Author Topic: Depreciation Recapture!? How did I not know about this?  (Read 3794 times)

Neo

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Depreciation Recapture!? How did I not know about this?
« on: July 10, 2017, 09:09:04 PM »
I am about to close on my 4th rental property. First three are multifamily with 11 total units. The 4th is a single family. I am getting strong cash flow on these properties and really felt like these were great investments. Somehow, despite tons of research prior to investing in rentals, I never came across the concept of depreciation recapture. I feel like this is a major hit to the profitability of my investments. I know about 1031 exchanges but to me thats just kicking the can down the road.

Lets say I bought a property for $100k. Is avoiding recapture as simple as selling the property for $99k down the road? What strategies is everyone using to minimize the impact of recapture? Im feeling pretty bummed out about the whole thing. Thanks in advance for the input.

ender

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Re: Depreciation Recapture!? How did I not know about this?
« Reply #1 on: July 11, 2017, 06:25:02 AM »
Did you think you could just depreciate the entire purchase price against your taxes for free and then sell the asset at a profit without paying taxes on that?

If you buy it for $100k, depreciate it $20k, and sell it for $99k you will have $19k in capital gains.

Also if you buy cash flow properties you don't care about appreciation much at all so depreciation recapture (which happens when you sell them) doesn't matter much at all, since you're profitability has no dependency on appreciation - just cash flow.

CareCPA

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Re: Depreciation Recapture!? How did I not know about this?
« Reply #2 on: July 11, 2017, 06:31:52 AM »
Did your accountant not tell you about it, or are you doing all your own tax work?
Either way, it only really matters when you sell. You'll pay tax on recapture, which is the lesser of gain or depreciation allowed or allowable. Capital gain will be gain above original basis (including improvements and transaction costs).

Neo

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Re: Depreciation Recapture!? How did I not know about this?
« Reply #3 on: July 11, 2017, 10:30:50 AM »
Did you think you could just depreciate the entire purchase price against your taxes for free and then sell the asset at a profit without paying taxes on that?

If you buy it for $100k, depreciate it $20k, and sell it for $99k you will have $19k in capital gains.

Also if you buy cash flow properties you don't care about appreciation much at all so depreciation recapture (which happens when you sell them) doesn't matter much at all, since you're profitability has no dependency on appreciation - just cash flow.

No, I didn't think I would sell at a profit with no taxes. I expected to pay capital gains tax if I sold for more than I bought it for but wasn't aware of depreciation recapture's affect on cost basis. Also, to say that people who buy cash-flow properties don't care about depreciation recapture makes no sense. Just b/c my properties make healthy cash flow doesn't mean I won't still sell them someday.

So to make sure I understand this: I buy a house for $100k. Depreciate it $20k. Sell for $110k. When I sell I will owe $20k*.25 for depreciation recapture and then $10k*.15 for capital gains. Do I have that right?

SeattleCPA

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Re: Depreciation Recapture!? How did I not know about this?
« Reply #4 on: July 11, 2017, 11:03:34 AM »
Did you think you could just depreciate the entire purchase price against your taxes for free and then sell the asset at a profit without paying taxes on that?

If you buy it for $100k, depreciate it $20k, and sell it for $99k you will have $19k in capital gains.

Also if you buy cash flow properties you don't care about appreciation much at all so depreciation recapture (which happens when you sell them) doesn't matter much at all, since you're profitability has no dependency on appreciation - just cash flow.

No, I didn't think I would sell at a profit with no taxes. I expected to pay capital gains tax if I sold for more than I bought it for but wasn't aware of depreciation recapture's affect on cost basis. Also, to say that people who buy cash-flow properties don't care about depreciation recapture makes no sense. Just b/c my properties make healthy cash flow doesn't mean I won't still sell them someday.

So to make sure I understand this: I buy a house for $100k. Depreciate it $20k. Sell for $110k. When I sell I will owe $20k*.25 for depreciation recapture and then $10k*.15 for capital gains. Do I have that right?

Yes... for federal income taxes... and then you'll maybe owe state income taxes too...


CareCPA

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Re: Depreciation Recapture!? How did I not know about this?
« Reply #5 on: July 11, 2017, 11:09:34 AM »
With the caveat that it all depends what income tax bracket you're in.

srad

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Re: Depreciation Recapture!? How did I not know about this?
« Reply #6 on: July 11, 2017, 11:15:43 AM »
Here's a follow up question, what if i move back into a rental I've had for years and live in it for 2 years then sell it? Would I still have to pay the depreciation back?

