Ideas for how to avoid paying recapture

[nwsteve]

Hope this is not hijack but I am trying to figure out legal ways to avoid paying the recapture. The only ones I have found are death and a 1031 exchange--others?
It seems that even with a gift of a depreciated asset, you have to deduct the recapture amount from the amount of the deduction.
If there are other ways, I am "all ears"
Nwsteve

Mod Edit - this was broken off at the OP's request to a thread of it's own.

 

[Sunset]

In case you didn't know;
You can do a 1031 into a shared investment much like a REIT, except you have a share of some real estate vs a share of a company.
This was news to me as I always thought 1031 was just a building to building exchange.

 

[Onward]

Little known fact: the amount of the sale price you allocate to the depreciated asset does not have to be the amount you allocated to it for purposes of depreciation.

Let's say you bought a rental house for $100,000. For purposes of depreciation, you allocated $60,000 to the land and $40,000 to the structure. So over the years you depreciate the $40,000.

Then you sell the house. You do NOT have to allocate the gain 60/40. Instead, you can allocate gain to the structure equal to its adjusted basis (after depreciation), and the remainder (vast majority) of the gain to the land.

In this way you reduce or eliminate the gain on the structure, also eliminating recaptured depreciation.

 

[brucethebroker]

You could exchange for your future "retirement home/principal residence". Rent it out for a year or two (read up on CPA determinations (per IRS code) of time spent as rental-opinions vary), then move in for the rest of your life.

Or sell it later. Apparently, the gain is split out to investment property use and personal residence use (tax free), the way I understand it.

Of course, consult your CPA/Atty first.

 

[Amethyst]

This makes sense, since how can you "depreciate" land? You can't use it up or wear it out - well, not usually, anyway. (I'm sure some people could figure out ways to wear out land).

What happens if, over time, you depreciate the building down to nothing? Do you stop taking depreciation, or can you actually achieve a negative cost basis?

Little known fact: the amount of the sale price you allocate to the depreciated asset does not have to be the amount you allocated to it for purposes of depreciation.

Let's say you bought a rental house for $100,000. For purposes of depreciation, you allocated $60,000 to the land and $40,000 to the structure. So over the years you depreciate the $40,000.

Then you sell the house. You do NOT have to allocate the gain 60/40. Instead, you can allocate gain to the structure equal to its adjusted basis (after depreciation), and the remainder (vast majority) of the gain to the land.

In this way you reduce or eliminate the gain on the structure, also eliminating recaptured depreciation.

 

[calmloki]

Little known fact: the amount of the sale price you allocate to the depreciated asset does not have to be the amount you allocated to it for purposes of depreciation.

Let's say you bought a rental house for $100,000. For purposes of depreciation, you allocated $60,000 to the land and $40,000 to the structure. So over the years you depreciate the $40,000.

Then you sell the house. You do NOT have to allocate the gain 60/40. Instead, you can allocate gain to the structure equal to its adjusted basis (after depreciation), and the remainder (vast majority) of the gain to the land.

In this way you reduce or eliminate the gain on the structure, also eliminating recaptured depreciation.

As it happens, we are pretty close to this situation so I have an interest, but am confused. If in your example the property sells for $200,000, and you held the rental property 27.5 years so it was fully depreciated the taxes on sale would be on $200,000-$100,000=$100,000, not ($200k-$100k)+$40k depreciation recapture=$140k? I like the idea, but it seems a bit too good...

 

[Sunset]

As it happens, we are pretty close to this situation so I have an interest, but am confused. If in your example the property sells for $200,000, and you held the rental property 27.5 years so it was fully depreciated the taxes on sale would be on $200,000-$100,000=$100,000, not ($200k-$100k)+$40k depreciation recapture=$140k? I like the idea, but it seems a bit too good...

I thought it would be:
depreciated value of house = 0
House valued it as 40K and the land as 60K.

Capital gain is: selling price 200K - original price 100K = normal 100K capital gain. (taxed at whatever tax rate for capital gain applies for you).

Recapture depreciation is all depreciation taken = 40K (25% tax rate)

You end up with 2 amounts each possibly taxed at different rates.

 

[Letj]

In case you didn't know;
You can do a 1031 into a shared investment much like a REIT, except you have a share of some real estate vs a share of a company.
This was news to me as I always thought 1031 was just a building to building exchange.

How does that work if you still have a mortgage on the real estate?


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[Cobra9777]

As it happens, we are pretty close to this situation so I have an interest, but am confused. If in your example the property sells for $200,000, and you held the rental property 27.5 years so it was fully depreciated the taxes on sale would be on $200,000-$100,000=$100,000, not ($200k-$100k)+$40k depreciation recapture=$140k? I like the idea, but it seems a bit too good...

Using your $200K sale price and 27.5 year holding period, the gain is $140K regardless of the land/building allocation. The question is how much gets taxed at the 25% recapture rate, and how much at regular CG rates (max 20%). If the 60/40 purchase allocation ratio was maintained at sale, then $80K of the gain would be subject to the 25% rate.

