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?
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
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.
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.
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.