What is recapture?

[Melanie Baldridge]

Newton's law of tax:

What goes down must come up.

Everyone enjoys the sweet benefits of bonus depreciation, but what happens when you sell?

A post on recapture:

People are concerned about recapture when they cost segregate their improvements and for good reason.

Recapture is real, and those deferred taxes will need to be paid.

But fear not! If you think ahead, you can minimize recapture with the right tax planning.

So... What is recapture?

Basically, there's no free lunch when it comes to taxes.

Depreciating property lowers your tax basis. When you go to sell, you're subject to tax on the amount of profit between your adjusted basis and sale price, not your purchase vs sale price.

Recapture is NOT repaying the depreciation. It's a tax on the gain.

How is this calculated?

To set the scene: A cost seg study breaks your property into two important categories:

1250 "real" property aka the building, foundation and other long life assets.

&

1245 property aka anything that can be accelerated such as 5, 7, or 15 year property like carpets, cabinets, or other site improvements. This is most of the depreciation you are taking year one.

You can calculate your depreciation recapture by taking the sale price of the asset and subtracting the adjusted cost basis.

The adjusted cost basis is what you paid for the asset plus any improvements you made along the way minus the depreciation you took along the way.

The profit above this original cost is taxed as a capital gain, but the part linked to depreciation is taxed at a maximum rate of 25% under the unrecaptured gains of section 1250.

To recap the tax rates are:

- Sec. 1250 real property: 25%

- Sec. 1245 property and 15 year 1250 property: Ordinary Tax Rates

There are ways to minimize depreciation recapture especially if you know how to work smart with your CPA.

1) Asset Valuation at Time of Sale - Sellers can minimize recapture by reallocating the price of the assets on sale. Your old carpet did not become more valuable over the seven years you owned the property, even if you are selling for a gain. Work with your CPA to allocate more value to land and structure. For larger properties, some of our clients run another cost segregation study at the time of sale.

2) Partial Dispositions - Taxpayers can carve out and dispose of components removed or demolished from a building. By making partial dispositions, you can also avoid subsequent recapture on these items when you go to sell. Note this election MUST be made in the year of the dispositions.

2) 1031 - There's usually no tax on gains or losses when swapping property for similar property. However, even in an equal exchange, recapture tax might apply. But, if a cost-seg study is done on the old property, you can manage Sec. 1245 recapture tax by doing a study on the new property to confirm it has as much or more Sec. 1245 property.

You cannot swap a fully depreciated gas station for a raw piece of land and avoid recapture - you must replace all the 1245 and 1250 property.

3) OZ - Sure you can defer your capital gains for a few years into an OZ fund, but the magic of OZ investments is the ability to achieve tax-exempt growth after a 10-year holding period. Cost seg depreciation is not subject to recapture here! The compliance on these can be tricky, tread carefully or work with experienced funds.

4) Death - Nothing is certain but death and taxes. For RE owners, death allows you to pass assets to your heirs and step up in basis, effectively eliminating recapture. We generally advise our clients to go ahead and pay the recapture rates if death is the alternative.

The good news about recapture - the deductions are a deferred tax liability to you, and an interest free loan from the government. You will never pay more tax in recapture than what you originally deferred, assuming your personal tax rate stays the same. Borrow the money interest free and compound on

As always DYOR and talk with your CPA.

[Kevin S.]

@Melanie Baldridge

What is the tax implication if I swap one property for another that is valued at lesser amount.  Say sell property for 2M and buy another (within the required time frame) for 1.5M?

Does the swap has to be one for one property?  Can I sell one property for 2M and buy 2 properties for 1M each?

[Gregory Wilson]

Quote from @Melanie Baldridge:

Newton's law of tax:

What goes down must come up.

Everyone enjoys the sweet benefits of bonus depreciation, but what happens when you sell?

A post on recapture:

People are concerned about recapture when they cost segregate their improvements and for good reason.

