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Depreciation recapture in a like-kind exchange

Dear Tax Talk,
When I sell one of my rental condos, how will recapture of the depreciated value be addressed if I use a 1031 like-kind tax exchange to buy a replacement property? Thanks for your help. -- Deborah

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Dear Deborah,
Just as you will defer the tax on the sale of the property, you'll also defer the recapture of the accumulated depreciation in most cases. A section 1031 exchange allows the seller to defer tax on the gain from the sale of the property if he or she purchases replacement property of a like kind. The sale has to occur in escrow and the identification and closing of the replacement property have to meet strict time limits.

The gain is deferred by reducing the cost basis of the replacement property. The reduction is equal to the amount of the gain that was realized on the sale. For example, if condo No. 1 had a cost of $100,000 and accumulated depreciation of $10,000 and it sold for $120,000 in the exchange, $30,000 in gain was realized. This $30,000 gain is not recognized but instead reduces the cost basis of the replacement property. Upon a later sale, tax would be paid on this deferred gain.

Since depreciation recapture increases the amount of gain realized on the sale, this additional gain gets rolled into the cost of the replacement property but maintains its character upon a later sale. The reason that it maintains its character is that recapture is taxed at a higher rate: 28 percent versus 15 percent. For example, if you claimed $10,000 in depreciation on condo No. 1 and $5,000 on the replacement condo, the first $15,000 in gain on the eventual sale of the replacement condo would be taxed at 28 percent.

One type of depreciation recapture that is not eligible for rollover in a like-kind exchange is the amount that would be treated as ordinary income if the relinquished property were sold. In the context of real estate, this exception would apply mainly to commercial real estate depreciated using an accelerated depreciation method that applied to property prior to 1987. As a condominium is generally residential real estate, your depreciation would roll over into the replacement property.

Bankrate.com's corrections policy
-- Posted: June 17, 2005
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