Author: Ben Mandel
When using a 1031 exchange to defer the tax on investment property, the depreciated cost basis of the relinquished property is carried-forward to the replacement property and any subsequent replacement properties purchased in the same line of exchanges. This significantly dilutes the depreciation benefit.
For instance, if a real estate investor purchased an office building for $1 million and held it for 10-years, over the 10-years, they took approximately $256,000 in depreciation. The real estate investor then sold the office building for $2.5 million and purchased a replacement office building for $5 million using a 1031 exchange. Once the investor purchased the replacement property, the remaining carry-forward depreciation benefit available to them from the relinquished property was $744,000. While the investor deferred the taxes on the $2.5 million sale, they will only have $19,000 a year to depreciate over the next 39-years. Also, the depreciated cost basis will continue to reduce year over year that the property is held. Further, if the real estate investor purchases another replacement property using the same 1031 exchange, the depreciation continues to become more diluted.
If the real estate investor had been able to re-establish a new fully depreciable cost basis of $5 million, the investor would benefit from $128,000 a year of depreciation, rather than $19,000 a year. This is a notable difference of $109,000 per year. Additionally, if the real estate investor held the replacement property for 10 years, the total lost depreciation benefit could be up to $1,090,000.
Given the added depreciation benefit, how you deal with future real estate investment purchases is very important. The decision isn’t only about deferring the capital gains tax but also about maximizing the depreciation by re-establishing a fully depreciable cost basis in the next real estate investment.
Horizon Tax Advantage has a solution where an investor can sell their real estate investment and defer the taxes while establishing a new fully depreciable cost basis to maximize the depreciation benefit.
Please contact us for more information.
Disclaimer: The content provided here is for education and illustration purposes only. It is not intended to provide tax, legal, financial or investment advice; nor does it guarantee that tax deferral will be achieved. Interested parties should consult with their legal, tax, and investment advisers before participating in any transaction.
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