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Understanding Depreciation Recapture for your 1031 Exchange

Posted by Daniel Raupp on Jul 6, 2018 1:16:00 PM

Depreciation recapture is a significant factor in participating in a like-kind exchange. While capital-gains tax rates are currently at historical lows, tax rules require you to recapture the portion of the gain on the sale that relates to allowable depreciation over the period the asset was held.  Additionally, you must recapture it at a higher tax rate (typically 25%).

For the purpose of discussion, the depreciation recapture rules assumes that:

(a) your regular marginal income tax bracket is greater than 15%, and

(b) the real estate sold is the only business asset sold by you in the tax year of the sale

Generally, the gain from the sale by a non-corporate taxpayer of real estate that is a capital asset (or is used in a business) and is held more than 12 months is not taxed at a rate higher than 15%.

However, a more complex set of rules comes into play when the asset sold is depreciable real estate. This is so because, in that case, a maximum rate of 25% will apply to "un-recaptured Section 1250 gain", and a maximum rate of 15% will apply to the balance of the gain. Un-recaptured Section 1250 gain refers to the portion of gain that is eligible for capital gains treatment even though it is attributable to previously allowable depreciation. A further complication is that the portion of the gain that is un-recaptured Section 1250 gain depends, as shown below, on when the property was placed in service.

Property placed in service after 1986

For real estate placed in service after 1986, all depreciation deductions allowable before the sale of the real estate give rise to un-recaptured section 1250 gain. For example, if you sell a building at a gain of $2,000,000 on which $900,000 of depreciation deductions were allowable to you through the time of sale, $900,000 of the gain is un-recaptured Section 1250 gain that will be taxed at a rate of 25%. The remaining $1,100,000 of the gain will be taxed at a rate of 15%.

Property placed in service between 1981 and 1986

For real estate placed in service after 1980 but before 1987, the treatment of gain on sale depends on whether the real estate is residential or non-residential.

Residential Real Estate

If you depreciated residential pre-1987 realty using straight-line depreciation, the tax result from the sale will be the same as for a sale of post-1987 property, as described above. But if you (as was possible), at any time, used a declining balance method to depreciate the real estate, the gain on sale would be taxed as follows:

  • Gain, to the extent of the depreciation claimed that exceeds what would have been allowable under straight-line depreciation, will be recaptured as ordinary income, and, thus, taxed at rates as high as 35% in 2003 and later years (ordinary income rates), but the amount of excess depreciation subject to recapture may be less for certain low-income housing
  • Gain, to the extent of the depreciation that isn't recaptured as ordinary income, will be taxed at a rate of 25%.
  • The balance of the gain will be taxed at a rate of 15%
  • Example – In January 1986, you paid $1.3 million for an apartment building (not a low-income building), of which $1 million was allocated to the improvements. You depreciated the property using the 175% declining-balance method. You sold the property in July 2003 for $2 million. From 1986 through 2003, a total of $915,750 in depreciation was claimed. Assuming the only adjustment to basis was for depreciation, there would be a gain of $1,615,750 ($2 million less remaining basis of $384,250), taxed as follows:
  • $19,583 (the excess of $915,750 depreciation claimed over $896,167 that would have been allowable using straight-line depreciation) would be taxed as ordinary income;
  • $896,167 (the depreciation that isn't recaptured as ordinary income) would be taxed at a rate of 25%;
  • $700,000 (total gain—$1,615,750 less $915,750 ($896,167 + $19,583) would be taxed at a rate of 15%.

 

Non-Residential Real Estate

As is the case for residential pre-1987 real estate, if you depreciated non-residential pre-1987 real estate using just straight-line depreciation, the tax results for a sale will be the same as for a sale of post-1986 property, as described above. But if, as was possible, you, at any time, used a declining-balance method to depreciate the realty, the gain on sale would be taxed as follows:

  • Gain, to the extent of the full amount of depreciation allowable to the time of sale, would be recaptured as ordinary income, and, thus, taxed at ordinary income rates;
  • The balance of the gain would be taxed at a rate of 15%.
  • Example – Assume the same facts as in the example above, except that the $1.3 million building is a commercial building. The gain is the same, $1,615,750, but would be taxed as follows:
  • $915,750 (representing all of the depreciation allowable) would be taxed as ordinary income;
  • $700,000 (the balance of the gain) would be taxed at a rate of 15%.

