1031 Exchange: Don't Forget Recaptured Depreciation

Section 1031 of the IRS Code permits investors to defer payment of tax on the gain from the sale of property held for productive use in business, trade or investment so long as the property is exchanged for a “like kind” asset (or assets). While this can be a powerful tax-deferral strategy, there is another significant potential tax liability that many investors don’t initially consider.

In any 1031 exchange, an investor must recapture all depreciation at 25%.

Depending on how long you’ve owned your investment property, the depreciation recapture could be a bigger tax liability than the capital gains tax. As a professional who has provided qualified intermediary services for more than a decade, I have personally witnessed many investors face IRS tax liability for as much as 50% or more of their total sale profits when the capital gains tax and depreciation recapture tax are combined.

While the IRS provides “safe harbor” to permit the deferral of both capital gains and depreciation recapture tax liability, this safe harbor only exists if all the rules of the 1031 exchange are followed. While a properly structured 1031 exchange usually passes IRS muster, it is important to understand all the potential liability.

When you are considering a 1031 exchange, don’t forget to factor in the depreciation recapture tax requirement.

To learn more about 1031 exchanges or our qualified intermediary and replacement property locator services, please visit our website.