How a 1031 Exchange Affects Your Depreciation Basis in the Replacement Property

The carryover basis mechanics

In a 1031 exchange, the gain is deferred by giving the replacement property a substituted basis — generally the adjusted basis of the relinquished property, adjusted for boot received or paid. Because the relinquished property's basis was reduced by years of depreciation, the replacement property starts with a lower basis than its purchase price.

The formula: Replacement Property Basis = Relinquished Property Adjusted Basis + Boot Paid − Boot Received + Gain Recognized (from boot). This means a property worth $800,000 might have a starting depreciable basis of only $500,000 if you carried $300,000 of deferred gain from the old property.

What this means for annual depreciation

A lower depreciable basis means lower annual depreciation deductions going forward. This is the tax cost of the exchange: you deferred the gain, but you also reduced the depreciation you can take on the new property. The IRS requires you to compute depreciation on the replacement property using the carried-over basis, not the purchase price.

However, if you paid cash to 'trade up' (the replacement property costs more than the relinquished one's equity), the excess — the amount by which the new property's purchase price exceeds its substituted basis — is additional depreciable basis you can depreciate on a fresh 27.5 or 39-year schedule.

A quick example

Relinquished property: $600,000 FMV, $200,000 adjusted basis ($600,000 original cost minus $400,000 depreciation, plus $0 improvements for simplicity). Exchange into an $800,000 replacement, paying $200,000 boot. Deferred gain: $400,000. Substituted basis in replacement: $200,000 + $200,000 boot paid = $400,000. The additional $200,000 above the substituted basis (the excess of purchase price over substituted basis) is new depreciable basis on the fresh 27.5-year schedule. Total depreciable basis: $400,000 carried + $200,000 fresh = $600,000 — still less than the $800,000 purchase price because $200,000 of land is not depreciable.

The default method: two schedules under Reg. §1.168(i)-6

The IRS regulations do not let you simply lump the carryover basis and new money together. Under Treasury Regulation §1.168(i)-6, the replacement property's depreciable basis is split into two pieces that are depreciated differently. The exchanged basis (the carryover from the relinquished property) continues on the remaining recovery period of the old property, using the same method and convention — as if the exchange never happened. The excess basis (any additional amount you paid above that carryover) is treated as newly placed-in-service property and depreciated over a full fresh recovery period.

So in the example above, the $400,000 carried basis keeps running out the relinquished property's remaining 27.5-year schedule, while the $200,000 excess starts a brand-new 27.5-year schedule from the month of the exchange. This 'two-schedule' approach is the default, and it is why 1031 depreciation is more than a single line on a spreadsheet.

Electing out: one fresh schedule instead of two

You may elect out of the two-schedule default under Reg. §1.168(i)-6(i). If you do, the entire depreciable basis of the replacement property — carryover plus excess — is treated as placed in service at the time of the exchange and depreciated over a single new recovery period. The election is made on a timely filed return (including extensions) for the year of the exchange and is irrevocable without IRS consent.

Which is better depends on the facts. Electing out simplifies your depreciation schedule to one asset and can slightly accelerate deductions when the old property had little remaining recovery period; keeping the default two-schedule treatment sometimes produces larger near-term deductions because the short remaining life of the exchanged basis writes it off faster. Model both before deciding — many preparers default to electing out simply for simplicity, which is not always the tax-optimal choice.

Bonus depreciation and cost segregation apply only to the excess basis

This is where real planning value lives. The excess basis — the new money you put into the replacement property — is treated as newly acquired property, so it can be run through a cost segregation study and the reclassified 5-, 7-, and 15-year components can claim bonus depreciation. The exchanged (carryover) basis generally cannot claim a fresh bonus deduction under Reg. §1.168(k)-2 — it is a continuation of the old asset, not newly acquired property.

The takeaway: if you want to accelerate depreciation after a 1031, the leverage is in trading up. The more you invest above the relinquished property's carryover basis, the more excess basis you create — and that excess is the slice a cost segregation study and bonus depreciation can attack. An investor who exchanges into a like-priced property with little new cash has little excess basis to accelerate.

Depreciation recapture carries over too

Deferring gain in a 1031 exchange also defers the depreciation recapture baked into the relinquished property. The recapture does not disappear — it rides along in the carryover basis. When you eventually sell the replacement property in a fully taxable transaction (without another exchange), the depreciation you claimed on both the old and the new property is pulled into the recapture computation: unrecaptured Section 1250 gain taxed at up to 25%, and any Section 1245 recapture on personal-property components taxed at ordinary rates. This is why serial 1031 exchanges — 'swap till you drop' — are so powerful: if you hold the final property until death, your heirs receive a step-up in basis that can wipe out both the deferred gain and the accumulated recapture.

