Hidden Dirty Secret

4 Replies

Hello,

   For the first time in many years, I had to pay some income tax.  This prompted me to read the return in detail - whereas in the past, I just filed it.   I have a 20 unit property that I bought some years ago in an exchange for a fourplex.  Seemed like a neat deal at the time - sell four, buy twenty!  Unfortunately, the deal really was not that good - the market crashed, and this 20-plex has been eating my lunch every month for the past 6 years.

   One detail that struck me in the Schedule E was the depreciation.  Even though I paid over a million dollars for this turkey, I'm only getting about a grand a month in depreciation. WTF?

   The dirty secret - that is only hinted at in glowing descriptions of the 1031 process - is that when you exchange, your basis will be that of your original purchase price of the OLD property.  So you only get depreciation at that rate.   There are a few adjustments, having to do with closing costs and recapture of depreciation, but that's basically it.

  

  So when you analyze your new deal, make sure to take account of the fact that your depreciation will not change - much.  For a long term buy&hold deal, depreciation can be a big part of the package.  It still might be a good deal, but you do need to take the basis & depreciation into account.

  A more serious effect (for me) is that if the replacement property decreases in value, you can't sell it cheap without incurring a - possibly mind-boggling - tax liability.

@Jerome Kaidor  You are correct if you are exchanging across the board at the same price.  By that, I mean you sell your relinquished property for $1.0 million and you exchange into a $1.0 million replacement property.  There will be slight adjustments due to selling expenses, etc. 

However, many investors use the 1031 Exchange as a strategic way to solve this problem by selling the lower valued property and then exchanging up in value.  The additional value they purchase is new cost basis that can be depreciated.  So, taking the example above, if you sell for $1.0 million and then reinvest at $1.5 million you have traded up and acquired an additional $500,000 in cost basis that can now be depreciated. 

@Bill Exeter  

Thanks for clarifying that. I thought that was how it worked, but after reading the above post I started questioning myself.

yes if you exchange 1 for 1, you keep the old basis. On the other hand any "increase" goes on your basis. Most people exchange up or divide. So if you turned one property into 3 peripheries through fully leveraging you can do awesome :). I have already completed one 1031 and done awesome. It is a huge part of my plan!

Just to add another exclamation point to what @Bill Exeter  and Elizabeth Colegrove said, you cant just look at the tax deductions as your gold standard of the quality of a deal.   

If all you did was trade straight across in 1031 exchanges for years yes you would lose the benefit of depreciation write off as you had not been increasing your basis.  But the flip side is that if you were using the tool that conservatively you were probably also not adding debt onto the other end.  So no depreciation but no debt.  That's when passive cash flow becomes so important in the latter years of your investing.  Either way the 1031 exchange can be flexibly used to help you achieve your goals .  Yes you can still increase basis and direct write off benefits.  But you can also leverage your entire portfolio using someone elses money (the govts) and you can nimbly adjust to changes in market to shape your portfollio. 

Could you do a little calculation for us.  It would be very interesting to see how much tax you sheltered years ago on that property year ago and how much that has leveraged to today.   Don't give up on them.  The market did what it did but that doesn't make your decision wrong years ago.

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