By: William L. Exeter, President/CEO of Exeter 1031 Exchange Services, LLC.
Each month we find it helpful to review some of the common questions we receive about 1031 Exchanges. Your questions are always welcome. We invite you to submit them to us at firstname.lastname@example.org or by posting them to the Exeter Discussion Board at exeterboard.com
ALLOCATION OF COST BASIS WHEN MULTIPLE PROPERTIES ACQUIRED
Q: We purchased a large property using a 1031 Exchange from the sale of a previous rental property. We have split that larger property into three parcels. Two parcels have a single family home on them, and one parcel is a vacant building lot. If we sell the vacant lot first, how should we handle the proceeds? How is the profit calculated when we don’t sell all the parcels at once? Also, if we move into one of the units (which has the original address) instead of selling it, does that change things?
A: Your cost basis from your relinquished property as well as your deferred gain and accumulated depreciation would be deferred into, and be allocated between, the three separate parcels that you acquired as part of your 1031 Exchange transaction. Your cost basis in the new property would also be adjusted up since you acquired a larger property as your replacement property.
You would most likely have to recognize some of your depreciation recapture and pay the corresponding tax since one of the three (3) lots is vacant (i.e. has no depreciable structures).
The allocation of your cost basis, deferred gain and accumulated depreciation is generally calculated based on the fair market value of each individual property as a percentage of the total fair market value of all the properties acquired. You might also allocate the values using acreage or square footage. Consult with your tax advisor to determine the most appropriate method to use in allocating the cost basis, deferred gain and accumulated depreciation between the new parcels.
Once this has been calculated, each new separate parcel has its own independent cost basis, deferred gain and accumulated depreciation. You can then sell one parcel and calculate the gain you would recognize on the sale of that one parcel. You can decide whether to sell the vacant parcel and cash out (pay the taxes) or structure another 1031 Exchange and acquire another rental/investment property once you know what your income tax consequences will be from the sale of just one parcel.
You can certainly convert one of the properties into your primary residence. However, you should make sure that you have held the investment property after initially acquiring it through your 1031 Exchange as rental, investment or business use property for a sufficient period of time to demonstrate your intent to hold for investment. Advisors often recommend between 12 to 24 months before you move into it and convert it into your primary residence. This ensures you do not jeopardize your 1031 Exchange. There are no income tax consequences from the act of converting it into your primary residence as long as you have held the property for rental or investment as mentioned above.
WHY CAN’T I START DEPRECIATING MY NEW PROPERTY AT THE FULL PURCHASE PRICE?
Q: I don’t agree with my accountant. I did an exchange about two years ago. The property I sold was fully written off on my taxes, so I did an exchange and bought another property. It was worth a little more than the property I sold so that I could begin writing the property off on my taxes again. My accountant said that I can’t do this. Is he right?
A: Yes, your tax advisor is correct. You are not permitted to begin depreciating your newly acquired property all over again since the property was acquired through a 1031 Exchange. The reason is actually very simple.
You would have recognized (and paid tax on) your depreciation recapture had you just sold your property and not acquired replacement property through a 1031 Exchange. Depreciation recapture essentially means that the amount of depreciation you had taken (written off) on your income tax returns over the years will now be added back to your taxable income since the property was sold (not exchanged).
However, in your case, you structured a 1031 Exchange and acquired replacement property. You were therefore permitted to defer the payment of your depreciation recapture taxes because of the 1031 Exchange. The “adjusted cost basis” in your newly acquired replacement property is not the amount that you paid for the property. The adjusted cost basis is essentially your old adjusted cost basis in the property that you sold deferred (carried forward) into your newly acquired property and adjusted for closing costs (assuming the sales prices of both properties were identical). You would have additional (new) cost basis to begin depreciating if, and only if, you acquired a larger (more expensive) replacement property.
For example, let’s assume that you acquired real property worth $100,000. Your tax advisor reviewed the transaction and determined that $90,000 of the purchase price would be allocated toward improvements (buildings or structures) located on the real property and would therefore be depreciable and that $10,000 of the purchase price would be allocated toward the land value and would not be depreciable.
You then proceed to fully depreciate the improvements located on the property during the time that you own it. This means that your original cost basis was $100,000, which is what you paid for the property. Your adjusted cost basis is now $10,000 because you have fully depreciated (written off) the $90,000 cost value that was allocated toward the improvements on the real property.
You decide it is now time to sell the real property. So, let’s further assume (just to keep the math simple) that you sell the property for $200,000 and you acquire a replacement property for exactly $200,000 through a 1031 Exchange. The 1031 Exchange allows you to defer your income tax consequences into the new replacement property.
The $200,000 purchase value represents three things: (1) deferred gain of $100,000 (because the property increased in value from $100,000 to $200,000), and (2) deferred depreciation recapture of $90,000 (the amount written off over the years as depreciation), and (3) adjust cost basis of $10,000 (non-depreciable land value). You are not able to depreciate this property because the adjusted cost basis is essentially land value.
Let’s assume the same information contained in this example except that you acquire property worth $250,000 instead of $200,000. This means that you traded up in value by acquiring a replacement property that is worth more than the relinquished property that was sold. You now have an additional $50,000 in cost basis that can be depreciated because you acquired a more expensive property (you acquired $50,000 in new or additional cost basis by trading up that can now be depreciated).
Have 1031 Exchange or 1033 Exchange questions? We have answers. Please submit them to us at email@example.com. You can always call us toll-free at 866-393-8370.
William L. Exeter is President/CEO of Exeter 1031 Exchange Services, LLC. He’s been in the fiduciary services industry since 1980, began specializing in real estate tax strategies in 1986 with a specialty emphasis in 1031 and 1033 Exchanges, Self-Directed IRAs, and Land Trusts. Bill has written and lectured extensively on 1031 and 1033 Exchanges, Self-Directed IRAs, and Land Trusts and is a frequent guest expert on San Diego Radio Shows “The Financial Advisors — Money Talk Radio Show” on AM 600 KOGO and on “Inside Business Radio Show” on AM 1000 KCEO. You can email your questions to firstname.lastname@example.org, call (866) 393-8370, fax to (866) 393-8371 or mail to 402 West Broadway, Suite 400, San Diego, CA 92101, exeter1031.com. We have Answers; Go Ahead, Ask!