When investors do a 1031 exchange, their basis carries over into the replacement property. They are also able to continue taking the annual depreciation expense. But does the depreciation restart or change from the existing schedule once the replacement property is acquired?
Calculating The New Basis
Using an example is the best way to see what happens to depreciation in a 1031 exchange. First, we will calculate the new basis for the replacement property. The properties in this example are residential rentals:
Purchase price: $500,000
Land Value: $100,000
Annual Depreciation: $500,000 - $100,000 = $400,000 / 27.5 = $14,545
Held for 7 years: 7 x $14,545 = $101,815 in total depreciation
Cost basis: $500,000 - $101,815 = $398,185
Sale price: $700,000
Gain: $700,000 - $398,185 = 301,815
The investor’s cost basis is $398,185, and the capital gain is $301,815.
This investor is doing a 1031 exchange into a $900,000 property. Because the replacement property costs more, additional funds must be added. In this case, $200,000 is added to the exchange (i.e., $900,000 - $700,000), which is also added to the cost basis.
New adjusted basis: $398,185 + $200,000 = $598,185
A 1031 Exchanges Impact on Depreciation
The investor has two options when it comes to depreciation for the replacement property. They can create two depreciation schedules or restart the schedule based on the new cost basis.
Two Depreciation Schedules
The first schedule uses the original cost basis of $398,185 and carries the depreciation through the remaining years. The property was held for seven years, leaving 20.5 years of depreciation. This sets up the first schedule.
The second schedule works off the amount of money added to the 1031 exchange. In this case, that’s $200,000. The $200,000 is depreciated over the full 27.5 years.
Restart Depreciation Schedule
This schedule works off the new cost basis of $598,185 and depreciates over the full 27.5 years.
Which schedule is right for you is best determined by talking to your tax and real estate professionals.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.
Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.
The income stream and depreciation schedule for any investment property may affect the property owner's income bracket and/or tax status. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities.
Costs associated with a 1031 transaction may impact investor's returns and may outweigh the tax benefits. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities.
Hypothetical examples shown are for illustrative purposes only.
