LTR Investor Saves $127K with Section 1250 Recapture Planning and 1031 Exchange

The Problem

This client owned a long-term rental property purchased 12 years earlier for $420,000 that had appreciated to a current market value of approximately $780,000. The client wanted to sell the property and upgrade to a larger multifamily asset. However, the accumulated depreciation over 12 years totaled $152,700 on a straight-line basis, and the client had never considered the tax implications of selling. The estimated capital gain was $512,700 ($780,000 sale price minus $267,300 adjusted basis), and the Section 1250 unrecaptured depreciation of $152,700 would be taxed at 25% while the remaining gain of $360,000 would face long-term capital gains rates of 20% plus the 3.8% Net Investment Income Tax (NIIT) under IRC §1411.

The client's prior CPA had simply recommended "just hold it" without presenting alternatives. The client was unaware that a 1031 exchange could defer the entire tax liability, that a cost segregation study on the replacement property could generate new accelerated deductions, or that the recapture exposure from the old property would carry over to the replacement property (not be triggered by the exchange). The estimated tax liability on a taxable sale would have been approximately $127,000: $38,175 on unrecaptured Section 1250 gain ($152,700 x 25%) plus $85,680 on remaining capital gain ($360,000 x 23.8%) plus $3,145 in Virginia state tax.

AE Tax Strategy

1. Section 1250 Recapture Analysis and Sale Modeling

We prepared a comprehensive tax impact analysis modeling three scenarios: (1) outright taxable sale, (2) 1031 exchange into a replacement property, and (3) installment sale under IRC §453. The taxable sale would trigger $127,000 in combined federal and state tax. The installment sale could spread the gain over 15 years but would still result in $127,000 in total tax paid over time plus interest cost. The 1031 exchange would defer the entire gain indefinitely, with the deferred gain reducing the basis of the replacement property. We recommended the 1031 exchange as the optimal path for a client planning to continue investing in real estate.

2. 1031 Exchange Execution Under IRC §1031

We coordinated the 1031 exchange under IRC §1031 using a Qualified Intermediary (QI). The client sold the relinquished property for $780,000 and identified a replacement property — a 12-unit apartment building — within the 45-day identification period. The replacement property was acquired for $1,350,000 within the 180-day exchange period. The client contributed an additional $570,000 in cash plus a new mortgage, ensuring no boot was received. The exchange deferred the entire $512,700 gain and all $152,700 in Section 1250 recapture. The replacement property's tax basis was set at $837,300 ($1,350,000 purchase price minus $512,700 deferred gain).

3. Cost Segregation on Replacement Property

We immediately commissioned a cost segregation study on the replacement 12-unit apartment building. The study identified $337,000 in accelerated components (40% of the $837,300 adjusted basis). Under 100% bonus depreciation, this produced $337,000 in Year 1 deductions on the replacement property. Combined with the client's REPS qualification (full-time property manager), the accelerated depreciation created non-passive losses that offset the client's other income. The net effect: the client traded a property with a $127,000 tax liability for a larger, higher-income property with $337,000 in first-year deductions — a $464,000 swing in tax position.

Before & After Comparison

Tax Category	Before	After	Savings
Capital Gains Tax (Taxable Sale)	$85,680	$0	$85,680
Section 1250 Recapture Tax	$38,175	$0	$38,175
Virginia State Tax	$3,145	$0	$3,145
Total Tax Deferred	$127,000	$0	$127,000
Total	$127,000	$0	$127,000

Key Takeaways

• Section 1250 unrecaptured depreciation is taxed at a maximum 25% rate upon sale — understanding this exposure before listing is critical for informed decision-making.
• 1031 exchanges defer both capital gains and Section 1250 recapture indefinitely, with the deferred gain carrying over as reduced basis in the replacement property.
• Cost segregation on a 1031 replacement property can generate new accelerated deductions even though the basis is reduced by the deferred gain — the reclassification applies to the available basis.
• The combination of a 1031 exchange followed by cost segregation on the replacement property is one of the most powerful wealth-building tax strategies in real estate.