Note: This blog post has not been updated for the Section 199A final regulations that appeared over the 2019 Martin Luther King Jr. holiday weekend. However, our “Maximizing Section 199A Deductions” ebook has been updated. We will update this blog post as soon as possible.
A reader of our “Maximizing Section 199A Deductions” monograph recently e-mailed to ask about the Section 199A Section 1031 connection.
His question? How do you handle the Section 199A deduction for income generated by property acquired through a Section 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 Section 1031 exchanges given the way the Section 199A deduction works?
The answer to this question? Probably some real estate investors should reassess their thinking about Section 1031 exchanges. But the tax accounting gets tricky. Especially given the approach described in the Section 199A proposed regulations (which the Internal Revenue Service published in early August 2018.)
In this blog post, therefore, I briefly describe how Section 199A works for real estate investors, how a Section 1031 like kind exchange works, and how these two taxpayer-friendly code sections work against each other when you combine them.
How Section 1031 Like Kind Exchanges Work
A very quick, simplified illustration shows how Section 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.
Section 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 Section 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 Section 199A deduction works for a real estate investor facing this investment choice.
How Section 199A Deduction Works for Real Estate Investors
The Section 199A deduction potentially 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 Section 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 Section 199A deduction “phased out” as described here: Section 199A Deduction Phase-out Calculations.
For these high income taxpayers, in any event, the Section 199A still equals (probably) 20% of their real estate property’s income. But a catch exists: The Section 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” Section 199A deduction to 2.5% of the original basis of the depreciable part of the property.
Determining Original Basis of Depreciable Real Estate
The “original basis” value used in the Section 199A formula equals the part of the purchase price allocated to the depreciable property but before adjusting for any depreciation..
The actual statutory language gives the gritty details and appears in Sec. 199A(2) and Sec. 199A(6) and then in the Section 199A proposed regulations. 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 Section 199A deduction calculation equals $800,000 as long as you’re taking full years of depreciation–so probably the first 27 or maybe 28 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.
The Section 199A Section 1031 Tradeoff
Okay, I apologize that we are now at the very bottom of the rabbit hole.
But now we’re ready to talk about the two surprising trade-offs of using a Section 1031 exchange if the taxpayer potentially might receive a Section 199A deduction.
But to keep things simple, I need to break this down into a couple of examples. One example looks at the impact of the like-kind exchange on the number of years you include depreciable basis in the Section 199A calculation. And the other example looks at the impact of the like-kind exchange on the actual depreciable basis that plugs into calculation.
Impact of Like-kind Exchange on Number of Years
So here’s the first thing to note: Remember that an asset’s depreciable basis only plugs into the Section 199A formula for a “set” number of years.
Note: You always get to plug the basis into the calculation for ten years-even if the property’s recovery period for depreciation equals 3 or 5 years.
For real estate, as noted earlier, you plug the depreciable basis into the calculation through the last full year of depreciation. For example, with residential real estate you get to include the depreciable basis in the calculation for 27 years or 28 years.
Predictably, for a property you buy in the usual way, you start the 27 year or 28 year countdown in the year you buy the property. (That makes sense.)
But here’s the odd thing about the “replacement” property you acquire in a like-kind exchange; That countdown starts at the point you acquired the first “relinquished” property. In other words, if you buy an apartment house, depreciate it for 10 years, and then do a like-kind exchange into another property with the same value, you don’t restart the countdown. You simply “burn off” the remaining time on the countdown clock. So 17 or 18 years?
Note: This same weirdness, by the way, appears for other nonrecognition transactions, which I mention here because who knows who will later be reading this blog post.
And then this wrinkle. A taxpayer may “reset” the countdown timer so it starts at the like-kind exchange date by making an election under §1.168(i)-6(i)(1).
And then another wrinkle. If you don’t do a straight trade but trade up by injecting additional cash or by borrowing additional funds or by recognizing a gain during the nonrecognition transaction, that creates “extra” basis or what the law calls “excess basis.” You do treat that excess basis like a separate asset with its own depreciable basis and its own countdown time clock.
My mind spins at the complexity of all this. Perhaps your mind does too. But here’s the takeaway. Something like a like-kind exchange may shorten the number of years you plug depreciable basis into a Section 199A calculation. Furthermore, in some cases, you can make an election that restarts the countdown time clock.
And now let’s look at the other way a Section 1031 impacts the Section 199A calculations
Determining Unadjusted Basis Immediately After Acquisition
A Section 1931 exchange also fiddles with the unadjusted depreciable basis that plugs into the Section 199A calculation.
To illustrate, let’s again 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’ve purchased a $1,000,000 apartment house, broken that price down into $200,000 of land (which you can’t depreciate) and $800,000 of building (which you are depreciating). Further assume that you have “half depreciated” the building: to date you’ve deducted $400,000 of depreciation.
In the case, the depreciable basis value that plugs into your Section 199A calculation equals $800,000. You ignore the depreciation, as noted earlier.
But say the building has grown in value to $2,000,000 and you want to trade your property for some new property–perhaps one closer to home–in a straight across exchange.
Note: I’m only saying you’re trading one $2 million building for another $2 million building to keep the example a little cleaner.
In this case–and this is the important bit–the depreciable property value for the new $2,000,000 replacement property–equals $400,000.
In other words, the old depreciation you used to ignore for purposes of the Section 199A calculation you now recognize. And as noted earlier, you also ignore the appreciation you’re avoiding tax on via the Section 1031 exchange.
In any case, the real impact of this loss? You lose potentially an annual 2.5% deduction on the “lost” $400,000 of basis, or a $10,000 annually. For maybe for 17 or 18 years.
Putting it All Together
Okay, you see the issues connecting Section 1031 and Section 199A.
If you do the like-kind exchange and trade your fully depreciated business for another building with equal value, you avoid that $400,000 of income tax. So that’s great. But you reduce the size of the Section 199A deduction and possibly you shorten the number of years you take the deduction.
But if you don’t do the like-kind exchange, you pay a bunch of tax–though tax you may someday pay anyway. But you enjoy decades of larger Section 199A deductions.
And so there you see the conundrum. Yes, a Sec. 1031 exchange allows an investor to delay paying income taxes.
But the Section 1031 may also cause a taxpayer to lose an enormously valuable tax deduction.
And this further complication: Right now, the law says the Section 199A only applies until 2025.
So maybe someone only loses 8 years of deductions.
But what if Congress doesn’t allow the Section 199A deduction to expire?
Final Thought: Section 1031 Exchange More Complicated
Here’s the way we all ought to think about Section 1031 exchanges as long as Section 199A is available.
We shouldn’t discard the option of using a Section 1031 like-kind exchange to delay paying income taxes. The gambit surely still makes sense for many taxpayers.
But for taxpayers eligible for the Section 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 Section 199A works (and why it works) for real estate investors, this blog post may help: The Real Estate Investor Section 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