Learn
A little clarity for your next decision.
Loading your learning library…
Investor WorkspaceWelcome, there!Log Out
Investor WorkspaceA little clarity for your next decision.
By Jerry Baker
A 1031 exchange usually carries your old tax basis into the replacement property instead of resetting it to the purchase price. Some added basis may start a new depreciation schedule, while the carried basis follows special continuation rules. An election can change those schedules, but it does not create a fresh market-value basis.
The new building may be newer and have better tenants. It may cost much more than your old property did. None of those facts, by themselves, tell you its depreciation deduction. The starting point is the tax basis that comes through the exchange.
Basis is your tax investment in the property. It starts with cost or another amount the law requires. It then changes for items such as upgrades and tax deductions. It is not the same as market value, your mortgage balance, or the equity you receive at closing. [1]
In an exchange, gain that is deferred stays in the new property’s basis math. That is how the tax system preserves gain you have not recognized yet. Saying “I spent $2 million, so I can depreciate $2 million” skips both the exchange calculation and the nondepreciable land.
I would want this worked out before relying on a claim that an investment will shelter a certain share of its income. A sample from a sponsor cannot know the basis history of each buyer.
Replacement value is the value of what you acquire. It matters for the exchange and investment analysis. Total replacement tax basis reflects the exchange adjustments. Depreciable basis is the portion eligible for depreciation after allocations and other rules.
Consider a hypothetical exchange with no debt, expenses, or boot. Your old property is worth $1 million and has adjusted basis of $400,000. You exchange into property worth $1.25 million and add $250,000. The replacement basis is $650,000, not $1.25 million. The $600,000 deferred gain is the difference. [1]
That $650,000 still is not all a building deduction. It must be allocated among the assets received. Land does not wear out for depreciation purposes and generally is not depreciable. Buildings and qualifying improvements may be. [4]
The example is deliberately simple. Real closings can include debt changes, taxable boot, exchange expenses, separate assets, and several properties. Have the CPA work from the actual sale and purchase. Do not just add your check to last year’s balance sheet.
Carryover basis is the tax history brought forward from the property you gave up. The tax rules use the term “exchanged basis.” It is measured after the old property’s allowed deduction for the sale year. Excess basis is the replacement basis above that exchanged amount. [3]
These labels describe basis, not profit. Carryover basis is not the deferred gain itself. In the simple example above, $400,000 of basis carries forward while $600,000 of gain is deferred. Confusing those numbers would produce a very different deduction.
Trading up can add excess basis. That additional investment can involve cash or financing, subject to the actual exchange calculation. But not every dollar borrowed becomes a new deduction. The loan must help pay an eligible cost that adds basis. Land still needs its share. [1]
Ask for a worksheet that shows old adjusted basis, recognized gain if any, exchange adjustments, total replacement basis, and allocation by asset. Then ask how each depreciable piece is carried forward. One total cannot show the timing of the deductions.
For qualifying MACRS property, the carryover portion generally continues over the old remaining recovery period with the same method and convention. MACRS is the federal system used to recover the cost of most business and investment property placed in service after 1986. [2]
That rule has limits. It generally applies when the replacement has the same or a shorter recovery period and the same or a more accelerated method. The new asset may require a longer period or a slower method. If so, special rules adjust the carried portion. The result is not always “copy the old schedule without changes.” [2]
For example, moving from residential rental property to nonresidential real property can change the analysis. Both may qualify as like-kind real estate for the exchange, but that does not make their depreciation periods the same. Whether an exchange works and how to claim deductions are separate questions.
The excess basis generally is treated as newly placed in service. Its method, period, and convention depend on the replacement asset and the applicable rules. A building, a land improvement, and another component may not belong on one schedule. [3]
Under the general depreciation system, residential rental buildings generally use 27.5 years and nonresidential real property generally uses 39 years. Those familiar numbers apply to the building basis under the relevant rules. They are not a promise that the full offering price can be divided by 27.5 or 39. [2]
A different tax system may require other periods. It applies in certain situations, including some tax elections. Other components may have their own treatment. Ask the preparer which system applies to each asset and why.
The start date matters too. For rental property, that generally means ready and available for its intended rental use. The day a deed is signed is not always the day a building is ready for tenants. [4]
First-year, exchange-year, and final-year deductions use timing conventions. Residential and nonresidential real property generally use a mid-month convention. A simple annual division is useful for a rough comparison, but it should not be presented as the amount to put on a return.
Assume the CPA has already completed the exchange and land allocations. The replacement residential building has $300,000 of depreciable exchanged basis and $200,000 of depreciable excess basis. The carried portion has 15 years remaining, uses straight-line depreciation, and qualifies for continuation. Ignore partial-year effects and special deductions.