CareCPA

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Re: Depreciation Recapture!? How did I not know about this?
« Reply #7 on: July 11, 2017, 11:18:32 AM »
Yes. There are several posts on this if you do a search. I don't have the links handy at the moment.

Term that might help: section 121 exclusion

cchrissyy

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Re: Depreciation Recapture!? How did I not know about this?
« Reply #8 on: July 11, 2017, 11:20:57 AM »
the answer to your follow up question is still YES

the only way to avoid this problem is 1) 1031 exchange and 2) die

I plan to do 2. maybe 1 and 2, but definitely 2 :)   
when you die, your heirs get the cost basis set to the value on that day instead of your purchase price, and all the depreciation is wiped away.

srad

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Re: Depreciation Recapture!? How did I not know about this?
« Reply #9 on: July 11, 2017, 11:30:03 AM »
yea, i'm on plan 2 also...  I'm sure i'll do a few 1031's along the way before 2 comes.  My heirs are going to love me :) 

waltworks

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Re: Depreciation Recapture!? How did I not know about this?
« Reply #10 on: July 11, 2017, 06:20:30 PM »
This is why some people can't bring themselves to sell a fully depreciated property - the tax hit can be HUGE.

I mean, you deferred paying those taxes in the first place, of course. So it's not a *loss* per se. But yes, it's a giant hit to profits when selling a property.

-W

Barben

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Re: Depreciation Recapture!? How did I not know about this?
« Reply #11 on: July 12, 2017, 08:51:44 AM »
Did you think you could just depreciate the entire purchase price against your taxes for free and then sell the asset at a profit without paying taxes on that?

If you buy it for $100k, depreciate it $20k, and sell it for $99k you will have $19k in capital gains.

Also if you buy cash flow properties you don't care about appreciation much at all so depreciation recapture (which happens when you sell them) doesn't matter much at all, since you're profitability has no dependency on appreciation - just cash flow.

No, I didn't think I would sell at a profit with no taxes. I expected to pay capital gains tax if I sold for more than I bought it for but wasn't aware of depreciation recapture's affect on cost basis. Also, to say that people who buy cash-flow properties don't care about depreciation recapture makes no sense. Just b/c my properties make healthy cash flow doesn't mean I won't still sell them someday.

So to make sure I understand this: I buy a house for $100k. Depreciate it $20k. Sell for $110k. When I sell I will owe $20k*.25 for depreciation recapture and then $10k*.15 for capital gains. Do I have that right?

Yes... for federal income taxes... and then you'll maybe owe state income taxes too...

I have a question about this actually.  Upon the sale, the depreciation you take is taxed as ordinary income (up to a maximum 25% rate), right?  Is there an ER-type loophole here where it's taxed at your current tax rate vs. the rate you had when you took the depreciation?  So if I'm in the 25% tax bracket while working and taking depreciation on the rental, and I retire and sell it (so my income is now in, say, the 15% bracket), how does the depreciation recapture get taxed?

(I do not own rental property currently, but this made me curious and my Google-fu wasn't strong enough to find the answer.)

Neo

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Re: Depreciation Recapture!? How did I not know about this?
« Reply #12 on: July 12, 2017, 09:01:07 AM »
I believe its paid at your current tax right at time of sale regardless of whether its higher or lower

Blindsquirrel

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Re: Depreciation Recapture!? How did I not know about this?
« Reply #13 on: July 13, 2017, 06:28:38 PM »
  Yep, planning on death avoidance of this tax. Hopefully far in the future. :)

Usury

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Re: Depreciation Recapture!? How did I not know about this?
« Reply #14 on: July 24, 2017, 11:16:58 AM »
I've heard of folks making an election NOT to depreciate a rental property when placed into service for this exact reason.  I don't really know if this is a viable option or how it would work.  Might be worth exploring depending on a person's situation and intentions.  As to the OP, I would say that ship has sailed at this point.  Either keep the property forever and realize investment returns or 1031 or take the tax hit.

Also, to be clear, this speculation about electing not to claim depreciation is just third or fourth party hearsay (on several different unconnected situations), so anyone considering this should DYODD with a reputable tax professional.
« Last Edit: July 24, 2017, 11:33:40 AM by Usury »

MaikoTsumi

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Re: Depreciation Recapture!? How did I not know about this?
« Reply #15 on: July 24, 2017, 11:43:13 AM »
I've heard of folks making an election NOT to depreciate a rental property when placed into service for this exact reason.  I don't really know if this is a viable option or how it would work.  Might be worth exploring depending on a person's situation and intentions.  As to the OP, I would say that ship has sailed at this point.  Either keep the property forever and realize investment returns or 1031 or take the tax hit.

