Depreciation Rules for a 1031 Exchange
Learn the nuanced tax treatment of a replacement property after a 1031 exchange, including how its prior tax history influences future depreciation.
A 1031 exchange allows investors to defer capital gains taxes by swapping one investment property for another, as outlined in Section 1031 of the Internal Revenue Code. While investors can also claim depreciation—an annual tax deduction for an asset’s wear and tear—the rules for it change after an exchange.
The tax basis of the newly acquired property is not its purchase price. Instead, the basis is calculated by carrying over the basis from the original property. This adjusted starting point directly impacts how future depreciation deductions are calculated, following a unique set of rules that differ from a standard property purchase.
Understanding Basis and Depreciation Recapture
An investment property’s adjusted basis is its initial purchase price, plus the cost of any improvements, minus the total depreciation deductions claimed. For example, if an investor buys a property for $400,000, spends $50,000 on a new roof, and claims $100,000 in depreciation, the adjusted basis becomes $350,000. This figure is the property’s value for tax purposes and is used to calculate gain or loss upon its sale.
When selling a property, the Internal Revenue Service (IRS) requires the repayment of taxes on prior depreciation deductions, a process known as depreciation recapture. This prevents property owners from receiving a double tax benefit from both depreciation and lower capital gains. The recaptured amount is taxed as ordinary income, with the depreciation portion of the gain taxed at a rate as high as 25%. A benefit of a 1031 exchange is that it allows an investor to defer both capital gains and this depreciation recapture tax.
Calculating the Basis of the Replacement Property
Determining the tax basis for the replacement property is a key step, as this figure dictates future depreciation. The basis is not the new property’s market price but is calculated with a formula that preserves the deferred gain from the relinquished property.
The formula is: Adjusted Basis of Relinquished Property + Additional Cash Paid or Debt Taken On + Gain Recognized = Basis of Replacement Property. The “gain recognized” component is triggered by receiving “boot,” which is any non-like-kind property received, such as cash. Receiving boot does not disqualify the exchange, but it does create a taxable event for the portion of the gain represented by the boot.
For example, an investor sells a property with an adjusted basis of $350,000 for $1 million. They acquire a replacement property for $1.2 million, using the $1 million in proceeds and adding $200,000 in cash. The new property’s basis is the $350,000 adjusted basis plus the $200,000 in additional cash, resulting in a new basis of $550,000. This calculation is reported to the IRS on Form 8824.
This calculated basis is much lower than the $1.2 million purchase price because it includes the deferred gain from the original property. Future depreciation deductions will be calculated from this $550,000 figure, not the full market value.
Depreciating the Replacement Property
After establishing the basis, the depreciation process follows a two-part rule. The total basis of the new property is split into two components, each with its own depreciation schedule, preventing the investor from treating the entire asset as new.
The first component is the “exchanged basis,” which is the portion of the new basis equal to the adjusted basis of the relinquished property. This amount continues to be depreciated over the remaining recovery period of the original property. If a residential property was 10 years into its 27.5-year schedule, the exchanged basis is depreciated over the remaining 17.5 years.
The second component is the “excess basis,” which is any additional basis created by adding cash or taking on more debt. This portion is treated as a new asset and depreciated over a full schedule, which is 27.5 years for residential rental property or 39 years for non-residential real property.
Continuing the previous example, the new property has a total basis of $550,000. The $350,000 exchanged basis is depreciated over the original property’s remaining schedule. The $200,000 excess basis is depreciated over a new 27.5-year schedule, assuming it is a residential property. This means the investor makes two separate depreciation calculations annually for the property.