Li-Ann owns a shoe factory on Grand Island, New York, that has decreased in fair market value since she inherited it 14 years ago. She was preparing to put the factory on the market when her lawyer suggested that she do a Section 1031 exchange rather than a sale in order to avoid paying capital gains taxes.
Li-Ann told her lawyer that she had no reason to use a Section 1031 exchange, since the property had decreased in fair market value. She wasn’t going to make a profit on the sale, she said, and therefore wouldn’t be paying any capital gains taxes. Since she wasn’t making any money on the property, she saw no benefit to a 1031 exchange.
Is Li-Ann correct?
The answer is No. By focusing exclusively on capital gains, Li-Ann has missed half of the potential benefits of a 1031 exchange.
Li-Ann needs to take recapture of depreciation into account, not just actual profit, when deciding whether she will save money by using a Section 1031 exchange.
In this example, Li-Ann might well be wrong in thinking that because her property has decreased in fair market value, she would not owe any capital gains taxes on a sale.
Because depreciation reduces the 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.
Moreover, the government 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.
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.
In fact, if you sell a property that you have owned for a long time, you are likely to have a sizable taxable capital gain (and be required to pay sizable capital gains taxes), even though you have no cash profit whatsoever.
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 carries over to the replacement property.
This recapture potential can be deferred endlessly if you continue to transfer the property through Section 1031 exchanges.
Li-Ann should therefore consider using a Section 1031 exchange in order to avoid paying capital gains taxes on a potentially substantial “profit” that exists in the account books of the IRS, even though her property has not appreciated in value.
For more information on depreciation and 1031 exchanges, see our previous post Why Do a 1031 Exchange in a Down Real Estate Market?
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 firstname.lastname@example.org