For a full illustrative year while both portions are running, the carried deduction is $300,000 divided by 15, or $20,000. The new portion is $200,000 divided by 27.5, or about $7,273. Together, they produce about $27,273 of depreciation.
| Basis portion | Amount | Illustrative remaining period | Full-year deduction |
|---|---|---|---|
| Carried depreciable basis | $300,000 | 15 years | $20,000 |
| New depreciable excess basis | $200,000 | 27.5 years | About $7,273 |
| Total | $500,000 | Two schedules | About $27,273 |
This is a schedule illustration, not a forecast for a named property. It assumes the CPA has already confirmed the relevant basis and treatment. The exact return uses dates, conventions, and the detailed rules. [2] [3]
Notice what happens later. The carried deduction finishes before the excess-basis schedule. A projection that repeats the initial total forever would overstate the tax shelter. Cash paid to you could stay the same while taxable income rises.
A taxpayer can elect out of the special continuation treatment for qualifying MACRS property. For depreciation purposes, the adjusted carried basis and excess basis are then treated as placed in service at the applicable replacement time. The election changes how you calculate deductions. It does not reset basis to market value or undo the gain deferral. [3]
Using the same simplified residential example, an election could put the $500,000 depreciable basis on a new 27.5-year schedule. That is about $18,182 for a full illustrative year. It is less than the approximately $27,273 produced by the assumed split schedules.
The longer new schedule can spread deductions into later years. That may or may not serve your tax picture. The point is that “restart” does not automatically mean “more.” It can mean smaller annual deductions for longer.
The election generally must be made with a timely filed return, including extensions, for the replacement year. Rules for the owner’s entity can control who makes it. Once made, it cannot simply be reversed at will; IRS consent is required. Have the CPA compare the options before filing. [2] [3]
Ask for both schedules over your expected holding period. Compare current usable deductions, later deductions, projected taxable income, and the sale outcome. Choosing from a first-year number alone can miss much of the difference.
A fully depreciated building has no remaining building basis to deduct merely because it is exchanged. Buying a more expensive replacement may create new basis. Acquiring different assets may also change allocation and treatment. But there is no automatic fresh deduction equal to the new property’s full value.
Also distinguish a fully depreciated building from a property with no basis at all. The land can still have basis, and later improvements may still have their own schedules. A summary that says “fully depreciated” can hide those details. [1] [4]
Exchanging nondepreciable land for depreciable property involves special rules too. Basis assigned to the acquired depreciable property may be placed into depreciation even though the old land had no building schedule. This is an allocation and classification question, not an exception that makes land itself depreciable. [3]
Before you compare deals, find the full fixed-asset schedule. Look for additions, replaced components, and prior exchanges. The building’s original purchase date alone does not tell you what basis remains today.
A cost-segregation analysis can identify components that qualify for different depreciation treatment. It does not turn deferred gain into basis. Nor does a large first-year deduction shown for a cash buyer prove that an exchange investor receives the same deduction.
Bonus depreciation has separate requirements for asset type, acquisition date, use, and other facts. Exchange rules also distinguish certain new property from used property when determining which basis can qualify. The election discussed above does not itself change bonus-depreciation eligibility. [2]
Do not apply one headline bonus percentage to an entire apartment building. The building shell, qualifying components, land, and carried basis can have different results. Federal law and state treatment also need separate review.
Ask the sponsor or seller for the underlying allocation and study, if one exists. Ask your CPA which figures apply to your basis and which do not. A useful answer identifies the asset, amount, timing, and reason for each proposed deduction.
There can be a future tradeoff. Faster deductions reduce basis sooner and may change the character of gain when the property is sold. A larger deduction is worth examining, but it is not a stand-alone measure of investment quality. [6]
Depreciation is generally a noncash deduction. You do not write a new check each year simply because you claim it. That is why a rental can produce cash and report less taxable income. But the cash and tax calculations can differ for other reasons too.
Loan principal payments use cash but are not the same as deductible interest. Capital spending may use cash before its cost is recovered through deductions. Reserves and timing differences can also separate cash distributions from taxable results. Do not label the difference “tax-free income” without explaining it.
For a stripped-down example, assume net rental income before depreciation is $40,000 and the applicable depreciation deduction is $27,273. That leaves about $12,727 before other tax adjustments. If the deduction is currently usable and the relevant marginal tax rate is 30%, the simplified current tax reduction is about $8,182.
Those are hypothetical figures, not a personal after-tax return. Passive-activity, at-risk, and other limits may delay a deduction. Tax rates and state rules can also change the result. A deduction that creates a suspended loss may not reduce this year’s tax bill. [5]
I would rather see a modest, well-supported estimate than a large shelter percentage that assumes every investor has the same tax return. Ask the CPA to separate deductions generated from deductions you can use now.
