DST Cost Basis and Depreciation Schedules After a 1031 Exchange

By Jerry Baker

Your DST tax basis is the amount assigned to your share of the property for tax purposes, and it may be much lower than its current value after a 1031 exchange. Depreciation depends on that basis, the assets you acquire, and the schedules and elections that apply to you. Keep your old property records with the new offering's tax documents so your CPA can connect the two.

Start with the tax structure of the actual DST

Revenue Ruling 2004-86 describes a DST whose owners are treated as owning their share of the underlying real estate for federal income tax purposes. The owners include their share of the related income, deductions, and credits on their returns. The result depends on the ruling's facts and other applicable requirements. [1]

That is different from owning shares of a corporation that holds property. It also does not mean every trust formed under Delaware law has the same federal tax treatment. Review the offering's structure and tax discussion.

I want the CPA involved before the first return is due. A tax packet can explain property-level activity, but it cannot replace the history of the property you exchanged. That history can follow you through several investments.

Keep four different numbers separate

A low basis does not mean a small ownership share. A high basis does not prove a strong investment. Basis is used to calculate deductions and gain or loss; market value is a different question.

IRS Publication 551 explains what changes basis. Some costs and improvements add to it. Depreciation and other items can reduce it. Good records support both the annual deductions and the later sale calculation. [2]

A new cash purchase and an exchange start differently

For a taxable purchase, cost generally provides the starting basis. Qualifying purchase costs and debt assumed or taken subject to can be part of that calculation. Not every fee is part of the real estate's basis. [2]

As a simple example, $400,000 of cash plus $600,000 of acquisition debt funds a $1 million property purchase. Before costs or other adjustments, the starting property basis is $1 million. It is not limited to the $400,000 cash payment.

In a 1031 exchange, a different rule applies. The replacement property's basis generally carries the old property's adjusted basis forward, with required adjustments. The value acquired does not create a fresh basis equal to that value merely because you bought a new interest.

The old property's loan balance is not its tax basis. Paying off a loan affects sale cash and exchange planning. It does not restore depreciation deductions that have already reduced basis.

Follow the deferred gain through a simple example

Assume an investor exchanges debt-free property worth $1.5 million with an adjusted basis of $500,000. The investor adds $500,000 of new cash and acquires $2 million of qualifying replacement real estate.

For this hypothetical example, assume the exchange qualifies fully and there are no costs, personal-use portions, cash received, or special recapture issues. The $1 million gain is deferred. The new property's total basis is $1 million: the old $500,000 basis plus the added $500,000.

You can also see the same result as $2 million of replacement value less $1 million of deferred gain. That shortcut illustrates these clean facts. A real closing requires the full calculation, especially when debt, fees, cash received, or several asset classes are involved.

Form 8824 reports the exchange calculation, including basis in the replacement property. Keep the completed form and the supporting worksheet. They are the bridge between your sale records and the schedules used after the exchange. [3]

Added basis is not limited to a new check from your bank account. Extra consideration can include additional debt and other items under the rules. Ask the CPA to identify each adjustment rather than equating “excess basis” with new cash alone.

Separate land from the assets you can depreciate

Land itself is not depreciable. Buildings and certain other assets may be. A purchase of land and improvements therefore needs a supported allocation. Do not assign the whole amount to the building just to increase the deduction. [4]

Return to a new taxable $1 million purchase. Suppose a supported allocation assigns $200,000 to land and $800,000 to the building. The building amount is the starting point for this simplified depreciation example. The land basis remains relevant when the property is sold.

MACRS is the federal tax system used to depreciate many assets. Under its general system, residential rental property usually has a 27.5-year period. Nonresidential real property usually has a 39-year period. Other systems, asset classes, and elections can change the result. Use the tax class, not just the marketing label. [4]

For a full middle year using straight-line depreciation, $800,000 divided by 27.5 is about $29,090.91. Divided by 39, it is about $20,512.82. These are comparison calculations for a new basis, not first-year deductions or the answer for an exchanged property.

What belongs on a depreciation schedule?

A useful schedule does more than list one annual deduction. It names each asset and its basis. It shows the start date, tax recovery period, method, and convention. It also keeps track of prior deductions and the basis left.

The convention determines how parts of a year are treated. For many buildings, the mid-month convention affects the first and last years. You cannot simply claim a full annual amount because you owned the interest on December 31. [4]

Ask the CPA to retain separate rows when assets have different histories. An original building, a later roof improvement, and another class of property may not share the same starting date or remaining schedule.

Keep federal and state differences visible. A federal deduction does not establish that every state allows the same amount at the same time. Where separate schedules are needed, update both rather than trying to reconstruct the difference at sale.

