Depreciation recapture in an exchange

How depreciation affects basis

Depreciation deductions reduce taxable rental income year by year, and they reduce the property's adjusted basis by the same amount. The reduction applies to depreciation "allowed or allowable" under section 1016(a)(2), meaning basis is reduced by the depreciation an owner was entitled to claim whether or not it was actually claimed. An owner who never filed the depreciation schedule, or filed it incorrectly, does not avoid the basis reduction; the deduction the Code allowed still lowers basis even if it was never used to reduce taxable income. A lower basis means a larger gain when the property is eventually sold, and that gain is not all taxed the same way.

Residential rental property is depreciated on a straight-line basis over 27.5 years, and nonresidential real property over 39 years, under the modified accelerated cost recovery system. Because both schedules are already straight-line, the ordinary-income form of section 1250 recapture, which applies only to the amount by which depreciation exceeded straight-line, rarely comes into play for real property placed in service after 1986. What remains is the 25 percent unrecaptured gain described below, which applies to essentially all of the depreciation taken on the building itself, not to any excess.

Unrecaptured section 1250 gain: the 25 percent rate

When real property is sold outside an exchange, the portion of gain equal to the straight-line depreciation taken is unrecaptured section 1250 gain. Under section 1(h)(1)(E) and section 1(h)(6), that portion is taxed at a maximum rate of 25 percent, separate from and generally higher than the 0, 15 or 20 percent rates that apply to the rest of the long-term capital gain. Ordinary-income recapture under section 1250 itself, which claws back depreciation in excess of straight-line as fully ordinary income, applies only to that excess amount, and it is rare on real property placed in service after 1986, when accelerated methods for real estate were largely discontinued.

Section 1245 property and cost segregation

Not everything in a building depreciates the same way. Personal property components, such as carpeting, certain fixtures, and equipment identified through a cost segregation study, are section 1245 property rather than section 1250 property. On a sale, depreciation on section 1245 property is recaptured as ordinary income, not capped at 25 percent. Since the Tax Cuts and Jobs Act limited section 1031 to real property for exchanges after 2017, personal property that is not real property under state law or the section 1031 regulations can no longer be exchanged, and gain on it is recognized. Building components that are section 1245 property for depreciation may still be real property for the exchange (Treas. Reg. §1.1031(a)-3(a)(7)), but section 1245 recapture rules can still apply to them. Ask a CPA to review a cost segregation study before the sale, because it affects how much gain is recognized even when the real property portion of the same transaction is exchanged.

The net investment income tax

Gain on the sale of rental real estate, including the recaptured portion, is generally subject to the 3.8 percent net investment income tax under section 1411 for owners above the applicable income thresholds. The surtax applies on top of the 25 percent recapture rate and the long-term capital gains rate. The tax applies to the lesser of net investment income or income above the threshold. Gain on property used in a non-passive trade or business, which can include property of a qualifying real estate professional, can be excluded.

A worked example

A residential rental was bought for $500,000, of which $100,000 is land value. It was held ten years and sold for $700,000 with $42,000 of selling costs. The owner is in the 15 percent capital gains bracket and above the net investment income tax threshold.

Federal tax on the sale, before state tax

Step	Calculation	Amount
Depreciable basis	$500,000 minus $100,000 land	$400,000
Depreciation taken	10 years, straight-line	$145,455
Adjusted basis	$500,000 minus $145,455	$354,545
Total gain	$700,000 minus $42,000 minus $354,545	$303,455
Unrecaptured §1250 gain tax	$145,455 × 25%	$36,364
Capital gains tax	$158,000 × 15%	$23,700
Net investment income tax	$303,455 × 3.8%	$11,531
Federal tax due	before state tax	$71,595

Of the $303,455 total gain, $145,455 is taxed at the 25 percent recapture rate and the remaining $158,000 at the 15 percent capital gains rate, before the net investment income tax applies to the full gain. Simplified: the example ignores the mid-month convention and assumes income before the sale already exceeds the net investment income tax threshold. The depreciation recapture calculator works through these steps for a given purchase, holding period and sale price.

How a fully reinvested exchange defers all of it

An exchange that meets the conditions described in the boot guide defers the entire $71,595 in the example above, not just the capital gains portion. Neither the recapture nor the capital gain nor the net investment income tax is due in the year of sale; all of it carries forward into the replacement property.

Carryover basis and how depreciation continues

Under section 1031(d), the replacement property takes a basis carried over from the relinquished property, adjusted for any additional cash invested or boot recognized. For depreciation purposes, Treas. Reg. §1.168(i)-6 generally continues the old depreciation schedule on the carryover portion of basis, over whatever remains of the relinquished property's recovery period, while any excess basis, representing new money put into the replacement property, begins a new depreciation schedule of its own. Many owners and preparers instead make the election available under the regulations to treat the entire replacement property as one newly placed-in-service asset; either approach is a depreciation methods question for the return, not a condition of the exchange itself.

Boot is taxed as recapture first

If any boot is received, as described in the boot guide, the recognized gain is generally characterized as unrecaptured section 1250 gain to the extent of prior depreciation before the balance is treated as long-term capital gain; your tax advisor confirms the characterization. A relatively small amount of boot on a property with substantial depreciation can be taxed almost entirely at the higher recapture rate.

The step-up at death

Under current law (section 1014), property held until the owner's death generally receives a basis equal to its fair market value on the date of death, which removes the deferred income-tax gain, subject to exceptions such as appreciated property given to the decedent within a year of death that passes back to the donor. Because the deferred gain, including the deferred recapture, is embedded in the old, lower basis, the step-up removes it rather than merely postponing it again. Owners who keep exchanging and hold the final replacement property until death generally never pay the recapture that a series of exchanges deferred along the way.

Sources

• Internal Revenue Code §1016(a)(2) (basis reduction for depreciation).
• IRC §1250 and §1(h)(1)(E), (h)(6) (unrecaptured section 1250 gain, 25 percent maximum rate).
• IRC §1245 (recapture as ordinary income on personal property components).
• IRC §1411 (net investment income tax).
• IRC §1031(d) (carryover basis); Treas. Reg. §1.168(i)-6 (depreciation of like-kind exchange property).
• IRC §1014 (basis at death).