Explained: What Role Does Depreciation Play In A 1031 Exchange? (Michael Brady & Alex Shandrovsky)

In this episode, Robert talks to Michael Brady & Alex Shandrovsky about depreciation recapture’s role in 1031 Exchanges.
Robert Leonard:
What role does depreciation play in a 1031 exchange? There’s been a lot of talk, and I’ve heard a lot of things about depreciation recapture when you sell a property. What role does that play in a 1031 exchange? And, for those who don’t know, what exactly is depreciation recapture?
Michael Brady:
Let’s start with depreciation. A benefit of owning real estate properties as an investment is that you get to take an income tax deduction each year to the extent of a portion of the value of your investment in the property. For residential properties, you have the 27 1/2-year depreciation schedule. For commercial properties, it’s 39 years. And so, you’re taking a tax deduction for a 39th of the value every year. That’s going to offset your rental income, and so you may actually have losses or very minimal income because of depreciation. Now, the downside is when you sell a property, you have to pay that back. Granted, you had tax savings for all those years, but now you have the depreciation recapture. That’s taxed at a higher rate than traditional capital gains tax. The real estate portion of your recapture is typically taxed at a rate of about 25% as opposed to 15% or 20% for federal and long-term capital gains tax. That’s the downside of depreciation. 1031 exchanges will allow you to defer the depreciation recapture as well by doing a 1031 exchange so you’re not just deferring your capital gain but also that depreciation recapture.
Alex Shandrovsky:
I will just add one caveat right now. You’re missing certain investors’ leverage tool called bonus depreciation, which is essentially accelerated depreciation. It’s a great tool to offset not even capital gains tax, but actually income tax. It’s a great tool. We highly recommend that, and actually have a cost sec team that specializes just in this area. There is a higher rate of recapture that happens to the bonus depreciation, but again, that would be deferred through a 1031 exchange. At a certain point, you will have to pay back that tax but that deference allows you to leverage that money right now. The dollar today might be more valuable than the dollar later when it comes to investments.
Michael Brady:
The ultimate technique in 1031 exchanges is swapping until you drop. It’s where you continue to do 1031 exchanges during the course of your lifetime, and ultimately die owning a piece of appreciated real property. Under current tax laws, the capital gain tax disappears. Your estate will get a step-up in the cost basis, and the capital gains will disappear. Of course, as a consequence, at your last dying breaths, you’ll think, “Well, at least my kids are getting away from paying capital gains taxes.” A good way to create generational wealth is by doing that.
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[@frankhouck4446]

But aren’t I minimizing my ability to depreciate future properties? I cant reuse that basis