Simple 1031 Exchange question

[Paul G.]

I have a question regarding 1031 Exchanges in regards to depreciation recapture and capital gains Taxes.  This is purely hypothetical, but I want to look forward to make sure I'm structuring everything correctly.  Also, I want to note, I'm assuming 100% financed loan to start.  I know you can't do this, but I want to basically take a look at it from the most simplistic model I can.

I own Property #1

Bought: 75K

Sold in year 5: 150K

Depreciation: 2.5K/y

If I were to sell, assuming those are my only numbers (I don't want to make it overly complicated).  I would pay:

Depreciation Recapture Tax: 3K (25% on depreciation recapture of 12.5K)

Capital Gains Tax: 11.25K (15% on capital gains 150K - 75K = 75K)

I would net 75K + whatever I've paid down through 5 years - (recapture and cap gains.)

Now, say I roll that into a new property using a 1031 and buy for 200K. Again, I dont want to overly complicate things, so assume I roll everything in.

Then same thing applies:

Bought 200K (down payment is whatever I calculated above)

Sold in year 5: 300K

Depreciation: 4K/y

Is this how I calculated my Depreciation and Capital gains?

Depreciation Recapture Tax: 7K (3K from previous property + 25% of 20K for new property depreciation).

Capital Gains Tax: 26.25K (11.25K from previous property + 15% on capital gains 300K - 200K = 100K)

So, all in all, after selling both properties if I want to pay tax after my second property and NOT 1031 again, I would end up owing 33.25K in taxes on my 100K in gains + whatever I put down prior?

[Dave Toelkes]

@Paul G.,

Let's remove a lot of extraneous information.  In your 1031 exchange scenario, you sell a relinquished property for $150K that has a tax basis of $62.5K ($75K cost minus $12.5K depreciation).  You are acquiring a replacement property for $200K, rolling in all your net sale proceeds from the relinquished property and adding another $50K in new debt (or cash) to complete the acquisition.  Let's assume that these numbers are for the depreciable dwelling structures only, otherwise you would make adjustments for the value of the non-depreciable land.  

At this point, your $62.5K in old basis becomes the initial tax basis (and depreciation basis) for the replacement property.  You would continue to depreciate this basis for the 22.5 years remaining on your old basis depreciation schedule at $2.5K per year (using your numbers).     Since you brought $50K in new money/debt to the settlement table to complete the replacement property acquisition, you have $50K in new basis that can be depreciated over the next 27.5 years at about $1818 per year.  Your total annual depreciation in the new property is $4318 per year for the first 22.5 years and $1818 for the next 5 years if you hold the property that long.

Your initial tax basis in the replacement property (ignoring the value of land) is $112.5K.  In your scenario, you sell the replacement property for $300K five years later in a taxable event.  In those five years, you took an additional $21590 in depreciation which is added to the $12.5K depreciation previously taken on your relinquished property, bringing your total unrecaptured depreciation to $34090.  The taxable capital gain due to appreciation is $175K ($75K on the relinquished property + $100K on the replacement property).  If your marginal tax bracket is at least 25% and the capital gain keeps your tax bracket under 39.6% at the time of the sale, your maximum tax bill will be 25% of the unrecaptured depreciation plus 15% of the capital gain due to appreciation for an estimated tax bill of $34773.  Note, that tax on capital gain due to appreciation in land value will be added to this projection