A reader of our “Maximizing Sec. 199A Deductions” monograph recently e-mailed to ask about the Sec. 199A Sec. 1031 connection.
His question? How do you handle the Sec. 199A deduction for income generated by property acquired through a Sec. 1031 “like kind exchange.”
The question is a really good one. And it points out—as the reader surely understood—an interesting conundrum: Should real estate investors change the way they think about Sec. 1031 exchanges given the way the Sec. 199A works?
The answer to this question? Probably some real estate investors should reassess their thinking about Sec. 1031 exchanges. But the tax accounting gets tricky.
In this blog post, therefore, I briefly describe how Sec. 199A works for real estate investors, how a Sec. 1031 like kind exchange works, and how these two taxpayer-friendly code sections work against each other when you combine them.
How Sec. 1031 Like Kind Exchanges Work
A very quick, simplified illustration shows how Sec. 1031 exchanges work.
Suppose you purchased an apartment building for $1,000,000 and allocated $800,000 to the building and $200,000 to the land.
Further suppose you fully depreciated the building over three decades—an interval during which the property appreciated in value to $2,000,000.
If you want to sell the original apartment building for $2,000,000 and then buy a $2,000,000 replacement property, you will pay income taxes on the $800,000 of depreciation you deducted over the decades. (That’ll run, say, 25%, so $200,000.) Further, you’ll pay capital gains on the $1,000,000 of appreciation. (Let’s say this runs 20% so another $200,000.)
The taxes on the sale and reinvestment, then, run $400,000 in this example.
Sec. 1031 says this, however. If you trade the old building for the new building, you don’t have to pay those taxes.
Further, in the case of a trade, your new building’s basis will equal not the $2,000,000 price you essentially paid for the building, but the $200,000 of basis you had “left over” in the old building due to land.
Pay attention to this basis thing: If you sell the old property and buy a new property for $2,000,000, you have to pay (per our example) $400,000 in taxes. But your basis in the new building equals $2,000,000.
Alternatively, if you effect a Sec. 1031 like kind exchange, you don’t pay that $400,000 of income taxes and your basis in the new building equals $200,000.
Note: Someday when you sell the new building, you probably will need to pay the taxes on the appreciation and depreciation recapture. The only way to avoid this tax is to never sell…
Now let’s look at how the Sec. 199A deduction works for a real estate investor facing this investment choice.
How Sec. 199A Deduction Works for Real Estate Investors
The Sec. 199A deduction gives real estate investors a deduction equal to 20% of the income they earn on a property. Essentially, this income equals the property cash flow plus any mortgage principal payments minus any depreciation. (This is the same value reported on Schedule E, by the way.)
However, the Sec. 199A deduction gets complicated for high income real estate investors. High income real estate investors means single taxpayers with taxable income over $207,500 and married taxpayers with taxable income over $415,000.
Note: A single taxpayer with taxable income between $157,500 and $207,500 and a married taxpayer with taxable income between $315,000 and $415,000 get their Sec. 199A deduction “phased out” as described here: Sec. 199A Deduction Phase-out Calculations.
For these high income taxpayers, in any event, the Sec. 199A still equals (probably) 20% of their real estate property’s income. But a catch exists: The Sec. 199A deduction can’t exceed the greater of two amounts:
- 50% of the W-2 pages paid by the business (which is the real estate property)
- 25% of the W-2 wages paid by the business plus 2.5% of the original basis of the depreciable part of the property.
Most real estate investors won’t pay W-2 wages probably. Which means the above rules may for high income taxpayers limit their “real estate” Sec. 199A deduction to 2.5% of the original basis of the depreciable part of the property.
Determining Original Basis of Depreciable Real Estate
Another wrinkle. The “original basis” value used in the Sec.199A works in an odd manner when you talk about real estate.
The actual statutory language gives the gritty details and appears in Sec. 199A(2) and Sec. 199A(6). But suppose you pay $1,000,000 for some apartment building and then allocate $800,000 of the purchase price to the building and $200,000 to the $1,000,000.
In this case, the original basis value you use for the Sec. 199A deduction calculation equals $800,000 as long as you’re taking full years of depreciation–so probably the first 27 calendar years of ownership for a residential property and probably the first 38 calendar years of ownership for a nonresidential property.
Note: You typically depreciate residential property over 27.5 years and nonresidential property over 39 years.
But for all practical purposes, once you deduct that last full year of depreciation, the original basis value drops to zero.
The Sec. 199A Sec. 1031 Tradeoff
Okay, I apologize that we are now at the very bottom of the rabbit hole. But you probably see the tradeoff if you’ve been able to follow the byzantine tax accounting.
Assume you are a high income taxpayer subject to the wages and depreciable property limitation, but that you pay no W-2 wages.
Further assume you face a tradeoff like that described earlier in this blog post about doing a Sec. 1031 like-kind exchange.
If you do the like-kind exchange, you avoid that $400,000 of income tax. So that’s great.
But if you don’t do the like-kind exchange, you enjoy decades of Sec. 199A deductions.
If the new $2,000,000 property is a commercial building with the land value equal to $400,000 and the building value equal to $1,600,000, that Sec. 199A deduction may equal 2.5% of $1,600,000, or $40,000. For 39 years.
That’s pretty good.
If the marginal tax rate equals 37%, that deduction saves about $15,000 annually in income taxes.
And so there you see it: The conundrum. Yes, a Sec. 1031 exchange allows an investor to avoid (or delay) paying income taxes.
But the Sec. 1031 may also cause a taxpayer to lose an enormously valuable tax deduction.
And this further complication: Right now, the law says the Sec. 199A only applies until 2025.
So maybe someone only loses 8 years of deductions.
But what if Congress doesn’t allow the Sec. 199A deduction to expire?
Final Thought: 1031 Exchange More Complicated
Here’s the way we all ought to think about Sec. 1031 exchanges as long as Sec. 199A is available.
We shouldn’t discard the option of using a Sec. 1031 like-kind exchange to delay paying income taxes. The gambit surely still makes sense for many taxpayers.
But for taxpayers eligible for the Sec. 199A deduction but constrained by the high-income limitation rules, the taxpayer, with the help of their tax advisor, needs to “run the numbers.”
Clearly, some folks who skip this step will actually end up paying way more in income taxes than they need to.
Other 199A Resources for Real Estate Investors
We have some other blog articles for real estate investors interested in really minimizing their taxes.
If you want to better understand how Sec. 199A works (and why it works) for real estate investors, this blog post may help: The Real Estate Investor Sec. 199A Deduction.
In the earlier discussion, I ignored the Obamacare tax on the gain, but if you’re not clear why that should be case, check out this post: Real Estate Investors and the Net Investment Income Tax.
If you’re a real estate professional investing in income property, you might also find this discussion insightful: Real Estate Professional Audits