How to Handle Depreciation in a 1031 Exchange

A 1031 exchange allows investors to defer capital gains taxes on the sale of an investment property by reinvesting the proceeds into a similar asset. Separately, depreciation is an annual tax deduction that lets property owners recover the cost of an income-producing property over its useful life. When these two tax concepts intersect, specific rules come into play.

An exchange involves not just the property’s market value but also its tax history, including all previously claimed depreciation deductions. Navigating these rules is necessary to avoid an immediate tax liability when transitioning between properties.

Understanding Depreciation Recapture in a 1031 Exchange

When an investment property is sold, the IRS requires the seller to pay taxes on the gain, a portion of which is subject to depreciation recapture. Since you lowered your ordinary income with depreciation each year, the IRS “recaptures” that benefit by taxing a portion of your gain. For real property, this part of the gain, known as unrecaptured Section 1250 gain, is taxed at a maximum rate of 25%. Any gain beyond the recaptured depreciation is taxed at the applicable long-term capital gains rates.

A 1031 exchange defers this depreciation recapture tax and the standard capital gains tax. The tax liability from recapture does not disappear; it is rolled over into the new property. This deferred amount is recognized when you sell the new property in a taxable transaction. To fully defer this tax, the value of the depreciable assets in the new property must be at least equal to the value of those in the old one.

If an investor exchanges an improved property for unimproved property like vacant land, the depreciation recapture is triggered. To defer recapture, the replacement property must contain depreciable assets of equal or greater value than the relinquished property, and land has no depreciable value.

Calculating the Basis of the Replacement Property

Calculating the new property’s tax basis is a core part of a 1031 exchange. The starting point is the relinquished property’s “adjusted basis”: its original purchase price, plus capital improvements, minus total depreciation claimed. The basis of the replacement property is its fair market value minus the deferred gain. The deferred gain is the total gain realized on the sale of the old property minus any “boot”—such as cash or debt reduction—received and taxed in the current year.

For future depreciation, this new basis must be separated into two parts: the “carryover basis” and the “excess basis.” The carryover basis is the portion of the new property’s basis equal to the adjusted basis of the old property. For instance, if the adjusted basis of your relinquished property was $350,000, then $350,000 of the new property’s basis is the carryover basis.

The excess basis is any additional basis created when you acquire a more expensive property by adding cash or taking on a larger mortgage. If your new property has a total basis of $630,000 and a carryover basis of $350,000, the remaining $280,000 is the excess basis.

Depreciating the Replacement Property

Once the basis is split into its carryover and excess components, you can determine the annual depreciation deductions. Per Treasury Regulation 1.168, specific rules apply to each component. However, taxpayers can elect to treat the entire basis of the replacement property as a new asset, depreciating it over a new recovery period. This election must be made for the tax year in which the property is placed in service.

How to Depreciate the Carryover Basis

The carryover basis is depreciated over the remaining recovery period of the relinquished property, using the same depreciation method. For example, if you exchanged a residential rental that you had depreciated for 10 years on a 27.5-year schedule, the carryover basis is depreciated over the remaining 17.5 years. This continuation rule applies if the new property has the same or a shorter recovery period. If the replacement property has a longer recovery period, the carryover basis is depreciated over the longer period of the new asset.

How to Depreciate the Excess Basis

The excess basis is treated as a new asset for depreciation purposes. This portion is depreciated using the standard Modified Accelerated Cost Recovery System (MACRS) recovery period for the new property type, such as 27.5 years for a residential rental.

Continuing the previous example, with a total basis of $630,000 composed of a $350,000 carryover basis and a $280,000 excess basis. The $350,000 carryover basis would be depreciated over the remaining 17.5 years. The $280,000 excess basis would be depreciated separately over a fresh 27.5-year schedule, and the total annual deduction is the sum of both calculations.

Required Tax Forms and Reporting

Reporting a 1031 exchange is centered on Form 8824, Like-Kind Exchanges. To complete the form, you will need several pieces of information:

• Dates the replacement property was identified (within 45 days of the sale) and received (within 180 days)
• Fair market values of both the relinquished and replacement properties
• The adjusted basis of the relinquished property
• Details of any boot, such as cash received or debt relief

Part III of the form uses this information to calculate the realized gain, the amount of gain that is taxable (if any), and the final basis of the new property.

Once completed, Form 8824 must be attached to your annual income tax return for the tax year in which the exchange was initiated. This filing officially documents the deferral of the gain and establishes the basis for future depreciation of the new property.