An exchange can create more than one basis component

The depreciation rules distinguish the basis carried from the old asset from excess basis in the new asset. Those components can follow different schedules. The replacement property's total value is not automatically a new amount to depreciate from year one. [4]

First compare the old and new recovery periods and methods. Is the new period the same or shorter? Is the new method the same or faster? If both tests are met, the carried basis generally keeps the old remaining period, method, and convention. The excess basis generally starts as newly placed in service.

The answer can change if the new period is longer or the new method is slower. For example, you might exchange an apartment building for a warehouse interest. Do not assume that change leaves every old schedule in place.

The regulation contains detailed rules for the exchanged and excess portions, the exchange year, different assets, and special cases. Have the CPA map those rules to the actual old and new assets. A sponsor's generic annual deduction cannot perform that work for every investor. [5]

This is why I avoid saying that a 1031 exchange either “restarts depreciation” or “never changes depreciation.” Both phrases leave out facts that can matter to the calculation.

A depreciation election is not a market-value reset

The rules allow an election to use a different approach for depreciation. In general, it treats the carried and excess basis in the acquired property as placed in service under the election's timing rules. It does not increase the total basis to fair market value. [4]

The election also does not change the gain or loss recognized in the exchange. It concerns how depreciation is calculated. Compare the schedules before assuming the election creates a larger or faster deduction.

The IRS says the election is made on a timely filed return, including extensions, for the year of replacement. Once made, it generally cannot be revoked without IRS consent. The person making it depends on who is treated as the taxpayer. [4]

Ask for a written record of the choice and why it was made. That record belongs with the tax return and schedule. It should not disappear when you change tax preparers.

Two investors in the same DST can have different deductions

Suppose two investors each acquire an equal interest representing $200,000 of property value, funded with $100,000 of equity and $100,000 of allocated debt. Their cash payments from the trust may be the same if their ownership rights are the same.

One makes a taxable purchase with new funds. The other completes a qualifying exchange with $120,000 of deferred gain. Under simplified facts with no other adjustments, the first could have $200,000 of total property basis while the second has $80,000.

Neither investor can depreciate land. The second investor may also have old schedules that carry forward. Equal shares and equal cash payments do not mean equal deductions. Their taxable income can differ even though they own the same type of interest.

This is an example of tax differences, not a claim that one investor chose the better deal. The exchange investor brought a separate deferral history. Evaluate that history with the CPA instead of comparing tax deductions in isolation.

Use the annual tax packet with your own records

For a grantor-trust structure, the reporting approach differs from a partnership's standard K-1 reporting. IRS Form 1041 instructions describe owner statements and optional grantor-trust reporting methods. The standard attachment for the grantor portion is not Schedule K-1 of Form 1041. [6]

Ask the sponsor what documents this particular offering will provide and when. A packet may be described as a grantor statement or tax letter. Do not assume its title alone proves that every number is ready to copy onto your return.

First check your name, tax ID, share, and purchase date. Then review the income, costs, and asset details. Do the depreciation figures assume a fresh purchase basis? Your CPA needs to match the packet to your own exchange history.

If the investment changes legal or tax form, reporting can change as well. Forward all restructuring notices to the tax preparer. “I always receive the same kind of form” is not a substitute for reading the new documents.

Cash received is not the same as taxable rental income

Depreciation can reduce taxable rental income without using cash during that year. Other differences work in the opposite direction. Principal payments use cash but are not interest deductions. Cash held in reserves may not have been spent on a deductible item.

Suppose your share of rent is $12,000 after deductible property costs and interest. Now assume your correct depreciation deduction is $7,000. The net rental income is $5,000 before other rules apply. These are invented figures to show the math.

If $3,000 of cash was used to pay loan principal, the cash available could be $9,000 under these simplified facts. Receiving $9,000 does not make all $9,000 taxable, and a $5,000 taxable result does not mean only $5,000 reached your account.

Do not subtract every cash distribution from real estate basis as though the interest were corporate stock. Have the CPA identify the tax character of the underlying activity and each applicable basis adjustment. A payment label in a portal cannot do that.

A deduction is not always an immediate tax saving

Depreciation can contribute to a rental loss. That does not mean the loss can always offset wages, interest income, or any other income you choose. Passive-activity and at-risk rules may limit what you can use currently. [7]

At-risk limits generally come first, before passive-activity limits. Debt needs a separate check. Some loans that meet the qualified nonrecourse real estate financing rules can count toward your at-risk amount. Do not assume every loan counts just because it is secured by real estate.

Keep suspended losses in a separate record. They are not the same as remaining depreciable basis, and they should not vanish when a property is exchanged or a new tax preparer takes over.

