How Does the 1031 Exchange Work in Conjunction with Depreciation on Investment Properties?

If you’ve been following our blogs on a regular basis, you know that the 1031 exchange allows investors to “swap” real property used for trade or investment into other real estate of equal or greater value. The benefits of the like-kind exchange include the ability to “trade up” into another property and to defer capital gains taxes while doing so. 

While the theory behind the 1031 exchange is straightforward, there are factors that can raise questions or concerns during the process. One such factor is depreciation. While depreciation can be hugely beneficial to you when it comes to real estate investment, it can be complex when it comes to determining its treatment or a 1031 exchange.

A Depreciation Refresher Course

Before discussing depreciation tied to 1031 exchanges, it would be helpful to discuss what, exactly, depreciation is. Depreciation is the allocation of an asset’s cost over the period of what is known as its “useful life.” Going further, “useful life” is the period of time during which an asset will be useful to a business or investor.

To make life easier for investors and their financial advisors, the IRS considers the useful life of residential real estate to be 27.5 years and 39 years for commercial property. So, if you are taking depreciation on an apartment building you own, you would take the adjusted cost basis and divide it by the remaining years of useful life. You would then use that as a deduction on your tax return.

Reviewing Real Estate Cost Basis

Cost basis is a fancy term describing the original purchase price of a real estate asset, plus out-of-pocket expenses or closing costs. The adjusted basis is a little more involved. It consists of the original purchase price of the particular asset, along with acquisition costs and capital improvements. All of this is subtracted by the cumulative depreciation deductions claimed during the time of ownership and previously deferred capital gains.

With the above definitions in mind, let’s move on to depreciation methods and 1031 exchanges.

The Depreciation Methods

With the above in mind, there are actually two ways to depreciate real estate following the 1031 exchange.

Single-Schedule Depreciation

If you decide on single-schedule depreciation, you are likely choosing simplicity over the preferred tax code method. When you depreciate through this method, you take the new adjusted cost basis of the replacement property and divide it by the asset’s estimated useful life. This is 27.5 years for residential real estate and 39 years for commercial real estate. While this method might mean less depreciation on an annual basis, it’s definitely preferred if you continue exchanging into additional properties.

Two-Schedule Depreciation

Sometimes known as “step-in-the-shoes” depreciation, the two-step method is definitely more complex but can offer greater benefits. This involves depreciating your replacement property with two separate depreciation schedules. Specifically, it involves continuing the relinquished property depreciation over its remaining useful life, as well as depreciating the remaining cost basis in the replacement property. 

Remember, when making the exchange, you are rolling over the adjusted cost basis of your relinquished property into the replacement property – depreciation schedule #1. Meanwhile, the remaining cost basis in the replacement property (representing additional money spent on the new property) is depreciated separately – depreciation schedule #2.

And yes, this is as complex as it sounds. The benefit however is that you could end up with higher depreciation, meaning a potential reduction of your overall tax burden.

Which Is Right for You?

The first assumption to make when it comes to any type of 1031 exchange is that depreciation will be a given as part of the ownership process once you claim the replacement property. The second assumption is that the best depreciation method is one that takes your financial goals and objectives into play. As such, when it comes to any kind of depreciation analysis or strategy, be sure to work with your tax advisor.

This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice, meeting the particular investment needs of any investor. There is no guarantee that the investment objectives of any particular program will be achieved. The income stream and depreciation schedule for any investment property may affect the property owner’s income bracket and/or tax status. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities. All real estate investments have the potential to lose value during the life of the investment. Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation. Costs associated with a 1031 transaction may impact investor returns, and may outweigh tax benefits.

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