Bonus Depreciation Recapture and 1031 Exchanges

Real estate investors are turning to the tax deferral benefits of a 1031 exchange in droves to avoid paying significant depreciation taxes upon the sale of their investment properties. Even bonus depreciation recapture is eligible for 1031 exchanges. This is the investment vehicle of choice when real estate investors plan to sell off a current investment and purchase a new one that qualifies as a like-kind exchange. When combined with bonus depreciation, the tax savings benefits of a 1031 exchange can have a major impact for the investor.

Learn more about bonus depreciation recapture below and how many real estate investors are capitalizing on the 1031 exchange to defer their significant tax liability.

What is Bonus Depreciation?

bonus depreciation recapture is avoided with the 1031 exchange

Depreciation is how businesses are able to deduct the cost of an asset over one of two ways, whatever is shorter:

However long the business owns and uses the asset, or;

The asset’s useful life as determined by the IRS.

In real estate investing, buildings may be depreciated over a certain amount of time and are one of the many tax advantages of the asset class. The issue is that when it comes time to sell, the IRS will want their money in the form of depreciation recapture.

Bonus depreciation is an extension of this concept and allows the taxpayer to deduct a larger portion of the depreciation amount in the initial years after acquiring the asset. This is especially helpful for investors who do not plan on using the asset for an extended period and can benefit from the improved cash flow of taking a larger deduction in the years immediately following the purchase of the asset.

The Impact of the Tax Cuts and Jobs Act of 2017 (TCJA) on the Rise of Bonus Depreciation

The TCJA allows bonus depreciation to be accelerated quite significantly from its previous cap of 50% to 100% on qualifying assets. Keep in mind that the qualifying property for bonus depreciation under the TCJA must have a useful life of no more than 20 years, which excludes all real property from this potential tax shelter. In previous years, tangible property included in the sale of real property was eligible for inclusion in the 1031 exchange, but the new TCJA provisions distinguish between tangible assets and real property. To qualify for bonus depreciation under the TCJA, the qualifying property must have been bought after September 27, 2017. In its current form, the legislation also requires that the eligible property be purchased before January 1, 2023.

Improvements such as driveways or parking garages qualify for bonus depreciation recapture
Improvements such as driveways or parking garages qualify for bonus depreciation

Per the TCJA, state law definitions of real property versus personal property determine how the asset is classified for federal income tax purposes. The benefit for taxpayers under this new classification scheme is that many improvements and fixtures on structures can now be treated as eligible for both 1031 exchange special treatment and bonus depreciation, which amplifies the tax deferral savings for the taxpayer.

In addition, the TCJA allows taxpayers to deduct the full amount of the bonus depreciation even if it is in excess of the maximum limit on deductions.

Is Bonus Depreciation Subject to the Depreciation Recapture Tax?

bonus depreciation recapture tax

Unfortunately, bonus depreciation is subject to the depreciation recapture tax within the tax year of their sale. This means that any gains on the property upon its sale are taxed at the regular income tax rate instead of the reduced capital gains tax rate. That is why it is even more prudent for investors to plan strategically in their use of a 1031 exchange to defer the tax liability for depreciation recapture potentially indefinitely.

One way that the bonus depreciation changes under the TCJA have helped investors defer tax liability is by allowing for the accelerated depreciation of tangible property received during the sale of real property that would otherwise be treated as boot and subject to taxation of the gains.

How Can the 1031 Exchange Help Defer Bonus Depreciation Recapture?

bonus depreciation recapture man finding out
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The 1031 exchange is one of the most effective tools in the investor’s arsenal to avoid the sting of the bonus depreciation recapture tax in the year that they sell their investment property. As long as the investor is effectively classifying each property as like-kind for the purpose of the 1031 exchange, the tax liability for bonus depreciation and depreciation recapture upon the sale of a property can be deferred indefinitely.

It is important to consult with a qualified tax professional to ensure that the property that you seek to classify as a like-kind exchange is indeed eligible. Failure to meet the like-kind exchange requirements could result in taxable gain upon the sale of the property.

Making the 1031 Exchange Work for Your Real Estate Investments | Don’t Pay Bonus Depreciation Recapture

If you think that you may own investment properties that could qualify for a 1031 exchange upon their sale and want to also take advantage of bonus depreciation, you should consult with an experienced accountant or tax planning professional as early as possible. Navigating the complexities and eligibility requirements of the 1031 exchange combined with the bonus depreciation benefits under the TCJA may require expert tax accounting advice to avoid incurring unexpected and significant tax liabilities.

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