Right now I’m going to show you how to defer “Depreciation Recapture” Tax using a 1031 Exchange.
Because here’s the problem: It’s easy to get blindsided by the “Depreciation Recapture” Tax because nobody talks about it. And it’s often forgotten. And you’ll pay this tax even if you sell your rental property and lose money – if you don’t do a 1031 Exchange.
And real quick, a 1031 Exchange is when you sell one rental property and buy another one according to specific IRS rules and timelines, so that you can defer taxes and build generational wealth for your family just like the big boys do.
How to Defer “Depreciation Recapture” Tax With a 1031 Exchange.
1. Do a rough draft of math to take to your tax advisor.
2. Calculate “basis.”
2a. “Basis” is an accounting term. And the definition is basis equals purchase price plus improvements. Sometimes it’s not a purchase price, sometimes it’s a acquisition price. Sometimes basis is a little more nuanced and your tax advisor will show you that. However, in this example, the basis is purchase price plus improvements.
2b. To give you a real life example, you have a purchase price of $400,000. You add your $25,000 of roof costs, which is an improvement. And that equals $425,000 for your basis.
It is important to note that basis relates to your original purchase price. or acquisition price, plus improvements. Basis does not relate to eventual sales price for Depreciation purposes.
3. Figure Depreciation “taken or allowed”.
Why do I say allowed? Because you may not have taken the Depreciation and the IRS doesn’t care. It’s “taken or allowed”. It’s what they allowed you to do because that’s where you take your deductions. Even if you didn’t take it, you will be taxed on it. So “taken or allowed” is an important distinction.
3a. Separate land value from building and improvement costs. Why do you do this? It’s because you cannot depreciate land. It does not have any improvements on it.
3b. How do you determine land value? You use information from a tax assessor or an appraiser, or even your accountant, and that helps determine land value. And remember, this is value when you purchased the property, not today’s value.
3c. Back to our example. You had $425,000 as your basis for the property, minus $100,000 for land value that you determined. And that equals $325,000 for the value, remember, value when you bought it, of building an improvement.
3d. The Residential Depreciation rate determined by the IRS is your building plus improvements divided by 27.5 years.
3e. In our example, we take 325,000 for your building improvements, divided it by 27.5. That equals $11,818 for each year of Depreciation. Remember, this is Depreciation that you took off your tax return for this property, or you were allowed to take.
3f. In our example, let’s consider that you own the property for 10 years, you are taking $11,818 per year times 10 years, equals $118,181.
4. Estimate your Ordinary tax rate. This is the tax rate that’s on your tax return each year. And that can vary because you earn different amounts, you get married, you have children. It’s your tax rate as determined by the IRS.
4a. Use the federal tax rate chart. Or sometimes you can use your previous tax return to estimate if you haven’t had many changes. 4b. Ordinary Tax rates currently vary from 0% to 37% depending on your income and your marital status.
4c. However, the maximum tax rate for “Depreciation Recapture” is 25%. Thus, if you have a high income, this is a benefit to you
5. Estimate your Depreciation tax that could be deferred with a 1031 Exchange. Here’s where the money counts.
5a. This is an example. We calculated that you have $118,181 total Depreciation over the last 10 years. And if you’re taxed at the maximum rate, 25%, then your tax when you sell would be $29,545. That’s just for Depreciation recapture.
It’s really important to note this because some people are unaware of the Depreciation Recapture tax, and this will happen when you sell. However, you can defer it with a 1031 Exchange. And most people don’t even pay attention to Depreciation Recapture. They forget about it. They ignore it. They don’t even know about it. They haven’t heard of it. And this is a surprise. So the benefit of watching this and to calculate this is, you know, in advance and can take it to your accountant.
6. Substitute your actual numbers and take to your tax advisor.
You may have acquired the property at a lower amount than $400,000. You may have had larger numbers of improvements you may have bought the property for a much higher price may not have any numbers since maybe it was just land.
7. Do a 1031 Exchange and defer your tax.
And yes, using our example, the $29,545 Depreciation Recapture tax will be saved, postponed, maybe forever, and you can use it for equity in the property you’re buying.
So how do you do a 1031 Exchange?
7a. The first thing you do is talk to your tax advisor to see if it’s appropriate for your property and your situation.
7b. Choose a real estate agent with some 1031 experience. This is very important because I won’t be the only person monitoring your Exchange. Your agent will also do the same, and maybe the timetables, maybe other issues will come into consideration.
7c. Get ready to sell and buy.
7d. Sell your rental.
7e. All funds from your sale must go directly to a Qualified Intermediary.
You cannot put the money in your bank account. The Qualified Intermediary will hold it.
7f. Designate to your Qualified Intermediary your chosen by properties within 45 days of Closing the sale property.
7g. Contract to buy your new property.
7h. When you’re ready to close, authorize your Qualified Intermediary to send your funds to your new Escrow for your new property within 180 days of the original Closing.
7i. Your tax advisor then files your tax returns reflecting your Exchange with no taxes owed at this time.
Oh, and if we haven’t met, my name is Maxine Golden. I’m a longtime real estate broker, and I started the 1031 Exchange Lady Channel because I believe you deserve the same tax breaks as the big investors. The law says you deserve them, and you do. Don’t just take my word for it. Ask your accountant or ask the IRS. They will tell you the same thing.
So I specialize in helping rental property owners like yourself across America find Qualified real estate agents who are experienced in 1031 exchanges, and can help you to defer your taxes and to save money.
if you have any questions, ask me in the comments or book a call below. I look forward to seeing you in the next video.