Depreciation can be a real estate investor’s best friend, resulting in tremendous tax savings each year when it comes time to report rental income to the IRS.
One of the major downsides of depreciation is that it can be a bit complex to figure out. For example, your first and last year’s depreciation must be prorated depending on when you buy and sell the property. If you make any capital improvements, they must be added to the cost basis of the property and your annual depreciation deductions will change. And, you’ll need to keep a running total over the years to keep track of your total depreciation.
A 1031 exchange can help you avoid capital gains and depreciation recapture taxes, but it adds another layer of complication to the depreciation process. So, here’s a quick guide to help you navigate the depreciation schedule for your property after you’ve completed a 1031 exchange.
Depreciation becomes a bit more complex after a 1031 exchange
It sure would be easier if you could simply take the acquisition cost of the newly acquired, or replacement, property and start a new 27.5-year depreciation schedule after you complete your 1031 exchange. Unfortunately, it’s not nearly that simple.
Calculating the cost basis of your replacement property
When you complete a 1031 exchange, you’re essentially transferring your real estate investment (and its history) into another property. For this reason, your cost basis carries over from your original, or relinquished, property to the new one.
If the replacement property you acquire in the 1031 exchange costs more than the net sale proceeds of the relinquished property, the difference is also added to the cost basis.
For example, let’s say that I acquired a single-family investment property about five years ago for a net acquisition cost of $100,000. Over the time I’ve owned the property, I’ve taken $15,000 in depreciation, which brings my adjusted cost basis down to $85,000.
Now, let’s say that I sell the property for net proceeds of $150,000, giving me a $65,000 capital gain. Because I don’t need the money and have no desire to pay the capital gains tax on that amount of money, I decide to complete a 1031 exchange. So, I start the 1031 exchange process and acquire a duplex for $200,000 including my acquisition and 1031 exchange expenses.
In this case, the $85,000 adjusted cost basis from the relinquished property will carry over and the $50,000 in additional money I spent to acquire the replacement property will be added, which will give me a new adjusted cost basis of $135,000 in the replacement property. This may seem odd, considering that I paid a lot more for it, but that’s the way it works in a 1031 exchange.
With all of that in mind, there’s a quick method to calculate the cost basis of your replacement property. Simply take its acquisition cost and subtract the capital gain you’re deferring in the exchange. In our example, the $200,000 acquisition cost minus the $65,000 capital gain on the relinquished property gives the same $135,000 cost basis.