How boot changes the basis math

Boot — cash or non-like-kind property you receive, and net debt relief — complicates the basis computation because it can force you to recognize gain. The general rule: your replacement basis equals the relinquished property's adjusted basis, plus any boot paid (additional cash or debt assumed), minus any boot received, plus any gain you are forced to recognize because of that boot. Recognized gain increases basis because you have already paid tax on it, so it should not be taxed again through reduced depreciation.

A frequent trap is mortgage boot. If the replacement property carries a smaller mortgage than the one you paid off on the relinquished property, the net debt relief is treated as boot and can trigger recognized gain — even if you received no cash. That recognized gain then flows into your basis. Because the direction of each adjustment matters, work through the boot analysis (ideally with your Qualified Intermediary's closing figures) before you assume you have a fully tax-deferred exchange.

Allocating the new basis between land and building

Whatever your total substituted basis turns out to be, only the building portion is depreciable — land never is. So after you compute the replacement property's basis, you must allocate it between land and improvements, just as you would on any purchase. Common methods are the county assessor's land-to-building ratio, a purchase-price allocation in the contract, or a formal appraisal. Because a 1031 replacement already starts with a depressed depreciable basis (the carryover), an aggressive-but-defensible allocation toward the building matters more than usual: every dollar pushed to non-depreciable land is a dollar you can never depreciate.

Apply the land/building split separately to the carryover (exchanged) basis and to the excess basis, since they sit on different depreciation schedules. Keep the appraisal or assessor figures with your records — the allocation is a frequent audit item, and on exchanged property you may need to defend it years after the original transaction.

Common mistakes and recordkeeping

The single most common error is depreciating the replacement property at its full purchase price — which overstates deductions, understates gain at sale, and invites penalties when discovered. Others include forgetting to split the basis into exchanged and excess pieces, claiming a fresh bonus deduction on the carryover basis, and losing track of the relinquished property's adjusted basis after several exchanges. Serial exchangers are especially at risk because each exchange layers new carryover math on top of old.

Protect yourself by keeping, permanently: Form 8824 (Like-Kind Exchanges) for every exchange in the chain, the closing statements for each relinquished and replacement property, the depreciation schedules showing accumulated depreciation at each handoff, and the land/building allocations. This paper trail is what lets your preparer reconstruct the correct depreciable basis and compute recapture accurately whenever you finally sell in a taxable transaction.

Frequently asked questions

Can I depreciate a 1031 replacement property at its full purchase price?

No. The replacement property starts with a substituted (carryover) basis equal to the relinquished property's adjusted basis, adjusted for any boot. Only additional amounts paid above that basis get a fresh depreciation schedule.

Does a 1031 exchange reduce my depreciation deductions?

Yes, relative to what you'd get if you bought the replacement property fresh. The carryover basis is lower than the purchase price, so annual deductions are smaller.

What happens if I pay cash to trade up?

The amount by which the replacement purchase price exceeds the substituted basis is additional depreciable basis depreciated on a new 27.5 (residential) or 39 (commercial) year schedule starting from the placed-in-service date.

Do I use one depreciation schedule or two after a 1031 exchange?

By default, two. Under Reg. §1.168(i)-6 the carryover (exchanged) basis continues over the relinquished property's remaining recovery period, while the new money (excess basis) starts a fresh schedule. You can elect out under Reg. §1.168(i)-6(i) to depreciate the whole basis as one newly placed-in-service asset — an irrevocable election made on a timely filed return.

Can I take bonus depreciation on a 1031 replacement property?

Only on the excess basis — the amount you invested above the carryover basis. That new money can be cost-segregated and claim bonus depreciation. The carryover (exchanged) basis generally cannot claim a fresh bonus deduction because it is a continuation of the old asset, not newly acquired property.

Does a 1031 exchange erase depreciation recapture?

No — it defers it. The recapture baked into the relinquished property carries into the replacement property's basis. When you finally sell without exchanging, depreciation from both properties is recaptured. Holding until death, however, gives your heirs a stepped-up basis that can eliminate the deferred gain and recapture.

Sources

Educational information and estimates only. Not tax advice. Tax rules change and vary by situation; consult a qualified tax professional before acting.

How a 1031 Exchange Affects Your Depreciation Basis