1031 vs accelerated deprecation for qualified real estate prof.

[Chris Turek]

I will try to summarize my situation.  I sold a property last week and hired the necessary firm to put it into a 1031 exchange.  I have a cap gain of about 400k.  I have identified a property to purchased that would complete the 1031 exchange.  However, since my wife qualifies to claim status as a "qualified real estate professional" I'm trying to determine if different strategy  might also be on the table.  Should I buy the replacement property and instead of doing the 1031 exchange simply pay the taxes then do a cost segregation study on the new property then take accelerated depreciation.  What I really need help with is this part, my w2 income puts me in the highest tax bracket.  Since my wife qualifies as a qualified real estate professional and we file jointly any losses through real estate that would normally be passive can offset my w2 earnings.  Since those earnings are probably taxes at 45+% vs 25% for cap gains is it better for me to take the hit and pay the cap gains tax at 25% and then do a cost seg analysis and use that to offset my w2 earnings at a higher rate.  Is that what will happen or am I missing something.  I think the cost seg analysis will not dollar for dollar equal my gain on the sale but I'm guessin it will be 300k vs 400k of cap gains.  I'm not accountant so if I am getting this way wrong please let me know.

Thanks

Chris

[Michael Plaks]

@Chris Turek

Thumbs up for your big picture thinking.

Let's use a simplified example. Scenario A.

You're selling a property with $600k basis for $1M, creating $400k in capital gains. Let's not complicate it by talking about depreciation recapture and various minor complications and assume a 25% rate on the capital gain, or $100k tax hit.

You can buy a new property using $1M proceeds, do cost seg that at a typical 30% ratio creates $300k in deductible bonus depreciation and save $120k at the highest Federal rate. (I ignore the state taxes for simplicity, but they should be considered.) You end up still reducing your taxes by $20k.

Your remaining basis (with land) for future depreciation is $700k.

Scenario B.

You use $1M for a 1031 exchange and buy the same property. Since it's an exchange, your basis in the new property is the rollover basis of $600k, even though it's a $1M property. $100k in CG taxes is deferred.

You cost seg this property, but due to reduced basis, the 30% extra depreciation is only $180k, and the tax savings are $70k.

Your remaining basis is $420k rather than $700k, so your future available depreciation is substantially diminished, compared to Scenario A.

Comparison

You get $70k first-year savings under B, compared to $20k under A. Even with reduced future depreciation, B looks like a winner.

However, everything tax-related is case-by-case, and your mileage may vary.