A qualifying Delaware statutory trust can be treated as a grantor trust whose investors own interests in the underlying real estate for federal income-tax purposes. That treatment depends on the structure and restrictions described in the IRS ruling; the letters “DST” alone do not establish it. [7]
Two investors in the same DST can have different basis histories. One may buy with new cash. Another may arrive after several exchanges with substantial deferred gain. The property is the same, but their depreciation calculations may differ.
Give your CPA the tax records and your old schedules. Add your share of ownership and debt, plus the purchase details. Ask how sponsor-provided figures are being adjusted for your exchange. Do not assume a general tax illustration is a substitute for that work.
Also ask what happens if the program later changes structure, sells assets, or offers a Section 721 contribution. Those events need their own tax review. A depreciation discussion should not quietly promise that today’s reporting and future exchange options will remain unchanged forever.
Depreciation generally reduces adjusted basis. At a later taxable sale, that can increase the gain compared with an otherwise identical property with higher basis. The type of asset and past deductions affect how the gain is taxed. [6]
Do not use “25% recapture” as a label for every depreciation dollar. Unrecaptured Section 1250 gain can face a federal maximum rate of 25%. Section 1245 recapture is a separate ordinary-income rule. A building and components identified in a cost-segregation study may therefore require different treatment.
An exchange can postpone eligible gain, but special recapture rules still need review. The old depreciation history is not erased by changing the property’s address. Keep that history through each exchange.
Inherited property may receive a new basis under the rules that apply at death. That is a separate legal event with exceptions and ownership details. It is not a promise that every estate will avoid every tax. [1]
Start with the cash the property is expected to pay. Then ask what happens if that amount falls or stops. The deduction may soften a tax bill, but it will not pay a household expense when the property has no cash to send.
Next, build a separate tax column for each year. Show income before the deduction, the planned deduction, the portion you can use now, and any loss carried forward. Keep the federal and state estimates separate if they use different rules.
Mark the year each old schedule ends. If a large carried deduction finishes in year four, do not use year one as the model for years five through ten. Include planned improvements only when there is a sound basis for their cost and tax treatment.
Finally, add a sale case. Use a range of sale values and selling costs. Have the CPA estimate gain from the projected basis at that time. A tax benefit today and a tax cost later should be visible in the same comparison.
This also gives you a way to compare two deals fairly. One may pay more cash but produce fewer usable deductions. Another may generate a large paper loss you cannot use this year. Compare the money you expect to keep, the risks to that money, and how long it must stay invested.
The result will still be a forecast. Its value is that you can see which facts drive it and update them as new records arrive.
Bring more than the last tax return. Provide the full depreciation schedule, original purchase documents, improvement records, earlier exchange calculations, and sale closing statement. Include any cost-segregation study and elections already made.
For the replacement, gather the purchase or subscription documents, closing costs, allocation among assets, and placed-in-service information. Identify whether the property is held directly or through an entity and who files the relevant return.
Ask for a final schedule that reconciles to the exchange calculation and separates land from depreciable assets. The carried and excess portions should be traceable. Have the preparer flag assumptions that still depend on final sponsor information.
Keep these records long enough to support the tax result when the replacement is eventually disposed of. For property received in a nontaxable exchange, IRS guidance also points back to records for the old property. The chain matters. [8]
Not on the full purchase price. Carried basis generally follows continuation rules, while excess basis generally starts a new schedule. An election may change the schedule treatment, but it does not create market-value basis. [2]
It can create additional basis, but the deduction depends on asset allocation, land, recovery periods, and other rules. More price also means more capital at risk. Compare the investment and financing costs alongside any tax benefit. [1]
Generally, no. Land must be separated from depreciable buildings and qualifying improvements. A larger land allocation can reduce depreciation even when the property’s total value is higher. [4]
Have your CPA model both methods. Restarting the remaining basis over a full new period may reduce current annual deductions. The election has filing requirements and cannot be freely revoked later. [3]
No. Investors may bring different basis, exchange history, and personal tax limits. Sponsor figures need to be reconciled with each investor’s records. Owning the same percentage does not prove two investors will claim the same deduction.
Not automatically. Rental losses can be limited by passive-activity and other rules. The amount a property generates as a deduction and the amount you can use against other income can be different. [5]
Tell the CPA before calculating the exchange. Basis generally reflects depreciation allowed or allowable, so simply skipping a deduction does not preserve basis. The proper correction method depends on the facts and prior filings. [1]
Ask: “Using my actual basis and tax limits, what deductions can I use each year, and what happens when I sell?” That connects the tax schedule to the investment decision without turning an estimate into a promise.
Educational information, not an offer or a personal tax, legal, or investment recommendation. Examples are hypothetical and omit stated adjustments. Tax treatment depends on your facts and current law. Review your transaction with your CPA, attorney, and qualified intermediary. Real estate investments can lose value and may be illiquid.
Enter your approved email to explore investments, save your shortlist, and keep learning.