Swap ‘Til You Drop: Depreciation Recapture
Depreciation Recapture, including Accelerated Depreciation, and Capital Gains will take more of your wealth away from you than anything else.
But the 1031 Exchange Rules allow you to buy and sell investment property for your entire life without ever paying capital gains taxes or depreciation recapture taxes.
Regardless of whether you are doing a Delayed Exchange, Reverse Exchange, or Construction Exchange, aka Improvement Exchange or Build-to-Suit Exchange, the first item on your real estate investment strategy plan should be to defer taxes, and this includes depreciation recapture as well as Section 1250 gain.
Here’s how it works.
When you sell your investment property, hopefully you will have a profit, called Capital Gains. You will owe taxes on that income, maybe as much as 20%.
You will also have a Depreciation Recapture Tax, which will be up to 25% unless the depreciation taken was accelerated depreciation, in which case it will be taxed at whatever your income tax rate is.
But a Section 1031 Like Kind Exchange will allow you to defer taxes on that Capital Gains and Depreciation Recapture, and keep all of the profit, by investing it in another investment or business property similar to the one that you sold.
The requirements in the 1031 Exchange Rules are not difficult to meet.
:: You must reinvest all of the Net Sales Proceeds.
:: You cannot touch or control the proceeds.
:: You must buy a Replacement Property of equal or greater value.
:: You must identify the Replacement Property within 45 days.
:: You must close on the Replacement Property within 180 days.
:: Relinquished Property and Replacement Property must meet the IRS definition of “like kind” property.
:: Neither property can be inventory or stock in trade.
I go into much more detail on the 1031 Exchange Rules page above.
Now, we’ll take a typical investment situation and walk through the process of deferring all taxes forever.
Pay special attention to the role that accelerated depreciation plays in the transaction.
As I said, the tax on the recapture of regular straight-line depreciation is up to 25%.
But if you are in the high-income bracket when you sell your property, and you probably will be for that tax year, the tax on the accelerated depreciation that you took could be as high as 37%.
It's Like A Seminar In A Book
IF YOU USE A DELAWARE STATUTORY TRUST, TRIPLE NET LEASE, OR A T-I-C, YOU MUST HAVE THIS EDITION.
These are the real numbers from a real transaction. You can use your own numbers to see what your bottom line would be.
:: Alan Adams bought a Duplex ten years ago for $200,000 cash.
:: He assigned a value of $20,000 to the land, $180,000 to the building.
:: The furniture and furnishings had negligible value, none assigned.
:: He began claiming depreciation on the $180,000 building.
:: He built two garages for $30,000 and began claiming depreciation.
:: He borrowed $30,000 from the bank, putting a lien on the property.
:: The balance on the note is now $18,000.
:: He spent $20,000 cash on furniture and began claiming depreciation.
:: He has claimed a $65,400 in Straight-line Depreciation on the Duplex.
:: He has claimed $7,644 in Straight-line Depreciation on the garages.
:: His total Straight-line Depreciation claimed is $73,044.
:: He has claimed $15,200 in Accelerated Depreciation on the furniture.
:: His total overall depreciation claimed is $88,244.
:: His Basis in the property is now $161,756 (200,000 plus 30,000 plus 20,000 minus 88,244).
:: Bob Baker has offered him $400,000 cash for the Duplex.
:: His total costs of the sale will be $10,000 closing costs.
:: His Net Sales Proceeds will be $372,000 (400,000 minus 10,000 minus 18,000).
:: His Capital Gains will be $228,244 (400,000 sales price minus 161,756 depreciated basis minus 10,000 closing costs).
:: $15,200 of the $228,244 will be Accelerated Depreciation Recapture, taxed at 39.6%, resulting in $6,019 in taxes.
:: $73,044 of the $228,244 will be Straight-line Depreciation Recapture taxed at 25%, resulting in $18,261 in taxes.
:: $140,000 of the $228,244 will be regular Capital Gains (400,000 minus 10,000 minus 200,000 minus 30,000 minus 20,000) and will be taxed at 20%, resulting in $28,000 in taxes.
