Good Record Keeping is Critical if You Have Boot in a 1031 Exchange Transaction

Since this is tax season, it's a good time to remind you that if you have taken boot in a 1031 exchange transaction, it's absolutely critical you keep detailed records with your replacement property records.

"Boot" is what the IRS and the tax community calls the taxable part of an exchange. Boot typically arises when you buy down or take cash out of the exchange. The reason that records are so critical in this situation is that when you have boot, depreciation recapture is the first thing taxed, which reduces the future amount you have to recapture. Unless you keep track of the fact that you've already recaptured this amount in your records, and carry this notation forward from year to year until you sell your property, you could easily end up paying this tax again.

When you sell a property you typically pay three different taxes. The first you pay is a tax on the recapture of any depreciation you've taken. Currently, depreciation is recaptured at your normal tax rate as long as that rate is not greater than 25% (which is the maximum recapture tax you'll pay). The remainder of your gain is taxed at the current capital gains rate of 15%, which is the second tax you'll pay. The third tax is state tax on the entire gain.

As a simple illustration, say you bought a rental house several years ago for $200,000, and since then you've taken $50,000 in depreciation. Now you're selling that rental for $275,000. First things first--the $50,000 of depreciation is recaptured at 25% for a total of $12,500. Next, the $75,000 capital gain is taxed at 15% for a total of $11,250. And lastly, if you live in the state of Colorado like I do, you'll pay 5% state tax on the recapture of $50,000 and the capital gain of $75,000, meaning that the entire gain of $125,000 will be taxed by the state at 5% for a tax of $6,250. The three taxes total $30,000--which is equal to 24% of the overall gain $125,000, which is why people do 1031 exchanges. If you don't live in Colorado, you'll have to modify my example for your actual state tax rate.

Taking my example one step further, let's say you do an exchange when you sell the rental, but you take boot of $25,000 from the sale to buy a new car. IRS law requires that depreciation be recaptured first, so you'll pay 25% ($6,250) in recapture tax to the IRS and 5% ($1,250) to the state of Colorado, for a total tax of $7,500 (or 30%) on your boot.

Here's where record-keeping becomes critical: suppose a couple of years later you sell the replacement property and decide to pay the tax rather than do another exchange. By this time you've taken an additional $20,000 in depreciation, for a total of $70,000 of depreciation ($50,000 on the first rental and $20,000 on the second). Unless you have great records, the chances are slim that you're going to remember that you've already recaptured $25,000 of that amount on the sale of the first property. The end result will be that you'll pay recapture tax on $25,000 twice.

As a CPA, here's how I reflect the tax I've paid in my return: in my return there is a schedule generated by the tax program that shows the details of the depreciation I've taken, and one of the columns is labeled "accumulated depreciation"--this is a running total of all the depreciation I've taken and is updated annually. Every year I find this schedule and put an asterisk by the amount of the total depreciation taken to-date. At the bottom of the form, I'll boldly hand-write in something like: " * Of which $25,000 was recaptured in the 2011 income tax return." I add this comment every year, because I know that someday I might end up paying tax on this property.

Typically with most tax programs, this schedule is printed for inclusion only in the copy of the return for your files. I make a copy of this form, with my note prominently displayed at the bottom, and attach it to the federal and state tax returns I file. I do this so that if I get audited in the future, I have yearly proof for the agent that tax was already paid on this amount, and is not subject to taxation again, and a yearly reminder to myself so that I won't pay the recapture tax twice.