Depreciation and 1031 Exchange

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Depreciation can be a confusing and difficult concept to understand. Individuals and businesses need to have a working knowledge of how to use depreciation to maximize their profits. More importantly, they need to understand the tax consequences of recaptured depreciation and how to effectively defer the tax in a 1031 tax deferred exchange.

Depreciation in its simplest form is allocating the cost of an asset over the expected useful life. The value of the asset when it is new is not the same as the value after the asset has been used for two years. Depreciation adjusts the correct value on the business’ books. It sounds pretty simple but understanding the ins and outs can make a huge difference in the amount of taxes a company or individual pays.

An example of why to depreciate can be a business that buys a used excavator for $160,000. The modified accelerated cost recovery system (MACRS) specifies the life of every capital asset. In the typical environment of the excavator it’s useful life is five years. That doesn’t mean the excavator cannot be used for more than five years, but sets a limit recognized by the Internal Revenue Service (IRS) for how the asset is depreciated. Each year one-fifth, or twenty percent, of the $160,000 purchase price, or $32,000 can offset income taxes. This is advantageous for multiple reasons, such as lower taxes and higher net income.

When a business sells a capital asset, that tax depreciation is recaptured. For the unprepared, this can be a tax scenario that will trigger taxes owed on the sale. Recapture tax depreciation can cost a significant amount of money in taxes. For example, the recaptured tax is 25 percent of the amount of tax depreciation taken or eligible to be taken. A 1031 exchange defers the recaptured tax depreciation when a like-kind asset of equal or greater value is acquired within 180 calendar days of when the relinquished or an old asset is conveyed to the Buyer.

1031 Exchange Defined

A 1031 exchange is known also as Internal Revenue Code Section 1.1031 and states “no gain or loss shall be recognized on the exchange of property held for productive use in trade or business, or for investment, if such property is exchanged solely for property of like kind which is to be held for productive use in trade or business or for investment.” Property is either real or personal property. Real property includes land, condominiums, single family residential homes or commercial property. While land does not depreciate, the structures or improvements do. The MACRS life of a commercial property is 39 years while a condominium is 27.5 years. Noncommercial aircraft has a life of five years.

Benefits of an exchange overselling

  • The exchange allows the taxpayer to postpone taxes on the sale of equipment used in the business.
  • By not having that tax bill due now there is more money to invest in the business.
  • Realign the equipment no longer useful for like-kind equipment.

Variety of 1031 Exchanges

  • Simultaneous – The exchange occurs at the same time. A business gives up the exchanged equipment at the same time they get the new equipment.
  • Forward – A delayed exchange is simply when there is a delay between the time a business gives up the property and the time they get the new property.
  • Reverse – The new property is received before the older property is sold.

1031 Exchange Requirements

  • Property must be considered like-kind.
  • The purpose of the trade must be for equipment used in the business or for investment.
  • The exchange must take place, which means the equipment cannot be sold and the new equipment purchased is supported by exchange documentation.
  • A taxpayer cannot have access to the exchange proceeds.
  • A taxpayer who sells is the taxpayer who must purchase.

When equipment and aircraft are sold, the primary tax deferred is depreciation, not appreciation given equipment and aircraft do not typically appreciate in value over time. Consequently, understanding the impact of taking depreciation on net profits and the twenty five percent recaptured depreciation when selling is the primary reason to initiate a 1031 exchange, especially when the intent is to replace with like-kind equipment.

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