What About 1031 Exchanges and
Recapture?
• What is recapture?
– Portion of a capital gain representing tax
benefits previously taken and taxed as
ordinary income.
– IRS will “recapture” the accelerated
depreciation received in the event of the
sale of the property.
Recapture
1245 property is purchased for $10,000 two years ago.
The owner sells the property for $9,000.
$3,000 has been taken in depreciation.
Adjusted cost basis = $10,000 - $3,000 = $7,000
Gain on the sale = $9,000 - $7,000 = $2,000
Since the sale price of $9,000 is less than the
recomputed cost basis of $10,000 ($7,000 + $3,000),
the total gain will be treated as ordinary income.
Recapture
If the property is sold for $13,000 $3,000 has been taken in depreciation.
Adjusted cost basis = $10,000 - $3,000 = $7,000
Gain on the sale = $13,000 - $7,000 = $6,000
Since the sale price of $13,000 is greater than the
recomputed cost basis of $10,000 ($7,000 + $3,000),
$3,000 will be treated as ordinary income and $3,000
will be treated as capital gain.
1031 Exchanges
• What is a 1031 exchange?
A 1031 exchange is a method for
deferring any gain realized when
investment property is sold for a profit
and the proceeds are rolled over into a
new investment property of like kind.
Recapture and 1031
Exchanges.
Property A Relinquished
Purchased for $2M
Adjusted Cost Basis of $1M
Property B replacement
Purchased for $4M
New Cost Basis =
$1 M carried over from the
original property
Sold for $4M
39 year depreciation
Sale of $4M with a purchase of $4M into like property
equates to no taxes on the transaction.
I will be relinquishing my current property and acquiring
new property. How will this affect my 1031 exchange?
Here is what a 1031 exchange would look like without
cost segregation.
Property A Relinquished
Purchased for $1M
39 Year Depreciation
Held for 5 years
Valued at $2M
Adj. basis = $871,795
Property B Replacement
1031
Purchased for $3M
Carryover Cost basis =
$871,795
$1M in excess cost basis
1031 Exchanges and Cost Segregation
The carry over cost basis of $871,795 will continue to
be depreciated over the remaining 34 years based on
Property A.
The new cost basis of $1M will begin a new 39 year
depreciation schedule.
$871,795
Cost Basis
$1M
Cost Basis
Total Depr.
Tax Benefit
(40%)
Years 1-34
$25,641
$25,641
$51,282
$20,513
Years 35-39
$0
$25,641
$25,641
$10,256
1031 Exchanges and Cost Segregation
A Cost Segregation study is performed on the new
property.
30% of the property is reclassified to 5, 7 and 15 year
property.
This accelerated depreciation will result in increased
depreciation of $104,904 compared to the $51,282
based on 39 year schedule.
This results in a yearly tax benefit of $36,716 – A 205%
increase over the original schedules.
1031 Exchanges and Cost Segregation
By combining the 1031 exchange and cost segregation,
the owner has deferred $1,000,000 in capital gains
and increased his annual depreciation deduction
from $25,641 on Property A to $104,904 on the new
property.
With proper planning these two methods can provide
tremendous tax saving opportunity. Executing these
two methods together should be carefully
considered with a tax professional.
Can The Exchange of Cost Segregated
Property Lead to Recapture?
Cost segregation can result in recognition of gain in an
otherwise tax-deferred 1031 exchange.
Fair Market Value
Relinquished
Replacement
$4M
$4M
Can The Exchange of Cost Segregated
Property Lead to Recapture?
Relinquished 1245 Property
Fair Market Value
$900,000
Adjusted Cost Basis
$700,000
Cost Recovery
$300,000
Recomputed Cost
Basis
$1,000,000
The relinquished property has 1245 property with an
adjusted cost basis of $700,000. The cost recovery
of this property has been $300,000
Can The Exchange of Cost Segregated
Property Lead to Recapture?
A cost segregation study is performed on
the replacement property
Replacement 1245 Property
Fair Market Value
$500,000
Can The Exchange of Cost Segregated
Property Lead to Recapture?
Relinquished Property
Replacement Property
Fair Market
Value
$4,000,000
$4,000,000
FMV of 1245
$900,000
$500,000
The owner believes this is a non-taxable
transaction due to the overall FMV of the two
buildings
Can The Exchange of Cost Segregated
Property Lead to Recapture?
Not exactly - Code Sec. 1031 requires that
the relinquished property and the
replacement property be like-kind.
Relinquished Property
Replacement Property
Fair Market
Value
$4,000,000
$4,000,000
FMV of 1245
$900,000
$500,000
Problem
Can The Exchange of Cost Segregated
Property Lead to Recapture?
If the relinquished property is not like-kind to
any portion of the replacement property, then
all of the realized gain on that relinquished
property will be recognized in the exchange.
The portion of the recognized gain
attributable to depreciation recapture will be
treated as ordinary income.
Recapture Example
Example 1 – 1245 property sold for $900,000
Relinquished 1245 Property
Fair Market Value
$900,000
Adjusted Cost Basis
$700,000
Cost Recovery
$300,000
Recomputed Cost
Basis
$1,000,000
In this example, because the amount realized upon
the disposition of the property ($900,000) is lower
than the recomputed basis, the entire gain is treated
as ordinary income.
Gain taxable as ordinary income = $200,000
Recapture Example
Example 2 – 1245 Property sold for $1,200,000
Relinquished 1245 Property
Fair Market Value
$1,200,000
Adjusted Cost Basis
$700,000
Cost Recovery
$300,000
Recomputed Cost
Basis
$1,000,000
In this example, because the recomputed basis is lower than
the amount realized upon the sale, the excess recomputed
basis over the adjusted basis is treated as ordinary income.
The remaining amount from the sale is treated as capital gain.
Gain taxable as ordinary income = $300,000
Capital Gain = $200,000
Recapture and 1031 Exchange
Example
Example 3 – 1245 property is disposed of in an exchange. The
replacement 1245 property has a fair market value of $500,000
Relinquished 1245 Property
Fair Market Value
$900,000
Adjusted Cost Basis
$700,000
Cost Recovery
$300,000
Recomputed Cost
Basis
$1,000,000
This transaction represents a trade down
in $400,000 of 1245 property. Therefore,
the owner has ordinary recapture equal
to the realized gain of $200,000.
Recapture and 1031 Exchange
Example
Example 4 – 1245 property is disposed of in an exchange. The
replacement 1245 property has a fair market value of $1,000,000
Relinquished 1245 Property
Fair Market Value
$900,000
Adjusted Cost Basis
$700,000
Cost Recovery
$300,000
Recomputed Cost
Basis
$1,000,000
There is no recapture. If the replacement
property is composed of equal or greater value
of 1245 property , the owner can defer the entire
gain without any recapture.
Is This Recapture Worth
It?
Is This Recapture Worth It?
The owner effectively “purchased” the extra ordinary
income deductions at the cost of possibly
recapturing these deductions as ordinary income in
a later exchange.
Had the owner stuck with the 39 year schedule, there
would only have been $25,000 per year of deductions
with no recapture at the time of the exchange.
TIME VALUE OF MONEY
1031 Exchanges and Cost Segregation
These options should all be
discussed and analyzed with a tax
professional. CPC can help look at
the benefits and risks associated
with such a transaction.