{"id":6832,"date":"2018-06-18T05:53:20","date_gmt":"2018-06-18T12:53:20","guid":{"rendered":"http:\/\/evergreensmallbusiness.com\/?p=6832"},"modified":"2019-03-01T11:34:35","modified_gmt":"2019-03-01T19:34:35","slug":"the-sec-199a-sec-1031-conundrum","status":"publish","type":"post","link":"https:\/\/evergreensmallbusiness.com\/the-sec-199a-sec-1031-conundrum\/","title":{"rendered":"The Section 199A Section 1031 Conundrum"},"content":{"rendered":"

\"Picture<\/a>A reader of our \u201cMaximizing Section 199A Deductions<\/a>\u201d monograph recently e-mailed to ask about the Section 199A Section 1031 connection.<\/p>\n

His question? How do you handle the Section 199A deduction for income generated by property acquired through a Section 1031 \u201clike kind exchange.\u201d<\/p>\n

The question is a really good one. And it points out\u2014as the reader surely understood\u2014an interesting conundrum: Should real estate investors change the way they think about Section 1031 exchanges given the way the Section 199A deduction works?<\/p>\n

The answer to this question? Probably some real estate investors should<\/em> reassess their thinking about Section 1031 exchanges. But the tax accounting gets tricky.<\/p>\n

In this blog post, therefore, I briefly describe how Section 199A works for real estate investors, how a Section 1031 like kind exchange works,\u00a0and how these two taxpayer-friendly code sections work against each other when you combine them.<\/p>\n

One other note: This blog post’s information has been updated for the Section 199A final regulations, which appeared on January 18. 2019.<\/p>\n

How Section 1031 Like Kind Exchanges Work<\/h1>\n

A very quick, simplified illustration shows how Section 1031 exchanges work.<\/p>\n

Suppose you purchased an apartment building for $1,000,000 and allocated $800,000 to the building and $200,000 to the land.<\/p>\n

Further suppose you fully depreciated the building over three decades\u2014an interval during which the property appreciated in value to $2,000,000.<\/p>\n

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\u2019ll run, say, 25%, so $200,000.) Further, you\u2019ll pay capital gains on the $1,000,000 of appreciation. (Let\u2019s say this runs 20% so another $200,000.)<\/p>\n

The taxes on the sale and reinvestment, then, run $400,000 in this example.<\/p>\n

Section 1031 says this, however: If you trade the old building for the new building, you don\u2019t have to pay those taxes.<\/p>\n

Further, in the case of a trade, your new building\u2019s basis will equal not the $2,000,000 price you essentially paid for the building, but the $200,000 of basis you had \u201cleft over\u201d in the old building due to land.<\/p>\n

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.<\/p>\n

Alternatively, if you effect a Section 1031 like kind exchange, you don\u2019t pay that $400,000 of income taxes and your basis in the new building equals $200,000.<\/p>\n

Note:<\/strong> 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\u2026<\/p>\n

Now let\u2019s look at how the Section 199A deduction works for a real estate investor facing this investment choice.<\/p>\n

How Section 199A Deduction Works for Real Estate Investors<\/h1>\n

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.)<\/p>\n

\"Cover<\/a>
Developing Section 199A expertise? Use our best-selling e-book.<\/a> Instant download. Money back guarantee.<\/figcaption><\/figure>\n

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.<\/p>\n

Note:<\/strong> 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<\/a>.<\/p>\n

For these high income taxpayers, in any event, the Section 199A still equals (potentially) 20% of their real estate property\u2019s income. But a catch exists: The Section 199A deduction can\u2019t exceed the greater of two amounts:<\/p>\n