Also, to be clear, this speculation about electing not to claim depreciation is just third or fourth party hearsay (on several different unconnected situations), so anyone considering this should DYODD with a reputable tax professional.

The deprecation recapture happens whether you claim depreciation or not.  And when the government comes after the recapture, you won't be able file the depreciation for prior years.  No benefit in not claiming.

waltworks

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Re: Depreciation Recapture!? How did I not know about this?
« Reply #16 on: July 24, 2017, 11:44:10 AM »
I believe you are required to take depreciation. I could be wrong, but that's the impression I've gotten (from doing my taxes with rentals involved for the last 10 years or so).

-W

secondcor521

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Re: Depreciation Recapture!? How did I not know about this?
« Reply #17 on: July 24, 2017, 11:47:55 AM »
I've heard of folks making an election NOT to depreciate a rental property when placed into service for this exact reason.  I don't really know if this is a viable option or how it would work.  Might be worth exploring depending on a person's situation and intentions.  As to the OP, I would say that ship has sailed at this point.  Either keep the property forever and realize investment returns or 1031 or take the tax hit.

Also, to be clear, this speculation about electing not to claim depreciation is just third or fourth party hearsay (on several different unconnected situations), so anyone considering this should DYODD with a reputable tax professional.

I don't think electing not to depreciate a property works.  I think the tax laws say that you have to pay recapture on any depreciation that could have been taken, regardless of whether or not it was taken.

CareCPA

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Re: Depreciation Recapture!? How did I not know about this?
« Reply #18 on: July 24, 2017, 11:53:54 AM »
Yea - the wording to calculate gain is "depreciation allowed or allowable" - allowable meaning they don't care if you actually took it or not.

Goldielocks

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Re: Depreciation Recapture!? How did I not know about this?
« Reply #19 on: July 24, 2017, 03:13:07 PM »
Depreciation is great for people with large earned incomes,  it allows you to reduce high bracket taxes for many years before you sell.

Then, if you time it, you sell in retirement years, and claim back the recaptured depreciation, while in a lower tax bracket.

In Canada, you can choose whether to claim depreciation on your properties or not, or only partiallly, as long as you stay less than the maximum allowed for your class of asset.  This works great for people planning to sell in a few years for a profit.  I gather that depreciation is mandatory each year in the US...

cliff

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Re: Depreciation Recapture!? How did I not know about this?
« Reply #20 on: November 21, 2017, 02:33:30 PM »
If you plan properly, you can do 1031 exchange(s) to convert your investment(s) into residential property and live in it for the appropriate number of years so you can recharacterize it as your primary home. 

Here is an example:
Own a multifamily property and exchange it for a vacation house to rent out to others.  Eventually move into the vacation house and make it your primary home, and again in the requisite amount of time sell with the primary home tax exclusions of $250k single/$500k married.

I was quite happy when I exchanged.

Check with a CPA to make sure you understand how to do this before taking it on as your plan as I’m not qualified to give tax advice.

Feel free to PM me if you are looking for a firm to act as the necessary qualified intermediary for a 1031 exchange.  I found one I liked who are also CPAs.  I don’t have any business relationship with them.

-Cliff

...I know about 1031 exchanges but to me thats just kicking the can down the road...



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waltworks

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Re: Depreciation Recapture!? How did I not know about this?
« Reply #21 on: November 21, 2017, 06:43:29 PM »
My understanding is that the depreciation recapture happens when you remove the asset from service - regardless of whether that is via sale or conversion to primary residence. But I'm not a CPA. I would tread very carefully there, for sure.

-W

Goldielocks

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Re: Depreciation Recapture!? How did I not know about this?
« Reply #22 on: November 21, 2017, 07:01:08 PM »
My understanding is that the depreciation recapture happens when you remove the asset from service - regardless of whether that is via sale or conversion to primary residence. But I'm not a CPA. I would tread very carefully there, for sure.

-W

Yeah +1 to this...

waltworks

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Re: Depreciation Recapture!? How did I not know about this?
« Reply #23 on: November 21, 2017, 07:52:02 PM »
There may be some confusion here wrt capital gains (which can be avoided in this manner, since there is no gain realized if you don't sell the property) and depreciation, which is something you do have to pay back when you stop using the property for business.

