Depreciation plays a vital role in determining the adjusted basis of property, making it a crucial element in the non-recognition provisions of IRC §1031. It enables taxpayers to deduct a reasonable amount for the wear and tear experienced by investment or business-use property. When such property is sold or exchanged, the Tax Code mandates the recapture of previously claimed depreciation. Depreciation recapture applies to the sale’s proceeds received, up to the amount of depreciation taken over the asset’s lifespan. Investment/business-use property is subject to depreciation recapture upon sale, but the specific provisions differ based on whether the asset is real or personal property.
IRC §1250 property generally refers to improved real property eligible for depreciation deductions on a taxpayer’s return. The recapture provisions applicable to §1250 property are somewhat complicated. Property placed in service on or before December 31, 1986, utilized an accelerated cost recovery (ACRS) depreciation method, while a modified accelerated cost recovery (MACRS) straight-line system was employed after 1986. For §1250 property, any depreciation claimed under ACRS beyond what would be allowed under the MACRS straight-line cost recovery method is taxed as ordinary income. Additionally, any gain attributable to unrecaptured depreciation under the MACRS schedule (referred to as unrecaptured §1250 gain) is currently taxed at a rate of 25%.
IRC §1245 property generally encompasses depreciable personal property, although the Code classifies certain types of real property placed in service before 1987 as §1245 property. Currently, §1245 property refers exclusively to personal property used in a trade or business. Disposing of §1245 property that results in a gain triggers depreciation recapture. Unlike §1250 property, however, recaptured depreciation on §1245 property does not benefit from a preferential lower tax rate. Under §1245, all depreciation taken on the property must be recaptured and taxed as ordinary income, but only to the extent that gain is recognized from the sale or exchange transaction.
Cost Segregation: Some owners of large real estate properties employ a “cost segregation” study to maximize the advantages of both real property straight-line depreciation and accelerated depreciation for personal property. A cost segregation study involves a detailed engineering analysis that reclassifies specific components of §1250 (real) property as §1245 (personal) property. The objective of cost segregation is to identify fixtures, HVAC systems, and other elements of personal property incorporated into the building and treat them separately from the real estate. This enables taxpayers to take advantage of more generous accelerated depreciation schedules available for personal property. When exchanging improved real property that underwent cost segregation, caution must be exercised to ensure that the Replacement Property has sufficient §1245 property to offset §1245 recapture, as well as enough §1250 property to offset §1250 recapture. Failure to meet these requirements may result in the recognition of boot. For instance, if a cost-segregated shopping center is exchanged for raw land, there would be no depreciable personal property in the Replacement Property to offset the §1245 depreciation claimed for the shopping center relinquished property, necessitating recapture.
Step in the Shoes: In 2004 the IRS revised the rules for “step in the shoes” depreciation to eliminate any tax advantage of acquiring Replacement Property with a longer recovery period or more favorable accelerated depreciation method than the Relinquished Property it replaced. Treasury Regulation §1.168(i)-6T requires that portion of basis in the new Replacement Property representing exchanged basis (not basis from additional cash) to be recovered over the remaining life of the Relinquished Property using the same method that was used for the Relinquished Property if the Replacement Property has the same or shorter recovery period or the same or more accelerated depreciation method. Alternatively, the regulation requires exchanged basis to be recovered over the remaining life of the Relinquished Property utilizing the depreciation method of the Replacement Property if it has a longer recovery period or a less accelerated depreciation method. In summary, the IRS wins both ways. Pre-existing basis of property acquired in an exchange must now be depreciated using the recovery period and method applicable to either the Relinquished or Replacement Property, whichever is least advantageous to the taxpayer.
As each situation is unique, exchangers should always seek the guidance of an attorney or tax advisor in order to determine depreciation recapture and/or any relevant offsets thereto.
If you or someone you know has questions about the 1031 exchange process, our team of experts at Peak 1031 Exchange are here to help. Contact us today at [email protected] or by calling us at 818-960-7019 to discuss the deferral of capital gains taxes with a 1031 exchange.