Tax w/ & w/o 1031 exchange with multiple replacement properties

[Sheila Zhou]

I greatly appreciate any comments/corrections you have on my calculation!

3 properties are involved here. R, A and B.

In 2010, we converted our primary residence R to rental. At the time of conversion, the property R's FMV was $225K, with land valued at $40K. We have been taking the depreciation which is around ($225K-40K)/27.5=$6.7k/year – till now about $68K.

With the increase of property tax and other factors, it no longer makes a lot of sense for us to keep R as a rental. Let’s say we sell R and after the sale related cost (commission, closing cost, remodeling before putting it on mark, etc), we have $325K (part of it has been used to paying off the loan of course). Then the capital gain is $325K - $225K = $100K.

1) If we don’t do 1031, how much tax do we own? I think we are in the 15% bracket (married filed jointly with income between 70K and 400K) for Capital gain. So the tax for that is $100K * 15% = $15K. The recapture of the depreciation is at $68k * 25% = $19K. Did I do my calculation right?

2) If we would like to proceed with a 1031 exchange and replace this property of two properties: property A at $225K (land $40K) and property B at $150K (land $30K) – the ratio of the purchase price of the two replacement properties is at 3:2. My questions are:

a. How would I calculate the depreciation of these two replacement properties? Does property A depreciate at 185K/27.5 and property B depreciate at 120K/27.5 annually?

b. How would I recapture the depreciation upon selling A in the future? In addition to A’s own depreciated amount over the years, I guess I should also add its share (60%) of R’s depreciation of $68K?

c. How would I calculate capital gain upon selling A in the future? Let’s say we get 250K after sale related cost. Is A’s capital gain 250k – 225K + its share of capital gain from R (60% * 100K) = 85K?

Again, your help on this is great appreciated!  I am working toward closing a purchase this month and is wordering if I should do a reverse 1031 exhange.

[Dave Foster]

@Sheila Zhou, There's a lot of numbers buzzing around there and you would be very well served to buy an hour of your accountants time.  Because he has what youre asking about at the tips of his fingers from your past tax returns.   

First of all make sure that the number you're starting with is accurate. When you convert a property to investment you use the lower of purchase price or the FMV at conversion.

Second think of the 1031 as a carry forward of your basis.  So whatever your basis is in property R carries forward and is allocated into the two replacement properties.  So you would get to continue the depreciation that you carried forward and there would be some addition to depreciable basis as well.

Third you can use the 1031 to keep depreciation recapture at bay indefinitely.  As long as you hold the new properties, or as long as anytime you sell you do another 1031 you'll not have to recapture depreciation and when you die your heirs will get at the stepped up basis so the tax goes away.

If your calculations on gain are correct and the information on your bracket is correct I'd say you're pretty close on your tax liability.