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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.
Two depreciation options
With the cost basis method in mind, you might think that you now take the $135,000 adjusted cost basis and start the depreciation period on the replacement property. That is allowed, and is the easiest method, but there’s a lot more to the story.
Specifically, the IRS regulations state that you should split the depreciation into two schedules. Alternatively, you can choose to opt out and depreciate the entire cost basis on a new schedule. In simple terms, starting a new depreciation schedule is easier (especially if you acquired multiple properties in the 1031 exchange), but using the two-schedule method is generally the better way to go tax-wise. So, let’s take a closer look at both options.
Option 1: Separate depreciation schedules
If you choose to follow the IRS depreciation guidelines, you’ll have to depreciate the replacement property according to two separate depreciation schedules:
- Any remaining depreciation from your relinquished property must be continued on the original time schedule. In our example, if I owned the first property for five years, this means the remaining $85,000 adjusted cost basis would need to continue to be depreciated for another 22.5 years. (Remember that the total depreciation timeframe is 27.5 years for residential investment properties and 39 years for properties that are commercial in nature.)
- The rest of the cost basis in the replacement property -- that is, the portion that represents additional money spent on the new property -- is depreciated separately on a new depreciation schedule. In our example, the other $50,000 of the adjusted cost basis of the replacement property will be depreciated over a 27.5-year schedule, beginning at the time the 1031 exchange was finalized. This portion of the cost basis is also known as the excess basis and is the only part of the transaction that is treated as a new investment property in the eyes of the IRS.
Here’s the key takeaway: This method allows you to depreciate more of the cost basis each year than the alternative. It’s a bit more complicated, but it can be the most effective in reducing your taxable rental income.
Option 2: Treat the replacement property as a new asset
If you choose to opt out of the two-schedule method, you’ll still use the same cost basis method we discussed earlier. You’ll just choose to treat the entire cost basis as a newly acquired property.
Continuing the example we’ve been using of a replacement property with a $135,000 adjusted cost basis, you would simply take this amount and divide it by 27.5 to determine your annual depreciation deductions (or divide it by 39 if it’s a commercial property).
If you choose this method, you must elect to treat the replacement property as a new asset. You can do this on IRS Form 4562 (depreciation and amortization), which you’ll file along with your tax return in the year you close on the replacement property. If you don’t do this, you’ll be required to use the first option.
The key thing to know about this option is that it’s the less complicated of the two, but your depreciation deductions will be smaller than they otherwise would be (until the relinquished property’s depreciation schedule runs out).
Residential to commercial exchanges
So far, the discussion assumes that you’re exchanging one residential property for another, or one commercial property for another. And to be clear, most 1031 exchanges involve two properties of the same general type.
In the interest of being thorough, here are the rules for when you to a residential-to-commercial 1031 exchange or vice-versa.
- Residential to commercial -- If you’re replacing a residential property with a commercial property, you’ll use the longer commercial depreciation time period (39 years) for the new property, even if you choose the two-schedule option. In other words, the remaining part of the relinquished property’s cost basis would be depreciated over 39 years minus however long you’ve owned it.
- Commercial to residential -- If you replace a commercial property with a residential one, it’s a bit different. The remaining cost basis in the original property would still be depreciated on the commercial property schedule, with any excess basis in the replacement property depreciated over 27.5 years.
Which is the best option for you?
It depends of course. If you want to keep your taxes as simple as possible and aren’t too worried about your taxable rental income, it’s probably best to opt-out of the IRS regulations and simply treat the replacement property as a single, newly acquired asset. On the other hand, if you want to maximize your depreciation tax benefits after the 1031 exchange is complete, it’s usually smarter to use the two-schedule depreciation method as the IRS advises. And of course, remember that every 1031 exchange and personal financial situation is different, so it’s always a smart idea to seek advice from an experienced and qualified tax professional.
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