How Does Depreciation Work in a 1031 Exchange?
In a 1031 exchange, your old property's depreciation history carries forward, influencing the tax treatment and future deductions for your new asset.
A 1031 exchange allows investors to defer capital gains taxes by swapping one investment property for another. Under Section 1031 of the Internal Revenue Code, this process has a direct interaction with depreciation, which is an annual tax deduction allowing investors to recover their property’s cost over its useful life. When a property is sold, the tax implications of past depreciation deductions come to the forefront. The relationship between a 1031 exchange and depreciation rules impacts an investor’s tax basis in the new property and the strategy for future deductions.
Deferring Depreciation Recapture Tax
When an investor sells a property, the IRS requires a “recapture” of the accumulated depreciation deductions. This portion of the sale’s gain, known as unrecaptured Section 1250 gain, is taxed at a federal rate of up to 25%, separate from the standard capital gains tax. A 1031 exchange allows an investor to defer this immediate tax liability by rolling the entire gain into the replacement property. The tax is not eliminated but postponed, allowing the investor’s capital to remain fully invested.
Consider an investor who sells a rental property for $800,000. They originally purchased it for $500,000 and have since claimed $100,000 in depreciation deductions. Their adjusted basis is $400,000 ($500,000 cost – $100,000 depreciation). The total gain is $400,000 ($800,000 sale price – $400,000 adjusted basis). Of this gain, $100,000 is subject to the 25% depreciation recapture tax, resulting in a $25,000 tax liability on that portion alone. By using a 1031 exchange, the payment of this $25,000, plus any capital gains tax on the remaining $300,000 of gain, is deferred.
Calculating the New Property’s Tax Basis
After a 1031 exchange, an investor must determine the correct tax basis for the newly acquired property, as this figure is the foundation for future depreciation deductions. The basis is not the purchase price of the new property. It is calculated by carrying over the basis of the old property and adjusting it for any new funds or debt involved in the transaction. This process ensures the deferred gain from the original property is embedded in the new one.
The formula for the replacement property’s basis is the adjusted basis of the relinquished property, minus any cash received, plus any new cash paid or additional debt taken on. The adjusted basis of the old property is its original purchase price, plus capital improvements, minus the total depreciation claimed. Any gain recognized from receiving “boot” (cash or non-like-kind property) must also be factored into the basis calculation. These details are reported to the IRS on Form 8824, Like-Kind Exchanges.
For example, an investor sells a property with an adjusted basis of $350,000 for $1 million. They purchase a replacement property for $1.2 million, adding $200,000 of their own cash to the exchange proceeds. The basis of the new property is not its $1.2 million purchase price. It is calculated as the old property’s adjusted basis ($350,000) plus the additional cash invested ($200,000), resulting in a new tax basis of $550,000.
How to Depreciate the Replacement Property
Once the new property’s basis is calculated, the investor must determine how to depreciate it according to IRS regulations. The basis of the replacement property is not treated as a single amount for depreciation. Instead, it is divided into two components, each with its own depreciation schedule. This ensures the tax deferral is properly accounted for over the life of the new asset.
The first component is the “carryover basis,” which is the portion of the new property’s basis equal to the adjusted basis of the old property at the time of the exchange. This amount is depreciated over the remaining recovery period of the original property. For instance, if a residential rental property with a 27.5-year life was held for 10 years before the exchange, its carryover basis is depreciated over the remaining 17.5 years.
The second component is the “excess basis,” which is any additional basis created by investing more cash or taking on more debt to acquire a more expensive replacement property. This excess amount is treated as a new asset for tax purposes. It is depreciated over a full, new schedule of 27.5 years for residential real estate or 39 years for commercial real estate.
Continuing the previous example, the new property has a total basis of $550,000. The carryover basis is $350,000 (the adjusted basis of the old property). Assuming the old property was a residential rental held for 10 years, this $350,000 will be depreciated over the remaining 17.5 years of its original schedule. The excess basis is $200,000 (the new cash invested). This amount will be depreciated over a fresh 27.5-year schedule.
Taxpayers can elect out of this two-part depreciation method. By making a formal election with their tax return for the year of the exchange, an investor can treat the entire basis of the new property as a single asset and depreciate it over a new recovery period. This simplifies record-keeping but may result in smaller annual deductions. The decision depends on the investor’s financial situation and long-term strategy.