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George Saenz, the Tax Talk columnistTaxes on final 1031-exchange property sale

Dear Tax Talk,
We purchased a beach condo on Florida's west coast, in July 2004, using a 1031 exchange. This was purchased as a rental property. What are the tax implications of selling a rental property purchased in a tax-free 1031 exchange?

Since we have owned it for over one year, will it qualify for long-term capital gains treatment? Since we are above the income limits, we have not been able to claim any of the expenses against our income. When we sell, I understand that we will be able to claim all expenses not claimed to date. Also, how is depreciation expense treated in the sale? We are not real estate professionals.
-- Robert

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Dear Robert,
Does the start of another hurricane season have you worried? When you do a Section 1031 exchange, the gain that you would have had on the first property, if sold, is rolled over into the replacement property, thus reducing the replacement property's cost basis. When you sell the replacement property outright, you'll pay tax on the accumulated profit from both properties.

Depreciation is an annual deduction of the cost of the property. Depreciation reduces your basis in the property below its original acquisition cost. Accumulated depreciation on a property is taxed at a higher rate than the gain beyond your acquisition cost. In addition, the depreciation you claimed on the first property is still an element of the cost of the replacement property, and this accumulated depreciation will also be taxed at a higher rate.

For example, if the first property cost you $100,000, and you claimed depreciation of $10,000, and you received in the exchange a value of $200,000, your gain was $110,000. If the replacement property cost you $300,000, your adjusted basis after the exchange is $190,000. If you claimed another $10,000 in depreciation on this property and it sells for $350,000, your overall gain is $170,000 ($190,000 adjusted basis less $10,000 more in depreciation equals $180,000, and $350,000 minus $180,000 equals $170,000.) Of this gain, $20,000 is depreciation recapture and $150,000 is long-term capital gains.

The depreciation recapture is taxed at a maximum rate of 25 percent, and the remaining gain is taxed at a maximum rate of 15 percent (because you have owned it for more than one year, you qualify for long-term capital gains rates). By the way, in a Section 1031 exchange, the time that you owned the first property is added to time you owned the replacement property, in determining if you qualify for long-term capital gains.

You have suspended losses from rental real estate, as your income did not allow you to currently deduct these losses and you are not real estate professionals. These losses are deductible in full, in the year that you sell the property and can, in fact, save you tax at a rate higher than the maximum rates that apply to the recapture and the long-term gain.

To ask a question on Tax Talk, go to the "Ask the Experts" page, and select "taxes" as the topic.'s corrections policy -- Posted: July 20, 2006
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