It’s true that conducting a 1031 exchange helps you defer the capital gain taxes and depreciation recapture. And while deferring the capital gain taxes seems pretty clear to us, we all have our doubts related to depreciation recapture.
When it comes to real estate properties, depreciation is yet another issue faced by the owners and tenants. It can be a result of general wear and tear or harsh weather conditions. However, when it comes to deducting your taxes, depreciation can actually help in tax deductions and increased cash flow. In short, investors can use depreciation to their own advantage.
So, if you are wondering how you can use depreciation for an advantageous 1031 exchange, this article might be worth reading. Read on to explore what exactly is depreciation and how it can help with 1031 exchange.
Understanding Depreciation
The true meaning of depreciation differs from situation to situation. However, regardless of this, here is how the IRS defines depreciation.
According to the IRS, depreciation is a recovery of a property’s cost over several years. The term ‘recovery’ means that you can recover this depreciation through annual income tax deductions. Depreciation occurs due to factors like general wear and tear, obsolescence of the property or deterioration.
If we get into the real estate language, depreciation is estimated by calculating the loss of value on any improvement of the property. And, because the land is not subjected to any wear or tear, the value of the land does not depreciate. However, The structures built on it, usually known as improvements, are subject to depreciation.
In a simpler term, each property has a part that witnesses a loss in value due to wear and tear. And, you must put in an amount of money to make up for that loss. This cost reduces the actual worth of the property and is termed depreciation.
The Different Types Of Depreciation In A 1031 Exchange
When it comes to 1031 exchanges, there are two different types of depreciation- single schedule and two schedule.
A two scheduled method is generally used to calculate depreciation in a 1031 exchange. To calculate depreciation, you need an adjusted cost basis of the relinquished property and the remaining cost basis of the replacement property.
To determine the first schedule depreciation, you must divide the adjusted cost basis by 24.5 years. The digit you get would symbolize annual depreciation. To calculate double schedule depreciation, you must also divide the remaining cost basis by 27.5 years.
How Does Depreciation Lead To An Increased Cash Flow?
Increased income means higher cash flow. And, a depreciated property leads to deductions on tax returns. This means that you have to spend an amount from your income to pay for the depreciation. And a reduced depreciation would mean reduced income, which would further mean lower income tax, and, thus, higher cash flow.
In short, you receive higher tax breaks through depreciation recapture.
The depreciated value, then, goes back to your net income after having made the required improvements. This results in a higher cash flow without having to pay more income taxes.
Wrapping Up
It’s true that depreciation can be a major factor that might reduce the net worth of your relinquished property. But, if you keep the exact figures in mind, you can leverage the depreciation to your own advantage. Like capital gains, it is possible to defer your depreciation recapture when doing a 1031 exchange. However, you must keep the rules and timeline in mind to make it successful.