Real Estate Investor · Chicago, IL · Member since 2008 · 122 posts · 46 votes
I was reading an old BP article posted by Jeff Brown regarding the use of excess depreciation and how it could be used in replacement of 1031 exchanges: http://www.biggerpockets.com/renewsblog/2010/01/05/150k-year-excellent-strategy/ In it, Jeff mentioned something that I was hoping someone could elaborate on, as I think it is a critical point. He said:
I have two questions:
1. Why exactly does this significantly reduce your annual depreciation?
2. In the event you have excess depreciation, is there ever a time you HAVE to use it to offset capital gains, or can you use it to offset capital gains whenever you choose?
I have two questions:
1. Why exactly does this significantly reduce your annual depreciation?
2. In the event you have excess depreciation, is there ever a time you HAVE to use it to offset capital gains, or can you use it to offset capital gains whenever you choose?
1) The new property purchased through an exchange will have have a reduced basis based on the basis of the property exchanged and any boot paid. This means that the depreciation will be less because you start out with a lower basis than if you purchased the property outright.
2)Technically you are not talking about excess depreciation. Depreciation just happens to be one of the biggest expenses. An investor might be limited in any given year to how much they can claim in losses from real estate because of income as Steve mentioned above.
You are able to use the passive loss carry forwards in years that your situation allows it or in full when you dispose of the property.
1. Your passive activity losses(PAL, Losses not coming from your full time job) are limited by your income over 100k. Your allowable PAL drops 50 cents for every dollar of income over 100k.
2. Your losses will be used against capital gains of the sale of more real estate only. Your sale of property will be first be subject to depreciation recapture(Greater of what was taken of should have been taken). After that you will have traditional capital gain rates.
Example: Justin bought a house in 2004 for $80,000 and rented it out for six years. He sold the house
on May 17, 2010, for $100,000. Justin had claimed $19,392 of depreciation on the property. His total
gain on the sale was $39,392. Of this amount, $20,000 was long-term capital gain taxed at a maximum
rate of 15% and $19,392 was unrecaptured §1250 gain, taxed at a maximum rate of 25%.
1. Your passive activity losses(PAL, Losses not coming from your full time job) are limited by your income over 100k. Your allowable PAL drops 50 cents for every dollar of income over 100k.
2. Your losses will be used against capital gains of the sale of more real estate only. Your sale of property will be first be subject to depreciation recapture(Greater of what was taken of should have been taken). After that you will have traditional capital gain rates.
Example: Justin bought a house in 2004 for $80,000 and rented it out for six years. He sold the house
on May 17, 2010, for $100,000. Justin had claimed $19,392 of depreciation on the property. His total
gain on the sale was $39,392. Of this amount, $20,000 was long-term capital gain taxed at a maximum
rate of 15% and $19,392 was unrecaptured §1250 gain, taxed at a maximum rate of 25%.
Hey Steve,
I'm not sure you answered my questions. How does an exchange significantly reduce your annual depreciation vs the same property acquired through 'normal' purchase? I don't think Jeff was describing taking depreciation against one's regular income.
Regarding my second question, one builds up 'excess deprecition' which is depreciation in excess of what is taken against rental income, but that cannot be used to offset your ordinary income (because you earn >$150k, for example). Once again, in the event you have excess depreciation, is there ever a time you HAVE to use it to offset capital gains, or can you use it to offset capital gains whenever you choose?
I have two questions:
1. Why exactly does this significantly reduce your annual depreciation?
2. In the event you have excess depreciation, is there ever a time you HAVE to use it to offset capital gains, or can you use it to offset capital gains whenever you choose?
1) The new property purchased through an exchange will have have a reduced basis based on the basis of the property exchanged and any boot paid. This means that the depreciation will be less because you start out with a lower basis than if you purchased the property outright.
2)Technically you are not talking about excess depreciation. Depreciation just happens to be one of the biggest expenses. An investor might be limited in any given year to how much they can claim in losses from real estate because of income as Steve mentioned above.
You are able to use the passive loss carry forwards in years that your situation allows it or in full when you dispose of the property.
Now if you do move into a much bigger property for example you exchange a FMV 500k property with a 250k basis for a $1 mil property you will have a basis in it of 750k versus the $1mil you exchanged into.
1. Why exactly does this significantly reduce your annual depreciation?
Charles and Steven gave you half the answer to your question.
Let me use Steven's example where a $500K property with a basis of $250K is exchanged for a $1 million residential rental property. Yes, the new basis in the replacement property is $750K, but the old basis in the relinquished property becomes the initial basis in the replacement property and is depreciated over the term remaining in the relinquished property's depreciation schedule.
In this example, if the relinquished property improvements had 10 years left on the depreciation schedule, then the basis in the relinquished property becomes the basis in the new property and is depreciated over the ten years remaining in the depreciation schedule. Any new money added to the basis to complete the purchase, that is allocated to the replacement property improvements, is depreciated on a separate 27.5 year depreciation schedule.
So, you see that you only get ten years of depreciation on the first $250K of the replacement property basis, not the 27.5 years that might be allowed over the class life of the property if it were purchased outright rather than acquired in an exchange.