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How to offset depreciation recapture from a failed 1031 exchange
Hi! I sold a paid off duplex Nov 1, 2024. Half was owner occupied and qualified for the 121 exclusion, pretty clear cut so we don't need to worry about that part. The other half was intended to do a 1031 exchange. I identified the replacement property within the 45 days, had an inspection and appraisal but just before closing I found out one unit had squatters and I didn't want to take that on so the deal fell apart and the qualified intermediary released the 1031 funds to me the day after tax day, April 17, 2025. Since the 1031 straddled 2 years, I will owe for the 2025 tax year. I bought this (half of a duplex) in 2005 for $112k and sold it for $242k and the amount of the 1031 funds after all fees was $220k. My tax guy says I'm looking at a total tax bill of ~$47k, saying I have a recapture of $112K and a capital gain of $80k. A) does this sound right? B) What can I do to offset the recapture, which is being taxed at my marginal rate of 24% since I have a w2 job. C) If I buy another property this year and do a cost seg to speed up depreciation, will the depreciation on that property offset the recapture on the other? Thanks so much in advance!!
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- CPA, CFP®, PFS
- Florida
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@Crystal Mellor Yes, your CPA’s $47K estimate sounds reasonable. Since the 1031 exchange failed, you’ll owe taxes on:
- Depreciation recapture (~$112K) taxed at 25%.
- Capital gain (~$80K) taxed at 15–20%, depending on your income.
To offset the depreciation recapture, you'd need passive losses. Buying a new rental and doing a cost segregation study in 2025 can generate large losses, but those losses are passive unless you or your spouse qualify as a Real Estate Professional (REPS) or meet the STR loophole (material participation in a short-term rental).
If you qualify, the losses can offset W-2 income, capital gains, and recapture. If not, they’ll only offset passive income. To make this work:
- Buy and place a rental in service in 2025.
- Perform a cost seg study to front-load depreciation.
- Qualify for REPS or STR material participation to unlock the full tax benefit.
This can significantly reduce or eliminate your 2025 tax bill, just be sure to plan carefully with your CPA.
This post does not create a CPA-Client relationship. The information contained in this post is not to be relied upon. Readers should seek professional advice.
- Ashish Acharya
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- 941-914-7779
