How to avoid paying taxes on depreciation deductions

Question

I have a rental I am interested in selling. This rental was originally my primary residence. I have been renting it for the past 6 years. I have, of course deducted the depreciation from it during that time.... about up to $50,000. I do know that if I sell it, I'll owe taxes on the depreciation I've deducted. Question, is there any way that I can avoid paying taxes on the already deducted depreciation? Can i do a 1031 exchange to avoid/kick that can down the road?

Jason

Dave Foster · Answer

@Jason Keledjian, There's a number of ways this strategy can be used creatively by you to your benefit.  The short answer as @Dave Toelkes said is that you can sell one and buy more than one replacement property.  This is known as a diversification exchange.

You can also allocate your cash proceeds in any way in your purchases as long as you do purchase at least as much as you sell and use all of your proceeds (if you want to defer all tax).  Some folks will want to take the proceeds and use them as minimum down payments on as many properties as possible.

Some folks will use the proceeds and buy one property for cash and then use the remaining proceeds as down payments.

A strategy that's gaining traction as this market matures is to take some of the proceeds and put them into a cash only fractional passive ownership product That has long leases and national credit tenants and then use the remainder to aggressively leverage a value add property.  The average gains from the fractional product provide leverage free income as well as a safety net for the highly leveraged product.  The leveraged property provides the potential return that makes the blend of the two very attractive.

Dave Toelkes · Answer

@Jason Keledjian,

Yes. you can exchange one property for two or more properties.  As long as you meet the exchange timelines and the value of the replacement property (or properties) exceeds the value of the relinquished property, the exchange will be fully tax deferred.

Jason Keledjian · Answer

Thanks for the response.  I knew I could defer the capitol gains with a 1031 exchange......however I didn't know I could do that with depreciation deductions as well.

One more question.  When doing a 1031 exchange, can I exchange the value of the rental (one property) I'm selling for two properties that have a value that surpasses the that of the sold rental?  Or does it have to be only one property that surpasses the vale of the sold property?

Jason

Bill Exeter · Answer

Hi @Jason Keledjian,

You have been renting the property for six (6) years now, so you no longer qualify for the 121 Exclusion as your primary residence.  The property is fully investment property.  You could certainly structure the sale of the property as a 1031 Exchange and defer the payment of any capital gains and depreciation recapture taxes and you would avoid any Medicare Surcharge taxes since you would not recognize any taxable gain from the sale.

Dave Foster · Answer

@Jason Keledjian, That property is fully investment and no longer qualifies for any primary residence exclusion.  It would fully qualify for 1031 treatment which would defer all gain including depreciation recapture.  And any amount that your purchase more than what you sell in a 1031 is added to your depreciable basis for future depreciation.  Not a bad deal.

Albert Bui · Answer

Good Point Linda,

But "what if," the stored losses in his PAL's (passive activity loss) bucket from other rentals exceeded his gain and his depreciation recapture portion, would he then effectively escape from paying capital gains and recapture tax on the sale of this property?

The reason I ask this is because this is a part of the planning a lot of my clients do with their accountants to build up PAL's and use the law of large numbers of properties to create a wall of depreciation to offset occasional large gains from sales of properties. They wait strategically  till they have enough losses on paper to offset these gains as a way of avoiding the necessity of having to do a "1031."

Its just an extra strategy, as is, the 1031 is a strategy as well.

I was curious as to your interpretation or opinion of the above.

Linda Weygant · Answer

A 1031 would be your only viable solution at this point.  @Bill Exeter or @Dave Foster could add more to that.

Even moving back in for 2 years would not help as that only resolves the capital gains, not the Depreciation Recapture.