1031 Exchange and Depreciation: The Complete Guide

How depreciation works on investment property

The IRS requires you to depreciate the cost of improvements (not land) on investment and business property over a set recovery period:

You must claim depreciation even if you don't want to. Under the "allowed or allowable" rule, the IRS reduces your basis by the depreciation you should have claimed, regardless of whether you actually did.

Annual depreciation provides a current tax benefit (reducing taxable rental income). But it also reduces your adjusted basis, which increases your gain - and your depreciation recapture tax - when you eventually sell.

What happens to depreciation in a 1031 exchange

When you complete a 1031 exchange, three depreciation-related things occur:

1. Depreciation recapture is deferred. The 25% recapture tax on all depreciation you've claimed (or should have claimed) is deferred along with your capital gains.

2. Your carryover basis continues depreciating. The remaining depreciable basis from your relinquished property transfers to the replacement property and continues on the original depreciation schedule.

3. Any excess basis starts a new schedule. If the replacement property costs more than the relinquished property's adjusted basis, the difference starts a fresh depreciation schedule.

Carryover basis vs. excess basis

This is the most important concept in post-exchange depreciation.

Carryover basis = The remaining depreciable basis from your relinquished property. This amount continues to depreciate over the remaining useful life of the original schedule.

Excess basis = The difference between the replacement property's depreciable value and the carryover basis. This starts a new depreciation schedule from the acquisition date.

Example:

You now have two depreciation schedules running simultaneously:

• Schedule A: $190,909 over the remaining 17.5 years = $10,909/year
• Schedule B: $289,091 over 27.5 years = $10,512/year
• Total annual depreciation: $21,421

Calculating your new depreciation schedules

The calculation requires several inputs:

1. Your relinquished property's remaining depreciable basis. Original depreciable basis minus total depreciation claimed.
2. The remaining recovery period. How many years are left on the original 27.5-year or 39-year schedule.
3. The replacement property's total depreciable value. Purchase price minus land allocation.
4. The exchange calculation. Determines carryover basis and any boot or gain recognized.

Your CPA will typically prepare this calculation as part of the Form 8824 reporting. The dual-schedule output is then reflected on your Schedule E for each subsequent tax year.

Important: The land allocation on the replacement property matters significantly. A higher land allocation means less depreciable value, which means less excess basis depreciation. Have a reasonable basis for your land allocation - local assessor records, appraisals, or comparable sales analysis.

Serial exchanges and stacking depreciation

Investors who exchange multiple times accumulate multiple depreciation schedule layers. After three exchanges over 25 years, you might have:

• Carryover Schedule A from Property 1 (5 years remaining)
• Carryover Schedule B from Property 2 (12 years remaining)
• Excess Schedule C from Property 2 (20 years remaining)
• Excess Schedule D from Property 3 (27.5 years remaining)

Each schedule has its own annual depreciation amount and remaining life. This stacking is manageable with proper software and a CPA who understands 1031 exchanges, but it becomes increasingly important to maintain meticulous records with each exchange.

Cost segregation after a 1031 exchange

A cost segregation study accelerates depreciation by reclassifying building components (carpet, appliances, certain electrical, plumbing fixtures) from 27.5/39-year property to 5, 7, or 15-year property.

You can perform a cost segregation study on a replacement property acquired through a 1031 exchange, but it applies only to the excess basis, not the carryover basis. The carryover basis continues on its original schedule regardless.

This makes cost segregation most valuable when you're buying a significantly more expensive replacement property, creating substantial excess basis that can be accelerated.

If bonus depreciation is available (check current rates - it has been phasing down), the combination of excess basis and cost segregation can generate large first-year deductions.

Record-keeping requirements

For each exchange, maintain:

• Closing statements (HUD-1 or ALTA) for both the sale and the purchase
• Exchange documents from your QI (exchange agreement, identification letters)
• Form 8824 as filed with your tax return
• Depreciation schedules showing carryover basis, remaining life, and excess basis
• Land allocation documentation for both properties
• Capital improvement records for the relinquished property

Store these permanently. Unlike most tax records (which have a 3-7 year retention period), 1031 exchange records must be kept as long as you hold the replacement property and for 3 years after you eventually dispose of it. For serial exchangers, this means keeping records from every exchange in the chain - potentially spanning decades.