With long term capital gains tax rates set to approximately double, possibly retroactively to April, real estate investors who want to take advantage of this seller’s market are, of course, considering 1031 exchanges. A 1031 exchange lets you delay the payment of capital gains taxes, perhaps, until a new administration changes the taxes to rates that are more favorable to real estate investors.
But 1031 exchanges don’t always make sense. First of all, that tax obligation does not go away, it only gets delayed. There are proposals to eliminate at least part of the step-up in basis upon death.
There is a cost to a 1031 exchange. Besides the fees for the facilitator, you are not gaining a fresh depreciation schedule for the new property. You are, instead, continuing the deprecation of the prior property. If you have held the prior property for a long time, and will hold the new property for a long time (or if the new property is more expensive than the exchanged property) your total depreciation deductions will be less than if you sold outright, and then bought your next property without a 1031 exchange. In addition, you have time pressure to identify to the replacement property, which may result in a hasty purchase at perhaps too high of a price. That is particularly true in the current seller’s market.
Consider the following example:
I purchased a duplex in Cheney, WA in 2002 for $88,300. I tend to hold my properties for a long time. The land value was $11,640, meaning the building had a value of $76,660. Buildings are depreciated over 27.5 years, meaning a deduction of $2,787 per year has been taken over 19 years, reducing the basis by $52,953 to $23,707. 8.5 years of depreciation are left.
I can sell the duplex now, in 2021, for $335,000. That would give me a gain, for capital gains tax purposes, of $335,000-$23,707=$311,293.
If I use a 1031 exchange, I can delay taxes on $311,293 gains until later. Here are the new Biden capital gains tax rates https://smartasset.com/taxes/biden-capital-gains-tax. They have indicated that they want to make them retroactive to April, 2021 but we will not know for sure if that will come to pass until they actually pass something in congress.
The problem with doing a 1031 exchange is that I would need to mostly continue to depreciate the replacement rental property under the depreciation schedule of the old duplex. I could only continue depreciation for the remaining 8.5 years for a deduction of 8.5 x $2,787= $23,689. This would be carried over to the new property. I would also be able to depreciate the additional money sent to acquire the new property, calculated as the difference between the acquisition cost of the new property (let’s say $335,000) minus the capital gains ($311,293) from the sale, or $23,707. This amount will be depreciated over the full 27.5 years. That means total deductions of $23,698+$23,707=$47,396 over the life of the new property, if I kept it for 27.5 years.
If I sold, paid capital gains taxes, and bought a replacement property, I would be allowed to depreciate the full value of the new building. If I paid, for example, $335,000 for the new property (building plus land), with a land value of $25,000, that leaves $315,000 (building value) of deductions over the next 27.5 years or $11,455 per year. If I held the new property for the full 27.5 years, by doing the 1031 exchange I would lose out on $315,000-$47,396=$267,604 of deductions. That is a big price to pay just for a delay.
With interest rates close to zero, the time value of money of that delay could be said to be near zero. By time value of money, I mean that a dollar tomorrow has a lower value than a dollar today as the money supply increases over time, causing inflation. A present value calculator is here, if you want to run some scenarios: Time Value of Money Calculator – Calculate TVM (gigacalculator.com)
With a 1031 exchange you have to put your proceeds into a more expensive property, which you could otherwise buy with an (approximate) 3% loan minus the tax deduction, or 2% effective loan rate. So you have to compare the loss of depreciation versus 2% time value of money you are deferring.
If you are thinking you can 1031 into a rental property, then convert to a primary residence, then take the (partial) capital gains exemption on primary residences, that may not work out the way you think it will. Depreciation recapture cannot be excluded if you do this. Only some of the remaining capital gains will be excluded. Namely, you can only exclude capital gains that can be attributed to the time during which the property was used as your residence. And you must hold the property for at least five years after the 1031 exchange took place. https://www.fool.com/millionacres/taxes/1031-exchanges/using-1031-exchange-turn-rental-property-your-primary-residence/
The analysis changes depending on the price of the replacement building and number of years the new building is held.
I am not an accountant and cannot guarantee that I have made these calculations 100% correctly, but this is my rough understanding based on the following articles:
https://www.fool.com/millionacres/taxes/depreciation/depreciation-after-1031-exchange-how-it-works/
https://www.nerdwallet.com/article/taxes/capital-gains-tax-rates
https://www.thetaxadviser.com/issues/2009/apr/like-kindexchangesdeferralisnotalwaysthebestoption.html (detailed example calculations using tax rates BEFORE the Biden increases).
There are many unknowns, such as whether the Biden capital gains tax rates will really be retroactive (if they will affect you), how recaptured depreciation will be taxed under the new rates, and how long the new property will be held. But it is important to talk to an accountant, give them your assumptions, and ask if a 1031 exchange really makes sense.
To make things more complicated, there are two depreciation options after a 1031 exchange. One option is to depreciate the carryover basis of new property over the remaining period of the exchanged property using the same depreciation method and convention that was used for the relinquished property. Any excess basis is treated as newly placed in service property. That’s the method I used above. This option is typically better when the relinquished property is closer to the end of its tax life. The simplified option is to treat the adjusted basis of the exchanged property as if it was disposed of at the time of the exchange. The carryover basis and excess basis for the acquired property are treated as if placed in service on the date acquired. The basis of the new property is the adjusted basis of the exchanged property plus any additional amount paid for it. Bottom line for both methods is you are missing out on some amount of depreciation for the new property.
As it is all very complex, a tax accountant or tax attorney should be consulted before making any decisions. Do not just assume that a 1031 exchange will save you money on capital gains taxes.