When you engage in a 1031 exchange, accumulated depreciation plays a crucial role in determining the tax implications of the transaction. Accumulated depreciation is the total amount of depreciation expense that has been claimed on a property over its holding period. This depreciation reduces the property's adjusted basis, which is used to calculate gain or loss upon sale or exchange.

In a 1031 exchange, the goal is to defer capital gains taxes by reinvesting the proceeds from the sale of a relinquished property into a like-kind replacement property. However, the accumulated depreciation on the relinquished property can still have tax consequences, specifically through depreciation recapture.

Depreciation recapture is the process by which the IRS taxes the gain attributable to the depreciation deductions taken on the property. When you sell or exchange a property, the IRS requires you to “recapture” the depreciation by taxing it at a higher rate, typically 25%, up to the amount of the gain attributable to the depreciation.

In a 1031 exchange, the depreciation recapture is deferred along with the capital gains tax, provided the exchange is structured correctly. This means that the accumulated depreciation on the relinquished property is carried over to the replacement property. The replacement property inherits the adjusted basis of the relinquished property, minus any additional cash or other property received in the exchange (known as “boot”).

Example

Suppose you own a rental property that you purchased for $300,000. Over the years, you've claimed $100,000 in depreciation, reducing your adjusted basis to $200,000. You decide to sell this property for $500,000 and use Deferred.com as your qualified intermediary to facilitate a 1031 exchange into a new property.

In this scenario, your realized gain is $300,000 ($500,000 sale price – $200,000 adjusted basis). Without a 1031 exchange, you would be subject to capital gains tax on the entire $300,000, including depreciation recapture on the $100,000 of accumulated depreciation.

However, by using a 1031 exchange, you defer both the capital gains tax and the depreciation recapture. You identify and purchase a replacement property for $600,000 using the proceeds from the sale of the relinquished property. The replacement property inherits the adjusted basis of the relinquished property, which is $200,000, plus any additional cash you invest in the new property.

The accumulated depreciation of $100,000 is carried over to the replacement property. This means that when you eventually sell the replacement property, the deferred depreciation recapture will be realized, unless you continue to defer it through subsequent 1031 exchanges.

At Deferred.com, we ensure that your 1031 exchange is structured correctly to maximize tax deferral benefits. Our “No Fee Exchange” service helps you save money while navigating the complexities of the exchange process. By using our qualified intermediary services, you can confidently defer taxes and reinvest in more profitable properties, keeping your investment strategy on track.