of the three properties $36,363 in depreciation on each property, for a total of $109,089. Even though Joe has no capital gains on his current property, without a new 1031 exchange he will have to recognize $200,000 in capital gains from the first two properties, plus the recapture tax on over $109,000 in depreciation. Capital gains taxes on the $200,000 (20% Federal, plus state) and depreciation recapture taxes on the $109,089 (25% Federal, plus state and perhaps local) could easily exceed $100,000, depending on where Joe resides.

Another variation to consider is if Joe fell behind on his mortgage. To satisfy the lender, he provides a Deed in lieu of foreclosure. If his investment Property 1 has a current fair market value of $100,000, and debt of $30,000 he has backed himself into a new corner. He still has the depreciation recapture taxes previously discussed, but now he also has net debt relief of $30,000. This mortgage boot would be taxed similar to capital gains taxes, at the Federal, state, and local levels.

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 towards sale of the investment property, and to engage the services of Accruit before closing on the sale of the relinquished property as well.