on final 1031-exchange property sale
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.
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
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.
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