Recapture is real, and those deferred taxes will need to be paid.

But fear not! If you think ahead, you can minimize recapture with the right tax planning.

So... What is recapture?

Basically, there's no free lunch when it comes to taxes.

Depreciating property lowers your tax basis. When you go to sell, you're subject to tax on the amount of profit between your adjusted basis and sale price, not your purchase vs sale price.

Recapture is NOT repaying the depreciation. It's a tax on the gain.

How is this calculated?

To set the scene: A cost seg study breaks your property into two important categories:

1250 "real" property aka the building, foundation and other long life assets.

&

1245 property aka anything that can be accelerated such as 5, 7, or 15 year property like carpets, cabinets, or other site improvements. This is most of the depreciation you are taking year one.

You can calculate your depreciation recapture by taking the sale price of the asset and subtracting the adjusted cost basis.

The adjusted cost basis is what you paid for the asset plus any improvements you made along the way minus the depreciation you took along the way.

The profit above this original cost is taxed as a capital gain, but the part linked to depreciation is taxed at a maximum rate of 25% under the unrecaptured gains of section 1250.

To recap the tax rates are:

- Sec. 1250 real property: 25%

- Sec. 1245 property and 15 year 1250 property: Ordinary Tax Rates

There are ways to minimize depreciation recapture especially if you know how to work smart with your CPA.

1) Asset Valuation at Time of Sale - Sellers can minimize recapture by reallocating the price of the assets on sale. Your old carpet did not become more valuable over the seven years you owned the property, even if you are selling for a gain. Work with your CPA to allocate more value to land and structure. For larger properties, some of our clients run another cost segregation study at the time of sale.

2) Partial Dispositions - Taxpayers can carve out and dispose of components removed or demolished from a building. By making partial dispositions, you can also avoid subsequent recapture on these items when you go to sell. Note this election MUST be made in the year of the dispositions.

2) 1031 - There's usually no tax on gains or losses when swapping property for similar property. However, even in an equal exchange, recapture tax might apply. But, if a cost-seg study is done on the old property, you can manage Sec. 1245 recapture tax by doing a study on the new property to confirm it has as much or more Sec. 1245 property.

You cannot swap a fully depreciated gas station for a raw piece of land and avoid recapture - you must replace all the 1245 and 1250 property.

3) OZ - Sure you can defer your capital gains for a few years into an OZ fund, but the magic of OZ investments is the ability to achieve tax-exempt growth after a 10-year holding period. Cost seg depreciation is not subject to recapture here! The compliance on these can be tricky, tread carefully or work with experienced funds.

4) Death - Nothing is certain but death and taxes. For RE owners, death allows you to pass assets to your heirs and step up in basis, effectively eliminating recapture. We generally advise our clients to go ahead and pay the recapture rates if death is the alternative.

The good news about recapture - the deductions are a deferred tax liability to you, and an interest free loan from the government. You will never pay more tax in recapture than what you originally deferred, assuming your personal tax rate stays the same. Borrow the money interest free and compound on

As always DYOR and talk with your CPA.

Melanie:  Yours is a good explanation. I think you might also want to mention the benefit of abandoning specific assets on the depreciation schedule with residual or undepreciated basis. Getting the deduction when abandoned or at the time of updating those asset classes and also getting the assets off the balance sheet to avoid future gain from sale price allocation.

[Melanie Baldridge]

Quote from @Kevin S.:

@Melanie Baldridge

What is the tax implication if I swap one property for another that is valued at lesser amount.  Say sell property for 2M and buy another (within the required time frame) for 1.5M?

Does the swap has to be one for one property?  Can I sell one property for 2M and buy 2 properties for 1M each?

In a 1031 exchange, if you sell a property for $2 million and purchase a replacement property for $1.5 million, the $500,000 difference is considered "boot" and is subject to capital gains tax.

To fully defer capital gains taxes, the replacement property must be of equal or greater value than the relinquished property, and all proceeds from the sale must be reinvested.

