Hidden Dirty Secret

[Jerome Kaidor]

Hello,

   For the first time in many years, I had to pay some income tax.  This prompted me to read the return in detail - whereas in the past, I just filed it.   I have a 20 unit property that I bought some years ago in an exchange for a fourplex.  Seemed like a neat deal at the time - sell four, buy twenty!  Unfortunately, the deal really was not that good - the market crashed, and this 20-plex has been eating my lunch every month for the past 6 years.

   One detail that struck me in the Schedule E was the depreciation.  Even though I paid over a million dollars for this turkey, I'm only getting about a grand a month in depreciation. WTF?

   The dirty secret - that is only hinted at in glowing descriptions of the 1031 process - is that when you exchange, your basis will be that of your original purchase price of the OLD property.  So you only get depreciation at that rate.   There are a few adjustments, having to do with closing costs and recapture of depreciation, but that's basically it.

  So when you analyze your new deal, make sure to take account of the fact that your depreciation will not change - much.  For a long term buy&hold deal, depreciation can be a big part of the package.  It still might be a good deal, but you do need to take the basis & depreciation into account.

  A more serious effect (for me) is that if the replacement property decreases in value, you can't sell it cheap without incurring a - possibly mind-boggling - tax liability.

[Bill Exeter]

@Jerome Kaidor You are correct if you are exchanging across the board at the same price.  By that, I mean you sell your relinquished property for $1.0 million and you exchange into a $1.0 million replacement property.  There will be slight adjustments due to selling expenses, etc. 

However, many investors use the 1031 Exchange as a strategic way to solve this problem by selling the lower valued property and then exchanging up in value.  The additional value they purchase is new cost basis that can be depreciated.  So, taking the example above, if you sell for $1.0 million and then reinvest at $1.5 million you have traded up and acquired an additional $500,000 in cost basis that can now be depreciated.