1031 - Calculations of depreciation and various bases with and without the exchange

4 Replies

I am in the middle of a 1031 exchange.  The blog by Jeff Brown in today's newsletter (http://www.biggerpockets.com/renewsblog/2015/07/25/real-estate-investors-myths-eternal-truths/) was the latest place where I heard him beating the drum about 1031s only being worthwhile as a last resort.  His is the only voice that I hear say so in such an emphatic way, but it's convincing enough to get me to dig deeper!

My understanding of the various parts of the 1031, using my current transaction as an illustration:

#1 The replacement property needs to be more expensive in total than the relinquished property.  Done.

#2 All of the equity (including gains) from the relinquished property must be rolled into the replacement property.  Done.

#3 Time restrictions apply.  Done.

The original basis in my relinquished property was $85,055.  The net proceeds were $114,940.

114940

  85055-

  29885 capital gain

At the time of sale, $8,914 had been taken in depreciation.  This number was not taken out of the original basis above in calculating the capital gains.  Correct?

Taxes due if no exchange occurs:

29,885 cap gains x 15% rate = $4,483

8,914 depreciation x 25% dep recovery rate = $2,229

$6,712 total taxes due if no exchange is made.

The knock on the exchange process is that there is a loss in depreciation.  So I calculated what the depreciation would be with and without the exchange.  Without the exchange is the easier one:

Replacement property value: $230,000.

Improvement:Land Ratio: 80%

Depreciable basis: 230,000 x .8 = 184,000

184,000 / 27.5 years depreciation = 6,691 annually 

With the exchange, my understanding is that the depreciation falls into three tranches:

1) exchanged basis, which is a "carrying-on" of the relinquished property's depreciation schedule 

2) deferred gain, which is not depreciable, and

3) excess basis, which is the replacement purchase price less #1 and #2 above.

Exchanged basis = 

original cost basis - depreciation taken = 

85,055 - 8,914 = 76,141.  This will continue to depreciate according to the relinquished property's schedule, which in my case was $3,015 per year (which already backs out the land and incorporates some small post-purchase improvements)

Deferred gain = 

proceeds of sale - exchanged basis = 

114,940 - 76,141 = 38,799.  This is the same as "capital gain + depreciation taken."  No further depreciation can be taken on this amount.  This is the tranche that I believe Jeff Brown was focusing on, as this is the portion of the replacement purchase price that cannot be depreciated.

Excess basis = 

Replacement purchase price - Deferred gain - Exchanged basis = 

(I am not including closing costs and any future improvements in the purchase price)

230,000 - 38,799 - 76,141 = 115,060 

The excess basis needs to be divided between land and improvements, and I'll use the same 80% factor as above.

115,060 * 80% = 92,048

92,048 / 27.5 years depreciation = 3,347 annually

The summary of my depreciation tranches (as I'm calling them) is

3,015 Exchanged depreciation

0 Deferred gain depreciation

3,347 Excess depreciation

6,362 Total depreciation (for 12 more years, then it will go down by about $100, then the exchanged depreciation will drop off after an additional 12.5 years) 

Comparison of depreciations:

6,691 without exchange

6,362 with exchange

   329 annual difference in depreciation amounts 

At the 39.6% tax rate (which is not my tax rate), the $329 difference in depreciation is worth $130 a year in taxes saved (deferred, technically, due to the depreciation recapture).  It would take over 50 years of this tax savings (which is impossible) for $130 maximum annual savings to add up to the  $6,712 I can take now.

Upon sale, the gain will be subject to capital gains tax, and the depreciation will be subject to depreciation recapture.  Both occur with or without the 1031 exchange, so I did not incorporate them here.  The risk over time is that one or both of these rates increase between now and when the taxes are paid.  That is a real risk.

I'm eager to hear if this analysis is correct.  Of course every situation is different and maybe if I had held the first property longer, or if the first property's land were worth more, or if I were in a different tax bracket, etc etc, the analysis might yield a different result.

But if my calculations are correct, then I am not suffering from a (significant) reduction in depreciation, and I would much rather deploy the deferred capital gains in my next property than pay them at this time.  After all, the amount of the gain is locked in forever.  I will always owe some percentage of $29,885 to the IRS and all things equal, I would rather pay them in 2050 dollars than 2015 dollars!

Fire away.  Please. 

OK.....I think I've seen where the deficiency comes in.  The $3015 exchanged depreciation has a limited lifetime.  After 27.5 years from the time the property was put in service, I can no longer take that depreciation.  Ever.  If I keep this exchange alive for 40 years from the initial purchase, there will be 12.5 years with $3015 replaced by $0.00.  That's $37,000+ of income taxed rather than sheltered in those final years.  And if the exchange were to stay alive for another 10 years beyond that.....it adds up.

Always good to run numbers.  In my case, I still think this is the right call.  The federal and state taxes deferred (when leveraged by a new mortgage) allow me to reach comfortably into the price range of the asset I want to buy at a minimal hit to annual tax deductions. Still, I can see a clear case as to why, as time goes on, this may or may not be a good strategy. 

Just wish I were better at making charts to illustrate numbers.  The formatting above certainly doesn't help the cause......

@Dan Schwartz

I read that blog also with much amusement.  His vehement comments against 1031 exchanges run a little counter to the 300,000 plus exchanges that happen every year.  His voice is shrill but a little lonely.  So you probably need to take him with a little salt. 

 His main point seemed to be that you lose the tax benefit of depreciation if you hold until you die and you have a functionally expensive asset that has probably dropped in class and desirability from a passive management standpoint..  That's certainly true. But he forgets that the whole purpose of the 1031 exchange is to use deferred tax dollars to buy additional basis through up-purchases and to re-position assets into different classes, ages, and locations to take advantage of market and property  conditions - right up until you die - or convert some of your 1031 properties into a series of step down primary residences to convert some of those tax-deferred dollars into tax free dollars. 

What you are calling exchange basis is also commonly referred to as the adjusted cost basis.  One of the first analysees you must do to determine if a 1031 exchange is right for you is to make this calculation.  Your adjusted cost basis is the purchase price less depreciation plus capital improvements plus any passive activity expenses that may be pent up in the property.  Then compare this number to the net sales price.  The difference will be taxed at the current depreciation recapture rate and the remainder at whatever rate you fall into whether capital or ordinary, fed and state, and tax bracket sensitive.  A savvy CPA or EA can be a mountain of help in this process.

Then you get to make the call - go or no go based on your personal situation. And yes any new basis you buy keeps that tax benefit running for you.

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