When it comes to selling investment property, depreciation is a gift with a catch. When you own the property depreciation tax deduction is a wonderful thing. The IRS essentially lets you pretend that your property is losing value at an even rate over 27 1/2 years (39 years if it’s a commercial property. You get to take that pretend loss as a tax write off – Bonus!!!
But wait. The IRS wants that tax break back when you sell the property. It is one of those “I’m from the government, and I’m here to help” kinds of things. And it gets even worse. Even if you have never taken the depreciation allowance tax benefit on your tax return, the IRS will make you pay back what you could have taken when you sell. That’s how naughty it is. In the words of Lord Bramwell “Like mothers, taxes are often misunderstood but seldom forgotten.”.
In comes the knight on shining horse – the 1031 exchange. When you complete a 1031 exchange you get to defer the tax on all gain and the dreaded “depreciation recapture”.
A 1031 exchange allows you to defer all capital gains tax and depreciation recapture when you sell and purchase investment property. The key to the 1031 is that you must use a 3rd-party qualified intermediary to manage the 1031 process. And they must be in place prior to the close of your sale—you cannot simply sell and reinvest. It is this intermediary who can guide you through the wilderness of IRS rules around tax deferral, so you don’t get burned by a helpful IRS.