As you invest from a 1031 exchange into a Delaware Statutory Trust (DST), one concern that you might want to consider is depreciation. What happens to the depreciation from the previous property? Do you get a fresh start now that the DST has several underlying income-generating assets? The answer isn’t straightforward, but it’s largely reliant on how tax laws view your basis, what’s considered “new,” and what “carries over.”
In this article, Realized 1031 goes in-depth into this topic to help you gain a better grasp. Let’s take a closer look.
Depreciation, or more formally known as accounting depreciation, is the paper losses that account for an asset’s wear and tear over the years. The main benefit of applying depreciation is that it reduces the value of your property for tax purposes, reducing your tax burden. For commercial properties, the main framework followed is the straight-line depreciation. This is a 39-year schedule that allows you to deduct a roughly equal percentage of the building’s cost each year over that period.
In 1031 exchanges, depreciation schedules typically don’t reset. Since there is no official sale, depreciation also continues. This reality adds a few complications when you invest in a DST, which can own multiple properties.
The basis carries over from your relinquished property into the new investment, even if it’s a DST. This also means that the depreciation you applied to the old asset will carry over and continue in the new one, but only that portion.
Let’s say that you relinquished an asset that you’ve been depreciating for the past 10 years. As you enter the DST, the portion of your new investment that represents deferred gains continues to year 11. This continuation helps with compliance with IRS rules. Only when a taxable event occurs does the depreciation schedule reset.
The only time depreciation “resets” is when a portion of your investment is new capital, not from the basis carried over. This capital is also called the new-money basis, and it’s treated as a new acquisition. As such, this portion qualifies for a new depreciation schedule.
DSTs, thanks to their structure, take care of the depreciation schedules for the underlying properties. The resulting benefits flow through to the investors. As such, the only schedule that you really need to consider is that of the carryover and new basis, if applicable.
Even so, depreciation still has a direct impact on your taxable income from the DST. Since the figure reduces the portion of income subject to taxation, knowing what carries over and what resets helps you calculate your tax obligations more accurately, preventing unwanted surprises.
This understanding also applies when you sell DST interests. If you saw a profit, then depreciation recapture will be applicable. Knowing how much you’ll need to pay helps you prepare ahead.
As you finish a 1031 exchange by entering a DST, understanding how depreciation applies to your carry-over basis and new money basis is crucial for proper tax planning. Work closely with your tax advisor to better grasp how such a blended depreciation schedule works and what it means when you eventually sell your DST interests or stop the 1031 exchange cycle.
Sources:
https://www.irs.gov/publications/p946
https://www.investopedia.com/financial-edge/0110/10-things-to-know-about-1031-exchanges.asp
https://www.investopedia.com/articles/investing/060815/how-rental-property-depreciation-works.asp