What Happens to Depreciation in a 1031 Exchange?

A 1031 exchange allows real estate investors to defer capital gains taxes by reinvesting the proceeds from a sold property into a new, like-kind property. A frequent point of confusion for investors is how the depreciation claimed on the old property affects the new one, a process involving specific calculations for the new property’s basis and distinct rules for its subsequent depreciation.

Foundational Concepts of Basis and Depreciation

A property’s “basis” is its value for tax purposes. Initially, the basis is the purchase price of the asset plus any acquisition costs, such as certain legal fees, title insurance, and appraisal fees. Over time, the basis changes, leading to the concept of “adjusted basis.” The most significant adjustment comes from depreciation, an annual tax deduction that accounts for the wear and tear on the property. Each year, the amount of depreciation claimed reduces the property’s basis, meaning the adjusted basis is the original basis minus total accumulated depreciation.

Depreciation is a non-cash expense that allows investors to recover the cost of their income-producing property over its useful life, lowering their taxable income each year. For residential rental properties, this period is 27.5 years, while for commercial properties, it is 39 years. Only the value of the buildings and improvements can be depreciated; the value of the land cannot.

Calculating the Basis of the Replacement Property

In a 1031 exchange, an investor does not start with a new basis equal to the purchase price of the replacement property. Instead, the adjusted basis from the old (relinquished) property is carried over to the new (replacement) property, a concept known as a “substituted basis” or “carryover basis.” This preserves the deferred gain from the first property within the basis of the second.

The calculation for the new property’s basis begins with the adjusted basis of the relinquished property and is increased by any new value introduced. The formula is: Adjusted Basis of Old Property + Additional Cash Paid or New Debt Acquired = Basis of New Property. For example, if a property with an adjusted basis of $350,000 is exchanged for a new property by adding $850,000 in new funds, the new property’s basis is $1.2 million.

An element in this calculation is “boot,” which is any non-like-kind property received in the exchange. Boot most commonly takes the form of cash received by the investor or debt reduction, where the mortgage on the new property is less than the mortgage paid off on the old one. Receiving boot does not disqualify the exchange, but it does introduce a taxable component, as the gain is recognized up to the value of the boot received.

How to Depreciate the Replacement Property

Once the basis of the replacement property is determined, the method for depreciating it is not as simple as starting a new schedule. IRS regulations require the new property’s basis to be split into two distinct parts for depreciation purposes, each with its own schedule. This rule ensures the tax deferral benefits are properly maintained.

The first part is the “carryover basis,” which is the portion of the new property’s basis equal to the adjusted basis of the relinquished property. This amount must continue to be depreciated on the same schedule as the old property. For example, if a residential rental property was held for 10 years, it had 17.5 years remaining on its 27.5-year schedule. The carryover basis must be depreciated over that remaining 17.5-year period.

The second part is the “excess basis,” which is any additional basis created by investing more money in the replacement property. This excess amount is treated as a newly acquired asset and is depreciated over a fresh recovery period, either 27.5 years for residential or 39 years for commercial property. This creates two separate depreciation schedules that run concurrently for the same property.

To illustrate, assume an investor exchanges a commercial property with an adjusted basis of $500,000 and 29 years remaining on its schedule. They acquire a new commercial property for $800,000, adding $300,000 in new funds. The $500,000 carryover basis continues to be depreciated over the remaining 29 years, while the $300,000 excess basis is depreciated separately over a new 39-year schedule.

The Role of Depreciation Recapture

A primary benefit of a 1031 exchange is the deferral of depreciation recapture tax. When a property is sold in a taxable transaction, the IRS “recaptures” the depreciation that was deducted over the years. The gain attributable to that depreciation is taxed at a special rate, which can be up to 25% for straight-line depreciation on real property under Section 1250 of the tax code.

In a fully deferred 1031 exchange, this depreciation recapture tax is postponed. The recaptured amount is rolled into the new property along with the capital gain, and the tax obligation is carried forward until the replacement property is eventually sold in a taxable transaction.

However, the deferral is not always absolute. If an investor receives boot in the exchange, it triggers a taxable event, and the investor must recognize their realized gain up to the amount of the boot. Tax rules specify that any gain attributable to depreciation is recognized first. This means boot is first taxed as recaptured depreciation at the 25% rate before any remaining amount is taxed at the lower long-term capital gains rate.