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.
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.
Sources
- IRS — Like-Kind Exchanges (Real Estate Tax Tips)
- IRS — About Form 8824
- IRS Publication 946 — How to Depreciate Property
Educational information and estimates only. Not tax advice. Tax rules change and vary by situation; consult a qualified tax professional before acting.