Tax Deferred Exchange With a Twist — How Purposeful Planning Makes a Difference

One of the most frequent questions asked during client meetings is about BawldGuy axiom #1.

It says potentially catastrophic problems are, or super opportunities missed, are more often than not, a result of the answer given to a question the investor didn’t know to ask.

Today I decided to give a real life example of how Purposeful Planning can make a huge difference not only in long term retirement planning results — but can also, sometimes, positively impact the investor while still on the road to retirement.

Depreciation is, in essence, a paper loss allowed by IRS rules. It accounts for the physical depreciation of the building and sometimes its components, as it ages. While holding an investment property, you can, if qualified, use this ‘loss’ to offset not only income from the investment, but your ordinary income. It’s a tool that can result, with proper Planning, in significant income tax savings. One of these rules says if you make more than the limit in ordinary (read: job) income, you’re disallowed from applying the ‘loss’ to that income. This is a crazy over-simplification — but you get the idea.

Not long ago, we executed a 1031 (tax deferred) exchange for a couple who had been clients for years. They were taking the last of their San Diego investment properties and moving the equities to Boise. They both worked, and between them made more than the maximum income allowed by IRS regs, so were not allowed to take depreciation to shelter some of their income. This irritated them no end, because it wasn’t always thus. They’d risen in pay scale over the years, and felt they were being penalized for their success — which of course, was correct.

Back to the exchange, and Cheryl, his wife whispers in my ear, that if the tax bite wouldn’t be too much, Randy sure needed a new pickup. Seems his was 12 years old, and he was treating it like the family pet. Was there anything we could do?

You bet.

Since the last few years they hadn’t taken depreciation, it had been steadily accumulating — to the point where it had reached over $50,000 worth. They needed around $35,000 for the new truck.

Here’s what we did.

IRS regs say unused, accumulated depreciation can be used to offset any cash ‘taken out’ of a tax deferred exchange. Cash taken out of an exchange is called boot. Tax wise, that’s a four letter word. All funds in an exchange are to be used for the acquisition and costs of the newly acquired property. Any funds constructively received by the taxpayer-investor will be called boot, and will be taxed.

However – and here’s the cool part – if there’s any accumulated, unused depreciation, it can be used to offset the aforementioned boot. And that’s what we did to get them the tax-free cash to buy the new pickup.

Problem solved.

Randy’s happy, because as it turned out, he’d been secretly lusting after a new truck for quite awhile. Cheryl was ecstatic because the old truck was history. And they were both very pleased to have been able to access the cash profits — without paying a dime in taxes of any kind.

Cheryl didn’t know to ask if avoiding taxes was even on their menu. Again — it’s not the answers to your questions that usually get you into trouble — OR — let you pass by a great opportunity.

Instead, it’s often the question you didn’t know to ask.

Related posts:

1. Section 1031 Of The IRC – The Tax Deferred Exchange — Not Always The Right Tool
2. Is It Always Advisable To Execute A Tax Deferred Exchange?
3. How Purposeful Planning Worked for the Greens—First Time Investors
4. 1031 — Tax Deferred Exchanges — 200% Rule
5. Planning Without A Purpose — Oops