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1031 Exchange Investments: Depreciation Of Replacement Property

replace a property with 1031 exchange investment

As an investor, you’ve probably heard about 1031 exchange investments. Income properties such as warehouses, offices, shopping malls, and other commercial investment properties. They can all utilize a 1031 exchange in order to maximize profits when selling your investment property.

1031 exchange investments help you recapture income that otherwise, you could lose. It’s possible by allowing you to defer taxes when selling your income property.

Below you’ll find details on exactly how that works.

What Are Capital Gains Taxes?

Capital assets are significant pieces of property – such as investment properties, cars, stocks, bonds, furniture, precious metals, or artwork. When you sell or exchange a capital asset, you will either have a capital gain or a capital loss.

Capital gain transactions are short-term if the capital asset has been in your possession for less than a year. A long-term capital gain is if the asset has been held for longer than one year.

Short-term capital assets are taxed differently than long-term assets. They are taxed at ordinary income rates which can often be as much 40%. Long-term assets, on the other hand, are taxed at a much lower rate of not more than 15%. In addition, capital assets can be broken down into personal property or investment property.

These classifications, like the short term vs. long term, also help to determine whether or not a loss can be deducted.

capital gain taxes

For example, if the capital asset is personal property, i.e. it is used for personal properties, then you cannot only deduct a loss due to theft or casualty. However, if the capital asset is an investment property, then certain types of loss may be taken away.

What Is Depreciation?

Over time the wear and tear on an asset lead to a decrease in value. This decrease in value is termed depreciation, and in real estate investment properties, depreciation can be written off from your taxes.

Investment properties depreciate at either 27.5 or 39 years. But once the property is sold, you will have to pay back a percentage of the depreciation that was claimed at the rate of 25%.

Termed depreciation recapture tax. And the sum is still only a percentage of the total amount that was claimed yearly when you were the owner of the property. Depreciation recapture tax can be significant if an investment property has been held for a long time. It’s one of the reasons why many investors choose to carry out with a 1031 exchange investment.

how to measure depreciation

What Requirements Are Necessary For A Property To Qualify For Depreciation?

Property that is used for personal use cannot be depreciated.

Investment property which is held for investment rather than sale purposes does qualify for depreciation, with these caveats:
– Must be a property you own;
– The property must be of a type that can wear out;
– The property must be used for investment purposes;
– The property must last more than one year.

For example, properties last more than one year, and they can be depreciated.

However, if you have installed an equipment, furniture, or computer equipment and that is used for the businesses leasing your property (such as an HVAC system), then they too can be depreciated, under the assumption that is will last for more than one year.

Land cannot be depreciated since land does not wear out, become obsolete, or get used up. But if you constructed a new building and put in landscaping right next to the property and around the property’s borders, the plants and bushes next to it can be depreciated.

how to participate in 1031 exchange investment

That’s because they are so close to the building, that they are considered part of the building. If by any chance, the building gets torn down, they will also be affected.

Do I Have To Pay Both Capital Gains And Income Taxes?

If you do not participate in a 1031 exchange, investments become liable for both capital gains taxes and income taxes. Your income tax rate will depend on your tax bracket, but capital gains taxes are 15% – 23.8%.

You will also have to pay a depreciation recapture tax, which as stated earlier, is 25%. Therefore you will be liable for three sets of taxes when you sell your commercial income property.

How Can I Participate In A 1031 Exchange?

If you are selling a commercial property and would like find out more about 1031 exchange investments, fill out a form here to contact Jeff Gitt, who has more than 40 years experience in the commercial real estate.

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Tags: 1031 exchange investments, capital assets, capital gains taxes, Depreciation, income property, investment property, taxes