 

Pre-1981 Property

The following rules apply if you sell real estate placed in service before 1981:

  • The excess of depreciation claimed over straight-line depreciation is recaptured as ordinary income, and thus taxed at ordinary income rates (but the amount of excess depreciation subject to recapture may be less for certain residential real estate or for real estate acquired before 1970).
  • Gain, to the extent of the balance of depreciation allowable, is un-recaptured Section 1250 gain, taxed at a rate of 25%.
  • The balance of the gain, if any, would be taxed at a rate of 15%.

Please remember, every investor faces a unique set of tax considerations. If you have further questions about the above rules, or would like to compute your potential tax liabilities, please contact your tax advisor.

Information and examples provided herein are for educational purposes only. Individual circumstances and results will vary.

 

Tax Issues

According to Regulation §1.1245-2(b), a taxpayer is generally required to report all gains or losses on the disposition of capital assets – including the transactions affecting capital gains or losses – in a separate computation on the tax return (Reg. §1.1202-1(a)). However, there is no statutory authority that requires the reporting of a full tax-deferred exchange. You should consult with your tax advisor on whether you should attach a schedule to your tax return. Attaching the schedule starts the clock on the statute of limitations – if there is a problem.

 

Schedule D and Form 4797

An exchange of like-kind property may be reported on Schedule D or on Form 4797, whichever applies. The instructions to Schedule D (Form 1040) state that all exchanges must be reported. The instructions apply to even fully tax-deferred exchanges. Again, there is no statutory authority for this instruction, but it does present a dilemma. Those who are more aggressive in their tax compliance will probably continue to report as little as possible while conservative advisors will usually recommend reporting the exchange even where no tax is generated, in order to start the on the statute of limitations. If you choose to report the exchange, keep it as simple as possible. A short "memo box" recapitulation on a single sheet of paper can suffice and be attached to Schedule D or Form 4797.

Form 8824

If you have a like-kind exchange, you must file Form 8824 – Like-Kind Exchanges, in addition to Schedule D or Form 4797. Form 8824 requests specific information about the exchange including:

  • Descriptions of the properties;
  • Date of disposition of taxpayer's property;
  • Dates of identification and acquisition of the replacement property;
  • Certain related party information. The balance of the form concerns computations of realized gain or loss, recognized gain, basis of property received, and deferred gain.

 

Disclosure

Examples used are for hypothetical purposes only.  This is for educational purposes only, does not constitute an offer to buy/sell securitized real estate investments, and is not meant to be interpreted as tax or legal advice. Because investors situations and objectives vary this information is not intended to indicate suitability for any particular investor. Please speak with your legal and tax advisors for guidance regarding your particular situation. Securities offered through Concorde Investment Services, LLC (CIS), member FINRA/SIPC. Advisory services offered through Concorde Asset Management, LLC, an SEC registered investment adviser. Insurance offered through Concorde Insurance Agency, Inc. Fortitude Investment Group is independent of CIS, CAM and CIA.

 

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Written by Daniel Raupp

Under Daniel’s guidance since 2000, Fortitude Investment Group has guided clients into over $1 billion worth of securitized real estate investment offerings directly and indirectly, in both the DSTs for 1031 Exchanges and REITs. Daniel directs a range of strategic initiatives in the firm to successfully leverage core competencies in tax efficient investing, alternative investments, and operational excellence to create customer value.

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Topics: 1031 Exchange, Depreciation Recapture

DST 1031 properties are only available to accredited investors (generally described as having a net worth of over $1 million dollars exclusive of primary residence or $200,000 income individually/$300,000 jointly of the last three years) and accredited entities only. If you are unsure if you are an accredited investor and/or an accredited entity please verify with your CPA and Attorney. There are risks associated with investing in real estate and Delaware Statutory Trust (DST) properties including, but not limited to, loss of entire investment principal, declining market values, tenant vacancies and illiquidity. Diversification does not guarantee profits or guarantee protection against losses. Potential cash flows/returns/appreciation are not guaranteed and could be lower than anticipated. The information herein has been prepared for educational purposes only and does not constitute an offer to purchase or sell securitized real estate investments. Because investors situations and objectives vary this information is not intended to indicate suitability for any particular investor. This material is not to be interpreted as tax or legal advice. Please speak with your own tax and legal advisors for advice/guidance regarding your particular situation. Securities offered through Concorde Investment Services, LLC (CIS), member FINRA/SIPC. Advisory services offered through Concorde Asset Management, LLC (CAM), an SEC registered investment adviser. Insurance products offered through Concorde Insurance Agency, Inc. (CIA). Fortitude Investment Group is independent of CIS, CAM and CIA.

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