If you are here, you probably know by now that a 1031 exchange enables you to defer the gain you have when selling a property that you purchased for investment or for business use. However, what many people don’t factor in is depreciation. Depreciation is a term that refers to the tax benefit that allows you to recover the cost of a property over a predetermined period of time. Depreciation recapture is a significant factor in participating in a like-kind exchange in order to take advantage of the 1031 tax benefit.
So, what happens to depreciation in a 1031 exchange? Depreciation can be a little confusing, particularly if this is your first 1031 exchange, so we will try and keep it simple.
If your new property costs the same as you sold your relinquished property for:
This is the simplest type of 1031 exchange and makes calculating depreciation very easy. As you might expect, your depreciation schedule will remain the same as it was for your old property. This means you can continue your depreciation calculations as if you still own your now relinquished property, and your acquisition date, cost, any previous depreciation is taken and remaining un-depreciated basis all remain exactly as they were before.
If your new property costs more than you sold your relinquished property for:
Many people who participate in a 1031 exchange do so with the intention of ‘trading up’ and furthering their investments. In this scenario, you treat the buy-up part as you would a new addition to an existing property. The cost that you factor in is the difference between the sale of your old property and the purchase of the new one, and the depreciation date is the date that you acquired the new property. Meanwhile, the type of depreciation method that you use will be the one that is the most appropriate for the type of property in the year you bought it – NOT the type for your relinquished property!
If your new property costs less than you sold your relinquished property for:
This is sometimes referred to as a ‘buy-down’. In this instance, the depreciation basis of the new property will be the same as that of your old property – essentially, you will continue your depreciation schedule as if you owned the old property. However, you need to keep track of your depreciation recapture. Depreciation recapture is a process then enables the IRS to collect taxes on the financial gain you have made from the sale of an asset. Exactly what depreciation recapture rate will apply will depend on your individual circumstances.
The prospect of depreciation recapture entices many investors and business owners to opt to ‘trade-up’ in a 1031 exchange, rather than buy down.