Is a 1031 Always the Best Choice?
March 29, 2017
Melissa Wall, CPA, Delap LLP
HFO Apartment Investor Newsletter
The days of running from the tax man and exchanging into whatever is available may soon be coming to an end. Many of Portland’s real estate professionals seem to be viewing the current multifamily market as frothy. However, for some, this tax savings tool still makes sense, but only if the transaction is one that the taxpayer would execute if they were not forced into it by the 1031 exchange criteria. If you wouldn’t consider buying the property with fresh capital, and don’t truly believe the asset you are receiving is of good value, paying the tax and taking the cash may be your best option.
The rules allowing a taxpayer to qualify for this treatment are very stringent and can often cause the taxpayer to recognize a portion or all of the gain if not fully satisfied. For instance, if the replacement property is not identified within 45 days, or if the replacement property is not closed on within six months, the exchange will not receive beneficial treatment. In addition, if boot is received—which can include cash left over from the new property acquisition or a reduction in liabilities assumed versus relieved—this will cause recognition of a gain. We have found that clients sometimes overlook the fact that all liabilities, including reserve accounts and security deposits, are included in the computation of boot and can lead to gain being recognized.
In our experience, some clients are electing to recognize the gain on the sale of their property and enjoy the flexibility and benefits of doing so. Such benefits include the ability to identify property that the client feels is of good value when it becomes available—rather than settling for something less during their 45-day window. These clients are cashing out at the high point of a cycle and waiting until the cycle begins again to re-invest. This takes advantage of resetting the depreciation clock in order to receive larger depreciation deductions over the next 10-20 years, as opposed to only receiving deductions on the adjusted basis of the original property. It is important to realize that we currently have relatively low capital gains rates and projections are that both capital gain and ordinary rates may increase. If this happens, the current market is the ideal time to sell, wait and invest in a new asset to receive additional benefits from depreciation deductions.
Property X is sold for $1 million with an adjusted basis of $500,000. Excluding ordinary income recapture and any selling expenses, the seller would recognize a gain of $500,000 taxed by the federal government at 20% ($100,000).
If the taxpayer then turns around and acquires an apartment complex for the $1 million, the useful life of residential real property is 27.5 years. This will generate a depreciation deduction of roughly $36,364 a year and a tax savings of nearly $14,400 ($36,364 x 39.6%) a year. After 7 years, the saving from ordinary deductions ($14,400 x 7 Yrs. = $100,800), will exceed the tax paid in recognition on the sale of the original property. In addition, the taxpayer will continue to receive this deduction for an additional 20 years.
The above example does not take into account application of the net investment income tax of 3.8%, or whether the taxpayer is active or passive or qualifies as a real estate professional.
Facts and circumstances of each taxpayer will ultimately determine the best course of action in a given transaction but both avenues should be considered when the decision to sell a property has been made.
Melissa Wall is a CPA and tax senior manager with Delap, where she works closely with real estate owners and high wealth individuals. Currently, her real estate clients are actively trading with over $85 million in 1031 transactions closing in the next month. Melissa may be reached at (503) 974-5713 and by email at firstname.lastname@example.org.