IRC Section 1250 Issues and 1031 Like-Kind Exchanges
Section 1250 Excess Depreciation Recapture Issues in a 1031 Exchange -
Have you ever wondered what happens to the Section 1250 excess depreciation recapture when depreciable real estate is exchanged for other depreciable real estate under IRC 1031 or IRC 1033?
If property subject to Section 1250 excess depreciation recapture is disposed of in the course of a 1031 exchange (or 1033 involuntary conversion) for replacement property that is also Section 1250 property, the potential ordinary income recapture rolls over into the replacement property and is deferred until a taxable sale of the replacement property occurs (IRC 1250(d)(4)(D) and Reg. 1.1250-3(d)(5)). Since the recapture is deferred, the amount of the recapture remains fixed and does not become diminished over the life of the replacement property. Therefore, taxpayers are compelled to track this deferred and potential 1250 ordinary income recapture until a cash-out occurs in order to comply with this requirement.
If the replacement property is raw land and contains no Section 1250 property, the Section 1250 excess depreciation is taxed and cannot be deferred.
Unrecaptured Section 1250 Gain
Unrecaptured Section 1250 Gain references all depreciation taken on a real property, whether straight-line or otherwise, except for Section 1250 excess depreciation subject to ordinary income recapture (see above). Unrecaptured Section 1250 Gain is the depreciation taken on the property that was not subject to recapture as ordinary income. Unrecaptured Section 1250 Gain is taxed at a maximum capital gain rate of 25% under the long-term capital gain tax rules (15% for taxpayers in the 15% and 10% tax brackets on ordinary income)..
What happens to Unrecaptured Section 1250 Gain in a 1031 tax-deferred exchange?
Have you ever wondered what happens to the Unrecaptured Section 1250 Gain when a property is exchanged for replacement property in a 1031 Exchange? Is the Unrecaptured Section 1250 Gain deferred in the same manner as Section 1250 Excess Depreciation referred to above? Guess what, the Code provides no guidance on this question. Does it simply disappear?
Tax professionals believe that the conservative position is to treat it in the same manner as Section 1250 Excess Depreciation is treated (see above). Under this assumption, the Unrecaptured Section 1250 Gain is deferred and rolls-over to the replacement property and will be subject to the maximum capital gains tax rate of 25% if the replacement property is sold at a future date.
If taxpayers set up the replacement property on a depreciation schedule in the manner prescribed by Reg. 1.168(i)-6T the accumulated depreciation rollover from the relinquished property will be obvious since it will be retained on the depreciation schedule just as if the relinquished property had not been sold. But, even this can get complicated if the taxpayer has to report some 25% rate gain on the 1031 exchange as a result of receiving boot (see below), in which case the Unrecaptured Section 1250 Gain may not be the same as the accumulated depreciation shown on the replacement property depreciation schedule.
If the taxpayer elects to rollover "old basis" into the new basis for the property, the accumulated depreciation on the relinquished property will become invisible on the depreciation schedule of the replacement property. Obviously, taxpayers will need to keep notes on the amount of the deferred Unrecaptured Section 1250 Gain if they wish to comply with this requirement.
What if a taxpayer has to report some gain from a 1031 exchange as a result of receiving boot?
If a taxpayer has to report some gain as a result of receiving boot in a 1031 exchange, is the boot 25% rate gain under this theory? Many tax professionals believe that the 25% rate gain should be taken into account before the 15% rate gain becomes applicable. This is consistent with the Section 453 requirements for installment sale reporting. However, there is no guidance compelling this treatment of boot. And, if the taxpayer's new depreciation schedule presents accumulated depreciation on the relinquished property under Reg. 1.168(i)-6T, it seems logical that the 25% rate gain would follow the basis (cost and accumulated depreciation) being transferred to the replacement property and be deferred to a future disposition cash-out.
Taking into account the deferred ordinary gain from Section 1250 recapture of excess depreciation and the deferred 25% rate capital gain from Unrecaptured Section 1250 Gain property, get ready for some major brain damage as these rules apply to 1031 exchanges. Please contact us with questions.
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