Onward seems to suggest adjusting the allocation of sale proceeds such that the depreciable building is only allocated an amount equal to its adjusted cost basis. In your example, that would be zero sale proceeds assigned to the building since it is fully depreciated. This attributes all gain to the non-depreciating land and thus no recapture and the entire $140K gain would be taxed at regular CG rates. That would never fly if the building was still a functional rental. If it was an uninhabitable pile of rubble, yes.

But that's an extreme example. I interpreted Onward's suggestion more along the lines of... if the allocation was 60/40 at purchase, and you took a few year's depreciation, maybe you could stretch it to 70/30 at sale to offset the recapture. For example, if the property sold for $110K after depreciating for 5 years, and you changed the allocation from 60/40 to 70/30, the result would be no gain on the building and thus no recapture at 25%.

But again, this has to be based on actual facts and circumstances. The IRS requires that the allocation between land and building be based on FMV. This applies to both your purchase price and selling proceeds. Generally, this would be based on either: (a) an independent appraisal performed in conjunction with the transaction, or (b) a ratio derived from tax assessment values. If you choose an allocation that is drastically different from either of those, you are in dangerous territory, IMO.

I agree that the allocation ratios can be different, and there's certainly nothing wrong with taking an aggressive position, i.e., allocate as much as possible to the building at purchase, and as much as possible to the land at sale. But for me, that means, if you have 2 or 3 data sources, pick the one that works to your advantage. Don't arbitrarily assign an amount to the building which is exactly equal to adjusted cost basis to avoid recapture.

 

[nwsteve]

Perhaps there are nuances to calculating the recapture I do not appreciate, but I thought the recapture amount comes directly from your previous tax returns. If you use TTax, one of the worksheets shows the accumulated depreciation (recapture amount plus current year depreciation). Not clear to what degree you can really reallocate basis. I do bet if you use a different amount for recapture than what you have already reported, you will get a "love note" from the IRS asking for proof.
Not a cpa, so YMMV.
Nwsteve

 

[Texas Proud]

Using your $200K sale price and 27.5 year holding period, the gain is $140K regardless of the land/building allocation. The question is how much gets taxed at the 25% recapture rate, and how much at regular CG rates (max 20%). If the 60/40 purchase allocation ratio was maintained at sale, then $80K of the gain would be subject to the 25% rate.

Onward seems to suggest adjusting the allocation of sale proceeds such that the depreciable building is only allocated an amount equal to its adjusted cost basis. In your example, that would be zero sale proceeds assigned to the building since it is fully depreciated. This attributes all gain to the non-depreciating land and thus no recapture and the entire $140K gain would be taxed at regular CG rates. That would never fly if the building was still a functional rental. If it was an uninhabitable pile of rubble, yes.

But that's an extreme example. I interpreted Onward's suggestion more along the lines of... if the allocation was 60/40 at purchase, and you took a few year's depreciation, maybe you could stretch it to 70/30 at sale to offset the recapture. For example, if the property sold for $110K after depreciating for 5 years, and you changed the allocation from 60/40 to 70/30, the result would be no gain on the building and thus no recapture at 25%.

But again, this has to be based on actual facts and circumstances. The IRS requires that the allocation between land and building be based on FMV. This applies to both your purchase price and selling proceeds. Generally, this would be based on either: (a) an independent appraisal performed in conjunction with the transaction, or (b) a ratio derived from tax assessment values. If you choose an allocation that is drastically different from either of those, you are in dangerous territory, IMO.

I agree that the allocation ratios can be different, and there's certainly nothing wrong with taking an aggressive position, i.e., allocate as much as possible to the building at purchase, and as much as possible to the land at sale. But for me, that means, if you have 2 or 3 data sources, pick the one that works to your advantage. Don't arbitrarily assign an amount to the building which is exactly equal to adjusted cost basis to avoid recapture.

Bold mine...

You cannot have more recapture than you took in depreciation... the recapture is capped at $40K....

 

[Cobra9777]

Bold mine...

You cannot have more recapture than you took in depreciation... the recapture is capped at $40K....

You are correct. It would be $40K at 25%.

 

[Sunset]

How does that work if you still have a mortgage on the real estate?
...

A 1031 exchange is really a 2 step process with a time limit, meaning you sell your rental which could include paying off the mortgage, then invest the money in another qualified "thing" which is normally thought of as another rental building.

The time limit is short so one has to be familiar with all the rules or get assistance to do it.

 

[Letj]

A 1031 exchange is really a 2 step process with a time limit, meaning you sell your rental which could include paying off the mortgage, then invest the money in another qualified "thing" which is normally thought of as another rental building.

The time limit is short so one has to be familiar with all the rules or get assistance to do it.

My understanding is that your replacement property/real estate investment would have to equal at least the sales price. In this case, you would have to come out of pocket with cash in order to invest in the REIT at the sales price since the property you surrendered was not paid off. Is my understanding correct?


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[Gatordoc50]

You can do an exchange for a property of less value. There will be some tax consequence. So if you bought a home for 250 and had a gain of 100 and then purchased a home for 300, you would pay tax on just the 50 excess and carry the rest. This is a simplification, of course.