AFAIK, the only way to avoid both is 1031 exchange (and in the long run, dying and leaving the property to heirs who will receive with basis stepped up to current value/depreciation wiped out).

-W

secondcor521

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Re: Depreciation Recapture!? How did I not know about this?
« Reply #24 on: November 21, 2017, 10:57:38 PM »
Did you think you could just depreciate the entire purchase price against your taxes for free and then sell the asset at a profit without paying taxes on that?

If you buy it for $100k, depreciate it $20k, and sell it for $99k you will have $19k in capital gains.

Also if you buy cash flow properties you don't care about appreciation much at all so depreciation recapture (which happens when you sell them) doesn't matter much at all, since you're profitability has no dependency on appreciation - just cash flow.

No, I didn't think I would sell at a profit with no taxes. I expected to pay capital gains tax if I sold for more than I bought it for but wasn't aware of depreciation recapture's affect on cost basis. Also, to say that people who buy cash-flow properties don't care about depreciation recapture makes no sense. Just b/c my properties make healthy cash flow doesn't mean I won't still sell them someday.

So to make sure I understand this: I buy a house for $100k. Depreciate it $20k. Sell for $110k. When I sell I will owe $20k*.25 for depreciation recapture and then $10k*.15 for capital gains. Do I have that right?

Yes... for federal income taxes... and then you'll maybe owe state income taxes too...

I have a question about this actually.  Upon the sale, the depreciation you take is taxed as ordinary income (up to a maximum 25% rate), right?  Is there an ER-type loophole here where it's taxed at your current tax rate vs. the rate you had when you took the depreciation?  So if I'm in the 25% tax bracket while working and taking depreciation on the rental, and I retire and sell it (so my income is now in, say, the 15% bracket), how does the depreciation recapture get taxed?

(I do not own rental property currently, but this made me curious and my Google-fu wasn't strong enough to find the answer.)

I believe depreciation recapture is at a 25% tax rate.  It is treated differently from income and capital gains.  Google "section 1250 depreciation recapture" to learn all the gory details.

ingrownstudentloans

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Re: Depreciation Recapture!? How did I not know about this?
« Reply #25 on: November 22, 2017, 04:47:49 AM »
Depreciation is great for people with large earned incomes,  it allows you to reduce high bracket taxes for many years before you sell.


But in the US, not if your income is too high.  My understanding (check with your tax people) is, you cannot take the rental property losses if your MAGI is >$150,000 (mfj), it phases out starting at $100,000.  You can, however, continue to depreciate to offset any income from the property during that year.  At least that is what my tax guy does for my property.  There is also something about carrying forward the excess depreciation to offset against capital gains if/when you sell.  I'll be honest, I am not entirely sure how that is all handled.

tralfamadorian

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Re: Depreciation Recapture!? How did I not know about this?
« Reply #26 on: November 22, 2017, 06:49:41 AM »
I believe depreciation recapture is at a 25% tax rate.  It is treated differently from income and capital gains.  Google "section 1250 depreciation recapture" to learn all the gory details.

This is a common misconception. Depreciation recapture is taxed at the taxpayer's income tax rate up to 25%. So, if someone is FIRE and has room in brackets less than 25%, then this can be an option to consider. (This bit was explained at length in another thread that I can't find atm by one of our resident MMM CPAs.

brooklynguy

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Re: Depreciation Recapture!? How did I not know about this?
« Reply #27 on: November 22, 2017, 08:16:57 AM »
I believe depreciation recapture is at a 25% tax rate.  It is treated differently from income and capital gains.  Google "section 1250 depreciation recapture" to learn all the gory details.

This is a common misconception. Depreciation recapture is taxed at the taxpayer's income tax rate up to 25%. So, if someone is FIRE and has room in brackets less than 25%, then this can be an option to consider. (This bit was explained at length in another thread that I can't find atm by one of our resident MMM CPAs.

This thread might be the one you're thinking of, and this post in particular was the first (of several) within that thread to clarify that the 25% rate is a ceiling but not a floor.

Incidentally, on the subject of depreciation, the Senate's current tax bill, if passed, would change the applicable recovery period for residential real property from 27.5 years to 25 years (see 13204(a)(1) (which can be found on page 158 of this PDF verion)).

dandarc

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Re: Depreciation Recapture!? How did I not know about this?
« Reply #28 on: November 22, 2017, 08:20:13 AM »
This thread might be the one you're thinking of, and this post in particular was the first (of several) within that thread to clarify that the 25% rate is a ceiling but not a floor.

