Why Do a 1031 Exchange in a Down Real Estate Market?

Should you consider a 1031 exchange in a down real estate market?

In the booming real estate market of a few years ago, property owners saw their real estate assets increase dramatically in value.  As a result, if they sold their property they would have significant capital gains and therefore owe significant capital gains taxes that could be deferred or eliminated by a 1031 exchange.

Such dramatic increases in value are much less common in our current real estate market.  In fact, many properties have decreased in value, and would not lead to significant capital gains taxes if sold.

The question then is: if your property has not significantly appreciated in value, and you will not have a significant capital gain if the property is sold, is there still a reason to do a 1031 exchange?

The answer is yes.

Most people think of 1031 exchanges only in regard to avoiding capital gains taxes.  That’s only half the story.

In almost all real estate transactions, capital gains taxation has two components – taxes on actual gain and recapture of depreciation. The depreciation recapture provisions of Section 1250 (real property) and Section 1245 (personal property) apply to Section 1031 exchanges as well as sales. These provisions require depreciation to be recaptured at the higher ordinary income rate (instead of the long-term capital gain rate) when the property is sold or exchanged and a gain is recognized.

On the other hand, if you exchange property that is subject to recapture and no gain is recognized, the recapture potential of the relinquished property is not paid by you, but instead, carries over to the replacement property.

Moreover, this recapture potential can be deferred endlessly if you continue to transfer the property through Section 1031exchanges.

Thus, from a dollar perspective, avoiding the recapture of depreciation is just as important – and often more important – than avoiding taxes on actual capital gain since the monetary amount demanded by the government as recapture of depreciation is often larger than the taxes on actual capital gain.

In order to properly understand how recapture of depreciation works, you must first understand depreciation, and especially how the government looks at depreciation.

Simply stated, depreciation is loss of value. Over time all property except unimproved land depreciates, in the sense that over time all property except unimproved land undergoes wear and tear, becomes obsolete, and loses some of its physical integrity as foundations settle, damage is caused by long term exposure to air, water, and insects, and materials such as wood, metal, and concrete deteriorate.

The tax code properly recognizes this natural loss of value over time and allows property owners to deduct a prorated portion of this natural and inevitable loss of value each year from the owner’s basis in the property.

Deductions based on depreciation are taken according to schedules established by the IRS. For residential real estate and improvements, depreciation is taken over 27 years (known as the recovery period). For all other real property, including nonresidential investment property, depreciation is taken over a recovery period of 31 years.

While different kinds of assets are depreciated by different methods, all real properties, including buildings and permanent improvements, are currently depreciated using the straight-line depreciation method. Under the straight-line depreciation method, an identical proportional amount is deducted from your taxes as depreciation each year over the entire recovery period.

Crucially, because depreciation reduces your adjusted basis in a property, it has the effect of increasing the amount of profit – or, more precisely, the amount of capital gains that the IRS insists that you pay tax on when you sell the property.

The longer you’ve owned a particular property, the more depreciation has been taken and the lower your adjusted basis. Thus, the longer you own a particular property, the more depreciation will increase the amount of taxable capital gain, even without any cash profit due to appreciation.

For example, let’s say that you purchased a property 20 years ago for $400,000 and sell it today for exactly the same amount. You have absolutely no profit due to appreciation. But because of the depreciation allowable over the 20 years that you have owned the property, you will still have a taxable capital gain of approximately $300,000, even though you will have no cash profit whatsoever.

Even more significantly, even though you have no cash profit, you would still owe the government capital gains taxes of approximately $45,000!

Using a Section 1031 exchange allows you to legally avoid paying this tax, and instead, legally keep the money that you have deducted from your taxes as depreciation over the time that you’ve owned the property.

It is also important to note that the scheduled deductions for depreciation (and the resulting decrease in your property’s basis) are built into the tax code and are not at the discretion of the taxpayer. In other words, you cannot choose whether to depreciate your property and, hence, decrease your basis.

Even more significantly, you cannot claim an exemption from the recapture of depreciation because you did not, in fact, take the deductions due to depreciation that you were entitled to.

The government simply and absolutely assumes that you have taken all scheduled depreciation deductions, regardless of whether you have actually taken the depreciation deductions or not, and will insist that this allowable depreciation be “recaptured” when the property is sold.

So the answer to the question “Should I consider a 1031 exchange in a down real estate market?” depends not only on your actual capital gains, but also whether you want to avoid paying the government the amount of depreciation that the property has been entitled to during the time you have owned it.

In many cases, the answer will be yes.

For more information on this topic, and for everything you need to know about 1031 exchanges, see our book 1031 Exchanges Made Simple, available at Amazon.com.

To contact Melissa J. Fox about serving as a qualified intermediary or for other 1031 exchange services, send an email to strategicfox@gmail.com

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