1031 Exchange and Depreciation Recapture

What Is Depreciation Recapture?

Every year you own a rental property, the IRS allows you to deduct a portion of the building's value as depreciation. Residential rental properties depreciate over 27.5 years; commercial properties over 39 years. This deduction reduces your taxable income while you hold the property.

The catch: when you sell, the IRS wants that money back. Depreciation recapture is the process by which the IRS taxes the depreciation deductions you previously took. For real property, this is called "unrecaptured Section 1250 gain" and it is taxed at a maximum federal rate of 25 percent, separate from and in addition to your capital gains tax.

How Depreciation Recapture Is Calculated

When you sell investment property, your gain is divided into two components. The first is your capital gain, which is the difference between your net sale price and your adjusted basis (original purchase price plus improvements, minus accumulated depreciation). The second is your depreciation recapture, which equals the total depreciation you have taken over your holding period.

For example: if you purchased a rental property for $400,000, took $100,000 in depreciation over 10 years, and sold it for $600,000, your adjusted basis is $300,000. Your total gain is $300,000. Of that, $100,000 is depreciation recapture taxed at up to 25 percent, and $200,000 is capital gain taxed at your long-term capital gains rate.

How a 1031 Exchange Defers Depreciation Recapture

A properly executed 1031 exchange defers both the capital gains tax and the depreciation recapture tax. When you exchange into a replacement property of equal or greater value, the entire gain, including the recaptured depreciation, is carried forward into the new property. No tax is due at the time of the exchange.

The deferred depreciation recapture does not disappear. It is embedded in the adjusted basis of the replacement property and will be due when you eventually sell without exchanging. However, many investors continue to exchange indefinitely, deferring the tax for decades. Some pass the property to heirs, who receive a stepped-up basis at death, potentially eliminating the deferred tax entirely.

Depreciation on the Replacement Property

After a 1031 exchange, your depreciation schedule on the replacement property is based on your carryover basis, not the full purchase price of the new property. This is an important distinction. If you paid $800,000 for the replacement property but your carryover basis is $300,000, you depreciate the $300,000 carryover basis over the remaining useful life, plus any additional amount paid (the "excess basis") over a new 27.5 or 39-year schedule.

This means your annual depreciation deductions on the replacement property may be lower than if you had purchased it outright without an exchange. Your CPA should prepare a detailed depreciation schedule after the exchange closes.

State Depreciation Recapture Rules

Most states follow the federal treatment and also defer depreciation recapture in a 1031 exchange. However, some states, notably California, have enacted "clawback" provisions that may require you to pay state tax on deferred gain if you eventually sell the replacement property while residing outside California. If you are considering exchanging out of a California property, consult with a tax advisor familiar with California's clawback rules.

Free Consultation

Understanding the full tax picture, including depreciation recapture, is essential before you list your property. Attorney Steve Wolterman, CES has guided hundreds of investors through the tax analysis and exchange process. Call 866-455-7268 or fill out our contact form for a free consultation.