Incidentally, on the subject of depreciation, the Senate's current tax bill, if passed, would change the applicable recovery period for residential real property from 27.5 years to 25 years (see 13204(a)(1) (which can be found on page 158 of this PDF verion)).
So that will make becoming a landlord a bit more attractive, right?  Lower denominator = higher depreciation deduction = lower taxes today.

brooklynguy

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Re: Depreciation Recapture!? How did I not know about this?
« Reply #29 on: November 22, 2017, 08:33:46 AM »
So that will make becoming a landlord a bit more attractive, right?  Lower denominator = higher depreciation deduction = lower taxes today.

Generally speaking, yes.

I haven't yet analyzed how this change would treat landlords who are already midway through a 27.5-year depreciation schedule (like myself), but I wouldn't be surprised if this fast-tracked legislation simply fails to address that situation altogether.

almosthere

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Re: Depreciation Recapture!? How did I not know about this?
« Reply #30 on: November 22, 2017, 10:58:36 AM »
As someone that sold my primary residence 2.5 years ago and moved into my former rental, I have a few questions/comments.

I generally get the gist of the depreciation recapture tax, but one thing I haven't heard discussed is the distinction between the value of the property (land) and the value of the house.

My understanding is that the recapture tax only applies to the house as you cannot depreciate the land. So in my case where the neighborhood is in it's final stages of gentrification and the homes value is in the land, I could wind up paying next to nothing in recapture tax because the house has little or no value.

Is this correct?

Also, now into my third year of making my former rental my primary residence, what percentage would be exempt from taxes? I don't believe it's the same $250K allowed from previous sale of home, something pro-rated?

The longer I live here the larger the exemption?

Unrelated but still curious, I bought another house out of state (with state income taxes, etc.) one year ago,  and wondering how to transition from here (no state taxes) to there without triggering their state cap gains if I sold here?
Is it a matter of timing?




brooklynguy

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Re: Depreciation Recapture!? How did I not know about this?
« Reply #31 on: November 22, 2017, 11:20:48 AM »
I generally get the gist of the depreciation recapture tax, but one thing I haven't heard discussed is the distinction between the value of the property (land) and the value of the house.

Read through the thread I linked above, which dives deep into the weeds on that precise issue.

Goldielocks

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Re: Depreciation Recapture!? How did I not know about this?
« Reply #32 on: November 22, 2017, 06:13:47 PM »
As someone that sold my primary residence 2.5 years ago and moved into my former rental, I have a few questions/comments.

I generally get the gist of the depreciation recapture tax, but one thing I haven't heard discussed is the distinction between the value of the property (land) and the value of the house.

My understanding is that the recapture tax only applies to the house as you cannot depreciate the land. So in my case where the neighborhood is in it's final stages of gentrification and the homes value is in the land, I could wind up paying next to nothing in recapture tax because the house has little or no value.

Is this correct?

Sort of correct.

The house value would need to DEPRECIATE at the same rate that you are claiming.

Example

Buy house for $1 million.
1) Land is worth $700k and house worth $300k according to appraisal at time of purchase.
2) Depreciate 4% per year (on a 25 yr cycle... IDK what your depreciation rate is)..   4% x $300k = $12k the first year, $11,500 the second year, etc.  (as the home decreases in value, 4%x that value decreases, too).

3)  after 2 years you have depreciated $23,500..   On paper the house is values at $276,500 now, down from $300k

4)  Sell property and home for $1.1 Million, net of all fees.   New Appraisal states that the value is $290k for the home, and $810k for the land.

5)  PAY INCOME TAX (at marginal rate, up to your max rate) on recapture of $290k - $276,500 = $3,500k...  even though you showed the home dropped in value by $10k when you sold, you had depreciated it by more than that, so you have to pay the overage back in taxes.

6)  Pay capital gains tax on ($1.1 Million - $1.0 million). 
« Last Edit: November 23, 2017, 11:12:21 PM by Goldielocks »

almosthere

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Re: Depreciation Recapture!? How did I not know about this?
« Reply #33 on: November 22, 2017, 08:04:49 PM »
I can see I will need  my CPA to navigate thru those weeds!
A 1031 is sounding better at the moment.

HawkeyeNFO

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Re: Depreciation Recapture!? How did I not know about this?
« Reply #34 on: November 23, 2017, 09:20:50 PM »
I can see I will need  my CPA to navigate thru those weeds!
A 1031 is sounding better at the moment.

You might want one, but a CPA isn't really required for this.  Most available tax software can walk you through the paperwork.