By: William L. Exeter President/CEO of Exeter 1031 Exchange Services, LLC.
Q: I bought a rental property in 1979 at age 24 and did a 1031 exchange in 1991, which has been continuously rented. I am currently listing this property for sale and planning to do another 1031 exchange, renting the replacement property for two years and then converting it to our primary residence. My questions are:
(1) Am I correct in understanding that the $46K in depreciation taken since 1979 carries over to the replacement property provided that no gain is taken in the exchange, and that I would have to pay federal tax at 25% on this depreciation plus the next two years if I sell the replacement property after five years of ownership under section 121?
A: Yes, you are right on the money. The depreciation would be deferred when you structure your next 1031 Exchange transaction into your new replacement property. You should also know that this strategy was changed with the 2008 Tax Act. Your capital gain will be prorated between the amount of time the property was held as rental property versus the amount of time it is held as your primary residence, and only the amount held during your primary residence usage will be tax free up to the limitations. The amount allocated to your rental property period will be taxable.
Q: (2) I had a Schedule F loss on my 2008 return that was limited due to the amount of adjusted gross income, such that the depreciation taken did not have an affect in reducing my tax liability. Would I not count that year’s depreciation when determining a future depreciation recapture amount, or count it and carry the prior year loss forward on subsequent year returns?
A: Yes, you would count that toward a future year depreciation recapture amount. The loss will be carried forward and will be used at some point in the future. It is important to note that you when (if) you are subject to depreciation recapture taxes in the future you will be taxed on all depreciation taken whether you actually took it or not. So, it is important to take the annual depreciation deduction even if you are not receiving any current benefit because it will hurt you in the future if you do not.
Q: (3) If depreciation taken on relinquished property since 5/6/1997 is carried forward to the replacement property, then for the purpose of determining long-term capital gain, is the number of years of non-excluded gain under Section 121 (number of years rented since 1/1/2009) divided by the total number of years of ownership since 1979?
A: It is applied to the number of years on the new property.
Q: (4) Is it likely that the Congress and the Administration will change the tax law in the future such that today’s planning may result in a drastically different outcome?
A: It is always possible. They have changed Section 121 twice during the last five years.
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!