What the 1031 actually defers
A properly structured 1031 exchange defers all taxable gain from the sale — including the depreciation recapture component. If you claimed $80,000 in depreciation on the relinquished property, that $80,000 of potential recapture is deferred rather than paid at sale. The IRS accomplishes this through a carryover basis mechanism: your basis in the replacement property is reduced by the amount of deferred gain.
How basis carries over
Your basis in the replacement property is not its full purchase price. Instead, it is the purchase price minus the deferred gain (both recapture and capital gain). This lower basis has two effects: (1) you get smaller annual depreciation deductions on the replacement property, and (2) the deferred recapture will be owed — at potentially higher tax rates — when you eventually sell the replacement property without another exchange.
Ending the chain: swap till you drop
Each successful 1031 exchange rolls the deferred recapture forward. If you exchange properties repeatedly until death, your heirs receive a step-up in basis to the date-of-death fair market value, permanently eliminating the accumulated recapture and deferred capital gains. This 'swap till you drop' strategy is one of the most powerful tools in real estate tax planning and effectively converts a tax deferral into a tax elimination.
Frequently asked questions
Does a 1031 exchange eliminate depreciation recapture?
No — it defers it. The recapture carries into the replacement property through a lower basis and is owed when that property is eventually sold without another exchange.
Do I get to restart depreciation on the replacement property?
Yes, but on a lower basis. You get new depreciation on improvements, and a full 27.5-year schedule restarts, but the base depreciable amount is reduced by the deferred gain.
Sources
- IRS Topic No. 409 — Capital Gains and Losses
- IRS Publication 544 — Sales and Other Dispositions of Assets
- IRS — Like-Kind Exchanges (Real Estate Tax Tips)
Educational information and estimates only. Not tax advice. Tax rules change and vary by situation; consult a qualified tax professional before acting.