[Kevin S.]

@Melanie Baldridge

Thank you. My second question was- Does it have to be one-for-one property or can it be one-for-two properties totaling 2M and more? Sometimes there is a quadplex and a SFH on one lot or 2 properties on 2 adjacent lots on sale.

[Sean Graham]

Quote from @Kevin S.:

@Melanie Baldridge

Thank you. My second question was- Does it have to be one-for-one property or can it be one-for-two properties totaling 2M and more? Sometimes there is a quadplex and a SFH on one lot or 2 properties on 2 adjacent lots on sale.

@Jackson Hanssen ? 

[Jackson Hanssen]

@Kevin S.

You can 1031 into multiple properties. no need to do 1 for 1. You can also do small changes, like going from a multi-family to a couple SFRs, or industrial to office. If you've done a cost seg before and have broken out your property into 1245 and 1250 property, it would be best to be thoughtful of your replacement property to ensure you'll get full deferral. As far as I know there isn't clear guidance on this topic from the IRS, but most professionals take a similar view as Melanie above. I think @Sean Graham would be able to help you on specifics of if your intended replacement property will have enough 1245 assets.

If you want we can hop on a call and go through all of the hurdles. requirements and timelines for a 1031. It's really important to go through everything upfront, as the timelines are pretty tight once you start, and certain mistakes will disallow the 1031 in its entirety.

[Sean Graham]

Quote from @Jackson Hanssen:

@Kevin S.

You can 1031 into multiple properties. no need to do 1 for 1. You can also do small changes, like going from a multi-family to a couple SFRs, or industrial to office. If you've done a cost seg before and have broken out your property into 1245 and 1250 property, it would be best to be thoughtful of your replacement property to ensure you'll get full deferral. As far as I know there isn't clear guidance on this topic from the IRS, but most professionals take a similar view as Melanie above. I think @Sean Graham would be able to help you on specifics of if your intended replacement property will have enough 1245 assets.

If you want we can hop on a call and go through all of the hurdles. requirements and timelines for a 1031. It's really important to go through everything upfront, as the timelines are pretty tight once you start, and certain mistakes will disallow the 1031 in its entirety.

Thanks Jackson! Happy to help as I can @Kevin S.

[Kevin S.]

@Jackson Hanssen

Thanks for answering my question that Melanie hasn't. I am still early in my journey of REI and wanted to buy property with end in mind. Buying one-for-one equal to or more than selling property sale price limit the choices. Just needed some clarification. I'll keep you and Sean in mind when time comes. Thanks again.

[Jackson Hanssen]

@Kevin S.

Best of luck! It's a big step but will surely move you forward in your journey for financial independence.  Feel free to message me as needed.

[Dave Foster]

@Kevin S., In the middle of the. partial exchange/diversification exchange you are exploring is another very important strategic consideration that can really propel you forward.  Yes, you can purchase less real estate than your net sale and pay tax on the difference.  Yes, it doesn't have to be one purchase.  You can purchase multiple properties.  As long as the aggregate net purchases are at least as much as your net sale you'll still defer all tax.

The other consideration is that you can allocate your net proceeds in any way you want on those multiple purchases.  As long as you use all of your proceeds in the purchase or purchases you'll defer all tax.  

This can be a great way to concentrate your equity in order to be able to make a later cash out refinance as powerful as possible.  In your example sell the $2 mil building (assume there's $600K of debt remaining so there are 1.4 mil in proceeds).  Take 1 mil and buy one property for cash.  Take the remaining $400K and use that as two down payments of $200K  on 2 more $1 mil properties.  

When you do this you end up with two properties leveraged.  And one property free and clear.  This property can be refinanced at any time you feel is right after the 1031 exchange is complete to buy other property or access funds for any reason.  And you've still deferred all tax in the 1031 exchange because you purchased at least $2 mil in real estate using all $1.4 in proceeds.