When you engage in a 1031 exchange, the calculation of depreciation for the replacement property involves a few key steps. The process is designed to ensure that the tax deferral benefits of the exchange are maintained while allowing you to continue depreciating your investment property. Here's a detailed explanation of how to calculate depreciation after a 1031 exchange, with an example to illustrate the process.  

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Understanding the Basics

In a 1031 exchange, you defer the recognition of gain or loss on the sale of your relinquished property by acquiring a like-kind replacement property. The basis of the replacement property generally starts with the adjusted basis of the relinquished property, with further adjustments based on items such as additional cash invested, liabilities, money received, or gain recognized. This is known as the "carryover basis."

Steps to Calculate Depreciation

1. Determine the Carryover Basis: The carryover basis of the replacement property is the adjusted basis of the relinquished property. This includes the original purchase price, plus any capital improvements, minus any depreciation taken.
   
2. Allocate the Basis: Identify any excess basis created by additional consideration you paid to acquire the replacement property, such as additional cash, additional debt, or other boot paid. In a fully deferred 1031 exchange, deferred gain does not become new depreciable basis. Instead, that gain carries into the replacement property and reduces its basis. The excess basis is generally treated as newly acquired property and depreciated separately.
   
3. Depreciate the Carryover Basis: Continue to depreciate the carryover basis over the remaining recovery period of the relinquished property using the same depreciation method and convention.
   
4. Depreciate the Excess Basis: The excess basis is treated as a new asset and is depreciated over the appropriate recovery period for the type of property acquired, using the applicable depreciation method and convention.
 

Example

Let's say you originally purchased a rental property for $300,000, and over the years, you took $100,000 in depreciation. Your adjusted basis is now $200,000. You decide to engage in a 1031 exchange and sell this property for $500,000, using Deferred.com as your qualified intermediary. You acquire a new replacement property for $600,000

• Carryover Basis: The carryover basis for the replacement property is $200,000, which is the adjusted basis of the relinquished property.
• Realized Gain: The realized gain on the sale is $300,000 ($500,000 sale price minus $200,000 adjusted basis).
• Deferred Gain: Assuming the exchange is fully tax-deferred and no boot is received, that $300,000 gain is deferred, not added to new depreciable basis.
• Additional Investment / Excess Basis: Because the replacement property costs $600,000 and the relinquished property sold for $500,000, the taxpayer must contribute an additional $100,000 (through cash, financing, or a combination). That $100,000 is the excess basis.
• Total Tax Basis in the Replacement Property: The total tax basis is $300,000, made up of $200,000 carryover basis + $100,000 excess basis.

Important: Before calculating depreciation, allocate basis between land and building/improvements. Land is not depreciable.

• Depreciation of Carryover Basis: You generally continue to depreciate the $200,000 carryover basis over the remaining recovery period of the relinquished property, using the same depreciation method and convention.
• Depreciation of Excess Basis: The $100,000 excess basis is generally treated as newly placed-in-service property. If the replacement property is residential rental property, you generally depreciate the building portion of that excess basis over 27.5 years using the applicable method and convention.

Conclusion

By separating the replacement property’s basis into carryover basis and any excess basis created by additional investment, you can calculate depreciation in a way that preserves the tax-deferral treatment of the 1031 exchange. This approach allows you to maintain the tax deferral benefits of the exchange while continuing to benefit from depreciation deductions. At Deferred.com, we are here to assist you as your qualified intermediary, ensuring a smooth and compliant 1031 exchange process. If you have any further questions or need assistance with your exchange, feel free to reach out to us.