We have a question that probably stumps a lot of people because there’s a lot of confusion about the depreciation tax savings that we get and benefit from real estate investing. So today’s question comes from Jonathan and he says, hi, Marco loved the podcast. I’m in the Washington DC area, own three condos to perform well, one breaks-even though it’s appreciated about 25% since I purchased it also own a single-family home out of the area, I’m going to sell the poor performing condo. And I’m considering a 1031 exchange as I’m planning to take the proceeds and invest in one or maybe two properties out of state. It seems like there are some major trade-offs with the 1031 exchange. Just wondering if you can explain the pros and cons, I’ll do my best.
For example, I would get to forego a $40,000 capital gain. If I do the 1031 exchange, I also have about $35,000 of paper losses on that condo that I’d be able to carry over into the new property. On the other hand, my understanding per my tax guy is that my entire existing depreciation schedule would also move to the new property. So instead of getting a new 27 and a half year timeline against a new structure where the improvement would be larger, I’d be carrying over my old depreciation schedule 22.5 years against a smaller quote-unquote improvement bottom line, I’d avoid a capital gain tax hit and would carry over some losses, but would lose tons of future depreciation, which would shield against the income taxes, which are higher than capital gains taxes. Anyway, that’s my understanding. Maybe you can clear this up and give a 10 31 explanation with pros and cons. Thank you.
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Okay, great question. I am going to give you a reasonably good, but general answer because everybody’s tax situation is different and this actually is or can become a little bit complicated, but I’m going to try to clarify and simplify. So what we’re trying to do here is just clear the confusion about the depreciation tax savings that come with the 1031 exchange, and as it applies to your particular situation. So for those of you new to this, 1031 is just basically a way for you to sell your real estate purchase replacement real estate with it, and defer the capital gains tax that you would normally be paying from the gains on that original property. And so it’s a beautiful thing because it allows you to depreciate the property in the case of residential for 27.5 years and write that off against the passive income of that property.
So what it does is it reduces and eliminates the tax impact from the income on that property. And it’s a great tool that I think a lot of real estate investors don’t understand, maybe don’t know about, or certainly don’t take advantage of it. And especially if you are someone who’s sitting on more than one property, you have a portfolio and more importantly, you have a lot of equity, something I call equity, rich cashflow poor. You can reposition that equity into one or more other properties and increase your cash flow, still protect and preserve the equity that you have. You’re just moving it to other properties and reset the clock on the depreciation schedule, which is really the core of the question here that I’m answering today from Jonathan’s question. So I am going to actually invite one of my 1031 exchange guys very soon, probably next week to record another episode about the 1031.
So you guys have a better understanding of what it is, how it works, how to take advantage of it, and maybe the pros and cons and pitfalls. So I’m going to keep it a little bit brief today, but we’ll expand on it when I bring on my guest in a week or so, but the short answer to the core question that you have here is that your tax guy’s wrong. I hate to say it. And I actually ended up making a phone call to double-check this cause you had me second-guessing it. So you do not carry forward. Your old depreciation schedule when you purchase one or more new properties from the equity you’re taking from the original property that you are disposing of, you will start that depreciation schedule all over again at 27.5 years. So even though you’ve had this property for five years and you’ve taken advantage of it, you’ve taken advantage of that deferred tax on the capital gains.
So when you make the swap from that original property to another property or two or four, whatever it may be when you swap, you reset the clock on the depreciation schedule, but you do carry forward. Whatever you have depreciated as a carry-over, however, you don’t pay tax on that until you either a sell the property or the properties without doing a 10 31 exchange or until you pass away and it doesn’t apply anymore. So the concept is you swap until you drop. So you keep swapping your properties using 1031 within that 27 and a half year period to reset the clock. And that will still apply to the improvements of that new property, not the land, but the improvements, basically everything, the sticks and bricks, everything above the dirt. And so you can take advantage of the 10 31 and the depreciation on your property or properties in perpetuity.
As long as you keep doing a 10 31, what they call swap till you drop. And this is a beautiful thing because you in effect can defer your capital gains forever. And then when your heirs or whoever is the beneficiary of your trust takes your property over the cost basis is reset. There’s a reset and they’re taking it over based on the market value of that day. Now there are some nuances and intricacies here along the way that is beyond the scope of this episode in your question, and it doesn’t necessarily apply, but the bottom line is this. And this is the important thing to understand is that you can continually take advantage of the tax benefits of real estate by properly implementing a 10 31 exchange strategy. As you grow your real estate portfolio. And over time, as you reposition your real estate portfolio to take advantage of newer markets, better markets that fit your investment goals, or to avoid having to run out of depreciation as a tax write off, which is a beautiful thing because it’s a non-cash expense.
