How Does 1031 Exchange Depreciation Recapture Work?

A 1031 exchange allows real estate investors to defer capital gains taxes by reinvesting sale proceeds into a new, like-kind property. This strategy intersects with depreciation recapture, which is the tax applied to the gain resulting from prior depreciation deductions. While an exchange can postpone the immediate tax bill from a sale, it does not eliminate it. The deferred tax liability is instead carried over to the new property, and certain transaction structures can still trigger an immediate tax payment.

Understanding Depreciation Recapture

Depreciation is an annual tax deduction allowing investors to recover the cost of an investment property over its useful life, set by the IRS at 27.5 years for residential and 39 years for commercial property. These deductions reduce an investor’s taxable income each year. This process also lowers the property’s adjusted basis, which is its original cost plus improvements, minus the total depreciation taken.

When the property is sold, the portion of the gain attributable to the depreciation claimed is subject to recapture. This gain is taxed differently than the gain from market value appreciation, which is treated as a long-term capital gain.

The most common type of recapture is unrecaptured Section 1250 gain. This applies to the straight-line depreciation on the building itself and is taxed at a maximum federal rate of 25%. Any gain above the depreciated amount is taxed at long-term capital gains rates.

A second type is Section 1245 recapture, which applies to personal property within a real estate transaction, such as appliances or equipment. Gain from these assets is recaptured at the investor’s ordinary income tax rates, which can be as high as 37%. Cost segregation studies may reclassify parts of a building as personal property to accelerate depreciation, which can result in this higher tax rate upon sale.

For example, an investor buys a property for $500,000 and claims $100,000 in depreciation, reducing the basis to $400,000. They sell it for $650,000, for a total gain of $250,000. The first $100,000 of this gain is unrecaptured gain taxed at a maximum of 25%, while the remaining $150,000 is a long-term capital gain.

How a 1031 Exchange Defers Recapture

A 1031 exchange allows an investor to postpone recognizing both capital gains and depreciation recapture. The principle is that the investor is continuing their investment in a new property rather than cashing out. The tax liability that would have been due is rolled over into the replacement property.

For a complete deferral, the replacement property must be of equal or greater value than the one sold. The investor must also reinvest all net equity and maintain an equal or greater amount of debt on the new property, or add cash to cover any debt reduction. When these conditions are met, the tax payment is deferred.

This deferral applies to both unrecaptured gain and any potential recapture from personal property. The tax attributes of the old property, including its recapture liability, are transferred to the new property. The deferred gain and recapture are held in suspense until the replacement property is sold in a taxable transaction.

This allows an investor to use the full proceeds for a new investment without reduction from immediate taxes. An investor can potentially defer this tax liability indefinitely by continuously exchanging properties. The obligation is triggered only when an investor sells a property for cash without reinvesting.

Triggers for Recognizing Recapture in an Exchange

Certain conditions can trigger the immediate recognition of gain, which is taxed first as depreciation recapture. This happens if the exchange is not a perfect rollover of value. Any cash or non-like-kind property received is known as “boot,” and its fair market value is taxable up to the total gain on the sale.

Common forms of boot include cash received from the proceeds or debt relief. Debt relief occurs if the mortgage on the new property is less than the mortgage paid off on the old one. This difference is treated as boot unless the investor adds an equivalent amount of cash to the purchase.

Receiving property that is not “like-kind” also constitutes boot. While like-kind is broad for real estate, it excludes personal property. If an investor exchanges an improved building for raw land, the value of the building’s depreciable parts may be considered boot if the new property lacks equivalent depreciable assets.

When boot is present, a tax ordering rule applies. Any recognized gain is first taxed as depreciation recapture before being treated as a capital gain. The gain is first allocated to recapture from personal property at ordinary income rates, then to unrecaptured gain from the real property at the 25% rate. Any remaining gain is then taxed at long-term capital gains rates.

For instance, an investor has a total gain of $200,000, including $80,000 of potential depreciation recapture. If they receive $50,000 of cash boot in the exchange, this entire $50,000 is taxed as depreciation recapture. The remaining $30,000 of potential recapture and the $120,000 of capital gain stay deferred.

Calculating Basis and Future Recapture on Replacement Property

A 1031 exchange impacts the new property’s starting basis for future depreciation and gain calculation. The deferred gain from the original property is embedded in the new property’s basis. This carryover basis is calculated as the replacement property’s purchase price minus the deferred gain.

For example, an investor sells a property for $800,000 with a $500,000 adjusted basis, resulting in a $300,000 gain. They exchange into a new property worth $1,000,000. The new property’s basis is its $1,000,000 price minus the $300,000 deferred gain, for a new adjusted basis of $700,000.

The deferred depreciation recapture from the old property is also carried over to the new one. If the investor’s $300,000 deferred gain included $150,000 of potential recapture, that liability attaches to the new property. Upon its eventual sale, the investor must recognize both the new depreciation taken and the $150,000 of recapture deferred from the prior property.

Investors must maintain detailed records for this reason. The depreciation schedule for the replacement property has two parts: the carried-over basis from the old property, which is depreciated over its remaining life, and any new basis, which is depreciated over a new 27.5 or 39-year schedule.