A sales illustration showing depreciation shelter needs your facts behind it. Ask how much deduction is expected, how much you can actually use, and whether the federal and state results differ. The tax saving may be smaller or later than a simple multiplication suggests.

Review component and bonus-depreciation claims carefully

Different parts of a property can have different tax lives. A supported study may identify items with shorter lives than the building. That does not make the land depreciable. Nor does it let you deduct the entire building at once.

The current IRS guide includes the restored 100% special depreciation allowance. It applies to certain qualified property bought and placed in service after January 19, 2025. It does not cover all property. Check the purchase date, asset type, use, elections, and other rules. [4]

Exchange basis needs another check. The rules differ for new and used qualified assets. The carried and excess portions also matter. A cost-segregation study can help identify assets, but it does not give every investor the same deduction.

Also ask about later tax effects and recordkeeping. Faster deductions can reduce basis sooner and affect the character of gain at sale. A first-year deduction should be evaluated alongside future years, not presented as free money.

Update basis each year, even when value changes

Start the annual record with last year's ending basis. Add costs that properly belong in basis. Subtract depreciation and other required changes. Show the new balance and keep the document behind each change.

For an arithmetic example, start with $300,000 of adjusted basis. Add $10,000 of costs properly capitalized to the property and subtract $15,000 of depreciation. With no other changes, ending adjusted basis is $295,000.

A higher appraisal does not, by itself, raise your basis. A drop in value does not give you a depreciation deduction for the full drop. Tax basis and market value change under different rules.

Basis generally must reflect depreciation allowed or allowable. That includes deductions you could have taken but missed. Skipping a deduction does not safely save that basis for sale. If old returns look wrong, ask the CPA how to fix them. Do not just change next year's number. [2]

Use adjusted basis when planning the exit

At sale, taxable gain is based on the amount realized and adjusted basis, with the applicable tax rules. It is not simply the cash check minus your original equity payment. Loan payoff and selling costs must be handled in the proper places.

A simplified debt-free sale for $400,000, less $20,000 of selling costs, gives $380,000 before tax. If adjusted basis is $250,000, the gain is $130,000. Prior cash distributions and your original investment are needed to evaluate the whole economic result.

Gain tied to depreciation is not all taxed the same way. Ask the CPA to separate Section 1245 recapture, ordinary Section 1250 recapture, and unrecaptured Section 1250 gain where they apply. These terms describe different tax rules. There is no single flat tax on all of them. [8]

Another valid exchange may defer eligible gain. Special recapture rules can still make some gain taxable now. Have the CPA review the asset classes before the transfer. Reinvesting the cash alone does not settle the tax result.

Build a file that the next CPA can understand

Keep the old purchase and sale statements together. Add records of improvements, depreciation schedules, and prior exchange forms. Include the QI file and the new purchase and closing records. Each year, add the sponsor's tax packet and any corrections.

Use a short cover sheet listing what the interest owns, who owns it for tax purposes, the acquisition date, and where the basis calculation is stored. Record any elections and differences between federal and state schedules.

Retain basis history for as long as it remains relevant, including through later exchanges. Old records may support a current number decades after the first property was sold. Ask your CPA about the full retention period before discarding them.

Frequently asked questions

Does my DST basis equal the cash I invest?

Not always. Debt used to buy the property can be part of purchase basis. Deferred gain can lower the basis of property you receive in an exchange. Land, fees, and other items also need their own review.

Does a 1031 exchange reset depreciation at current value?

No. The new basis follows the exchange rules. The carried and excess parts can have different schedules. An election can change how you depreciate the assets, but it does not raise basis to current market value. [4]

Can I depreciate the land in a DST?

No. Land itself is not depreciable. Supported allocations separate it from buildings and other assets. Its basis still matters when calculating gain or loss at sale.

Can I copy the sponsor's depreciation number?

First ask what basis and dates it assumes. Your CPA must connect the packet to your own exchange records, schedules, and elections. Investors with equal ownership can have different tax deductions.

Will depreciation shelter all of my cash flow?

There is no fixed shelter rate for every investor. Your basis, asset types, schedules, income, costs, and loss limits all matter. Cash paid to you and taxable rental income are different numbers.

What if I missed depreciation in a prior year?

Have the CPA review the error. Basis generally must reflect allowed or allowable depreciation, so not claiming it does not simply preserve basis. The proper correction may require more than changing a future schedule. [2]

What is the most important record to preserve after an exchange?

Keep the math and the records behind it, not just one final number. Save Form 8824, the old and new asset schedules, closing records, and elections. Add annual changes so a later CPA can trace each step.

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.