If you will, you don’t have to do anything or spend any money in order to get it. The IRS allows you to depreciate your property for 27 and a half years. So it’s there to take advantage of, so you can do that indefinitely, you know until you pass away or you just are done with it. So when I have my guest on, we can talk about recapture and any recapture taxes that might apply. If you are not doing a 1031 exchange or how, and when that might come into play. So just stay tuned for that and make sure you subscribe to the show. So you are notified. I’m guessing that we’ll probably be out in a couple of weeks, but the bottom line is that depreciation does not go on forever and ever, and ever in one particular property, but you can keep taking advantage of it by adding to your portfolio or doing the 10 31 exchange.
The cost basis on residential is 27 and a half years. Commercially would be 39 years. And the only other way that you can lose this benefit is that if you remove the property from its service by essentially selling it, or you stop leasing it out. In other words, it does not become an income-generating asset for you. The last thing I will mention about the 1031 exchange and depreciation is the calculation of the cost basis. I’m not going to get too deep into this, but a lot of people are wondering, how do you calculate the cost basis of the replacement property? When you complete a 1031 exchange, you’re essentially transferring your real estate investment and the history on that property into a new property, a replacement property, and therefore your cost basis carries over from the original property or what they call the relinquished property to the new property.
So if the replacement property that you acquire in that 10 31 exchange costs more than the net sales proceeds of the one you relinquished, that difference is added to the cost basis on that new property. So as a quick example, let’s say you bought a property five years ago for hundred thousand dollars. And over time that you’ve owned this property, you’ve taken a total of $15,000 in depreciation. So that brings your adjusted cost basis on that new property down to $85,000, started at a hundred. Now it’s 85. And now let’s say you sell that property and you have the net proceeds of $150,000. So that’s what goes into your pocket. Well, would go into your pocket if you sold it and just walked away, that in effect gives you $65,000 in capital gains. It’s the 150,000 minus your cost basis of 85 leaves you a $65,000 capital gain. So now you start the 1031 exchange process and you buy a new property worth $200,000. Now, in this case, the $85,000 adjusted cost basis from that first property will carry over.
Plus the $50,000 of additional money that you needed to purchase that $200,000 property. Those combined become your new adjusted cost basis in your replacement property. Now, this might seem a little strange considering that you paid more for it, but that’s the way the 1031 exchange works. And then we’ll get more into that when I do a 10 31 specific episode, but the bottom line is you can make a simple calculation by taking the new acquisition costs, the $200,000 subtracting your capital gain, which in this example was $65,000. And that gives you the same number, $135,000. That’s your new cost basis. That’s what you would be calculating that new depreciation schedule on of 27 and a half years that you can now put towards, against the income of that property to lower your tax impact from the income. So that’s how it works. Anyway. I hope this helps we’ll get into more detail later.
We’ll probably talk about the two depreciation options. IRS wants you to do it one way, but you actually have two different ways to implement the depreciation schedule. The way the IRS wants you to do it is to have two depreciation schedules, one for the original cost basis, and one for the additional monies that you had to put up to purchase the property. So in the case, in the example, I just gave you yet $85,000 coming from the old property, plus the $50,000 of cash that you had to put up for the replacement property. Now you have two depreciation schedules that you’re running one for the full 27 and a half years on that $50,000. And the other would be for 22 and a half years. And this is probably where your tax advisor or tax guy is getting a little, maybe not confused, but where he’s focused in terms of carrying forward the old depreciation schedule.
So he’s not entirely wrong, but there is an alternative. And that is really to treat the replacement property as an entirely new asset. And so you need to make this election on the IRS form 4562, which is about depreciation and amortization. So again, not to get too deep into the weeds, there are really two options here. So there is a way to do it. And the key thing to know about this is that it’s the less complicated of the two options, but your depreciation deductions will be a little bit smaller than they would otherwise be. If you had run two depreciation schedules, side-by-side one from that relinquished property. Anyway, hope that made sense. I’ll stop there. Cause I don’t want to get this to become cloudy or complicated.
All right, Jonathan, I hope that helps. I appreciate the question. If anyone else has any questions about real estate investing or finance, go ahead, submit them. I’ll do my best to get to them whether by email or on the podcast, remember to subscribe if you haven’t done so already share this show with your friends, family, and other like-minded individuals who might want to learn about real estate investing or finance or creating wealth or creating passive income. Leave us a rating on iTunes. We greatly appreciate it. Thank you for listening. I will see you all on our next episode.
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