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Depreciation Recapture Issues in a 1031 Exchange

Depreciation and depreciation recapture issues are something that any Investor should take into consideration when considering the plethora of options available in real estate investment, as these issues can have a significant effect upon income tax as it applies to an Investor’s portfolio.

As an Investor, depreciation expenses in the form of deductions relating to the renovations/upkeep of your real property held for rental purposes is required - as defined under Section 1250 of the Internal Revenue Code - as the typical wear and tear imposed by time and the elements is recognized as a very real thing that an Investor is expected to contend with.

To qualify for depreciation deductions, the Investor’s in-service property must not be excepted property; have a determinable useful life; have an expected life of more than 12 months; be property in which the Investor has a capital investment; and be used in the Investor’s business. Personal use property or property held for sale does not qualify for depreciation deductions.

Land cannot be depreciated, but structures and equipment (AKA tangible property, such as vehicles and buildings) on said land can be depreciated. Things such as copyrights and computer software are known as intangible property and can also be depreciated.

When it comes to Income Taxes, an Investor may find themselves subject to the maximum Federal capital gain income tax rate of 15% under current Federal capital gain income tax rates. However, a flat Federal income tax rate of 25% is applied for depreciation recapture, and state and local taxes may figure into the equation as well. It is these extensive income tax liabilities that may prompt an Investor to engage in a 1031 Exchange in order to keep their losses at a minimum.

When depreciable real estate is sold, a complex set of rules comes into play due to the fact that a maximum rate of 25% will apply to the portion of gain that is eligible for capital gain treatment even though it is attributable to previously allowable depreciation; this is known as “Unrecaptured section 1250 gain.” In addition, a maximum rate of 15% will apply to the balance of the gain.

Unless an Investor takes advantage of a tax-deferred or tax-exclusion strategy, they may have to add back (or recapture) into their taxable income the amount of depreciation taken on their investment property when it is sold. Depreciation is required be included in the depreciation recapture income tax computation upon the sale of the Investor’s real estate investment. Excess depreciation and 1250 unrecaptured gain is recaptured when depreciable section 1250 property is exchanged for non-depreciable real property.

Disclaimer: 1031 exchange made simple does not guarantee the performance of the QI's in our referral network and we can not be held liable for any misrepresentations or mistakes in regards to a 1031 exchange by one of the QI's that we refer to you. 1031 Exchange made simple does not provide tax advice nor can we make representations regarding the tax consequences of an exchange transaction. 1031 Exchange made simple is a 1031 QI Referral Network. 1031 made simple is not responsible (in any way) for the performance, creditability, and financial condition of any QI in our network. In this new economic environment it is imperative that all potential 1031 exchange customers do their own due diligence and research on any QI that they may use, on a 1031 exchange. Please verify and check the validity of the Bonding and Insurance of your QI. It may be wise to have your 1031 exchange accounts set up as separate, individual customer accounts. Our web site is to be used as a information based web site only. All parties doing a 1031 exchange must consult their tax advisors or attorney for this information.

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