1031 exchange what happens to the depreciation?

Question

Hello All,

I'm executing a 1031 exchange in September. I am realizing  $300,000 from the sale ($100,000 profit). I'm planning on purchasing new property for around $270,000. That will leave me with $30,000 in "boot" which I'm assuming I will pay capital gains tax on.

I have taken $40,000 in depreciation on the property I'm selling. Does anyone know what happens to that depreciation after I sell? Does it get folded into the cost basis of the new property? Do I have to pay taxes on any "depreciation recapture"?

I've talked to a couple of CPA's about this and I'm getting conflicting answers.

Thanks for your help.

Carol

Dave Foster · Answer

Good morning all.  @Bob B. I was either channeling my inner @Steve Vaughan and taking a nap or driving through Kansas and MO with triple digits on the car thermometer -- the nap sounds better.

@Carol Kotchek, There's a couple different questions and answers in your scenario that keep it from being cut and dried.

1. In order to complete an exchange with full tax deferral you need to do two things - Purchase at least as much as your net sale (the contract price minus closing costs as @Mark Creason said).  Second you must use all of your net proceeds (the net sales price minus mortgage pay off) in the next purchase or purchases.  It's a little strange to digest but the IRS doesn't care how much profit you have they simply tell you that to avoid all tax you must purchase at least as much as your net sale and use all of the proceeds.

2. But what if you want to buy less (say your net sale was 300 and you wanted to buy for 270) or say you wanted to take cash out of the deal?  In that event the IRS says the the difference is the same as taking profit out whether it is actually taking cash out or buying less than what you sold so you have a smaller mortgage.  You pay tax on the difference but still shelter the remaining profit.  In your case if you sold for 300 and wanted to buy for 270 you would pay tax on the 30K difference but shelter the remaining $70K of profit.

3.  And if you do a partial exchange what is the boot taxed at?  There's not a firm convention on this.  I've always asked my accountant nicely (the closer to April 15 the nicer I am) if they'd treat the boot as capital gain since I was willing to take some profit out but wanted to still do an exchange so I could avoid depreciation recapture.

4. And how is this figured and accounted for?  Like @Frank Chin said it can get complicated over the years.  Which is why every time you do a 1031 exchange your accountant files a form 8824 which takes the adjusted cost basis of your old property ( profit and depreciation) and carries it forward to the new property. With that 8824 you now have a new adjusted cost basis for the new property and depreciation, appreciation, capital expenses etc all start accumulating again from that point.

Frank Chin · Answer

There's been questions in the past on this, with some posts from Dave Foster. See: 1031 boot  Now, I've taken a real estate accounting course in the past which covered this, but it was over 20 years ago. As far as I know, there's not been major changes to the tax laws on this since.

There's several situations that leads to taxation of the boot. The major one is the seller receiving cash. The other is the seller having a smaller mortgage on the replacement property or properties.

To begin with, for your original property, you have the original basis, consisting of the original price, land/building ratio, accumulated depreciation on the building and improvements. Normally, when you 1031 up, to higher value property or properties, it's simpler.

If you 1031 into something smaller, and did not take on a smaller mortgage, you will have some tax consequences. The question is, by how much and how is it calculated. Now, for 1031's, whether you traded up, or down, for tax treatment, your replacement property becomes two for tax purposes.

In cases where you traded up, and took on a larger mortgage, the tax treatment is easier to explain and calculate. If you traded a $300K property into a $330K property, after the transaction, you'll have two properties on your schedule E. One is your original property, the other is the boot. The original property will continue it's life and will contain the same basis, same accumulated depreciation as your original property. Then you'll have to book a new property for the boot, for $30K. You'll do a land/building ratio, depreciate the $30K on the building. On sale, you'll have to calculate he recapture on two separate properties. Years ago, when they changed tax laws several times in the 80's and 90's, you may well have your original property on 18 years depreciation, and the boot at 27.5 years.

Now in your cases, where you traded down, same idea. You'll allocate the original property into two. One for $270K, one for $30K, for discussion purposes. You'll allocate the accumulated depreciation to the properties, in the same ratio. Then you do a sale of the $30K property, taking you depreciation just for this piece, calculate the recapture on it, with the $270K property piece, which should equal the value of your new property. So after the 1031, you book the newly acquired property, you'll have to take the depreciation figures, and prorate it, from the original property. In summary, the taxes are paid in declaring the sales of the $30K property.

Now I don't exactly recall what do you if the mortgage is smaller and you took some cash out. As I recall, if you took out, say $50K, then the allocation of the two properties is $220K and $80K.

Now, figuring out these 1031's can get complex as most of the course I took involves doing series 1031's where you trade a property in a 1031, to another one some years later in another 1031, and so forth, and then another one, where you actually own one physical building but on your books, can be several, each with it's own depreciation schedule on it's final sale, can have two or more separate depreciation recaptures calculated.

Mark Creason · Answer

Carol,

You would first be able to deduct selling expenses.  If you sell for 300k, you could deduct re fees, title, escrow, etc.  If you are doing a 1031 exchange and have a profit, I believe you would pay depreciation recapture first on the profit.  When you have "boot", it gets taxed first for the full amount.  So if you have 30k in boot, and 100k in profit, you would pay taxes on the full 30k.

@Dave Foster can confirm?

Mark

Bob B. · Answer

@Dave foster

@Dave Foster  will be along shortly and will gladly provide you with the correct answer.

Frank Chin · Answer

Yes, @Carol Kotchek, you summarized it correctly, better than I, and I'm glad you have a CPA that understand it as well.

Carol Kotchek · Answer

Thanks Everyone for your input.

Frank, what your saying makes sense to me and corresponds with what one CPA told me.

"You'll allocate the original property into two. One for $270K, one for $30K, for discussion purposes. You'll allocate the accumulated depreciation to the properties, in the same ratio. Then you do a sale of the $30K property, taking you depreciation just for this piece, calculate the recapture on it, with the $270K property piece, which should equal the value of your new property. So after the 1031, you book the newly acquired property, you'll have to take the depreciation figures, and prorate it, from the original property. In summary, the taxes are paid in declaring the sales of the $30K property."

If I realize $300,000 after all expenses, and I buy $270,000 in property, I will be taking $30,000 in cash for myself. In simpler terms, $30,000 is 10% of $300,000. If I have $40,000 in depreciation, I will pay regular income  tax on $4000 of depreciation recapture (that's 10% of my depreciation) and capital gains tax on $30,000, the cash I took out (the boot).  The rest of my depreciation (the leftover $30,000, that's $40,000 - $10,000) will follow along with the new property I purchased.

If I have it all wrong let me know. But if I have it correct then cool.

Also, thanks Dave for letting me know the tax form. I used to do taxes for a living so I can actually read those forms.

Matt K. · Answer

if you're seeing 100k profit and buying something for 270, then you wouldn't have any boot... I could be wrong, but I'm pretty sure it's only on your profit (and depends on what your actual basis is...).

1031 exchange what happens to the depreciation?

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