:: The total tax liability for Adams on the $228,244 Capital Gains will be $52,280 (6,019 plus 18,261 plus 28,000).
:: He will purchase a Fourplex from Carl Carter as his Replacement Property for $700,000.
:: His closing costs will be $5,000.
You can see how I arrive at each of these numbers by going to Capital Gains Tax.
Now let’s look at the investment plan that will allow Adams to turn this one investment into $31,000,000 of equity in three Triple Net Lease (NNN) Home Depot stores in forty years, without ever paying any Capital Gains taxes.
UNRECAPTURE SECTION 1250 PROPERTY GAIN
What you call deferred capital gains tax is what the IRS refers to as unrecaptured Section 1250 Property gain.
It is “unrecaptured” because it is deferred each time that you sell an investment property in a Section 1031 Exchange, with the proviso that it will be paid, that is, recaptured, when you eventually sell the Replacement Property.
But there is a way that you will never have to pay the taxes, both unrecaptured Section 1250 Property gain, and the Depreciation Recapture tax.
You story will be different, but this is how Alan Adams did it.
:: Adams is active in the community of real estate investors and finds a Buyer, Bob Baker, who is willing to pay him $400,000 cash for his Duplex, thus saving himself $24,000 in commission.
:: Adams researches property records for a Replacement Property and finds seven Fourplexes that he is interested in, all on the tax rolls for about $700,000.
:: Adams talks to his lender and gets a conditional approval for a loan up to 80% on the Replacement Property.
:: Adams talks to all seven owners, gets interests from three, makes verbal offers, and settles on one.
:: Adams looks at companies and individuals advertising their services as a Qualified Intermediary, and selects one who is an Attorney and a CPA, knowing that this person would have more to lose than the others if anything goes wrong.
:: Adams signs a contract with Baker to sell his Duplex for $400,000 providing for closing within 30 days, and with an option to extend the closing for two more 30-day periods.
:: Adams assigns the sales contract to his QI.
:: Adams signs a contract with Carter to purchase his Fourplex for $700,000 and with the same closing provisions as above.
:: Adams closes on the sale of his Duplex and the Net Sales Proceeds of $372,000 are sent by the Title Company to his QI who deposits $250,000 in one Qualified Trust Account, and the remaining $122,000 in another Qualified Trust Account, both insured by the FDIC.
:: Adams identifies the Replacement Property to his QI within 45 days.
:: Adams obtains a loan for $333,000 secured by the Fourplex.
:: Adams now owns a $705,000 property with a basis of $476,756 and deferred Capital Gains of $228,244 which has a deferred tax liability of $52,280.
:: Ten years pass, and, assuming the historic rate of property appreciation and historic interest rate, Adams sells the Fourplex for $1,255,000 and pays off the note, and closing costs, leaving $1,000,000 Net Sales Proceeds and an additional $773,244 in Capital Gains, with additional deferred tax liability of $201,043.
:: Adams purchases an Apartment Building as a Replacement Property for $5,000,000.
:: So, after 20 years, Adams has a $5M Apartment Building with $1,000,000 deferred Capital Gains and a deferred tax liability of $253,323.
:: He does this two more times, and at the age of 60 he ends up with three Home Depot Stores under NNN (Triple Net) Leases that require none of his time and provide huge cash flow.
:: The total value of his properties is $150,890,000.
:: The total equity in his properties is $31,000,000.
:: His total deferred Capital Gains is $21,560,000.
:: His total deferred tax liability is $5,605,000.
:: Before he dies, he structures his estate so that he and his spouse pass $10.9M to his heirs without taxation, and the remainder goes into devices to bypass probate.
:: All of the properties pass to his heirs with a new basis of the current Fair Market Value, so that they can be sold without incurring Capital Gains liability, and therefore no deferred tax liability.
This is how you buy and sell real estate all of your life without ever paying taxes on the profit.