Your New Building Depreciates on Two Schedules, and Only One Is New

After a 1031 exchange, many investors assume the replacement property is depreciated like any new purchase: 27.5 years for residential rental property or 39 years for commercial property, starting from the day they acquire it.

That is only partly right. The tax rules generally treat the replacement property's basis as two pieces with two different depreciation schedules. Understanding the split affects your deductions every year you own the property.

Why does depreciation not start fresh?

Because a 1031 exchange carries your old basis into the new property. The tax code treats that carried over basis as a continuation of the old investment, not as a new purchase.

The portion of basis carried over from the relinquished property generally continues to be depreciated over the remaining recovery period and using the method of the old property, as though the old building had never been sold.

What gets a new schedule?

Any additional basis. If you paid more for the replacement property than the carried over basis, by adding cash or taking on more debt, that excess basis is treated as newly acquired property. It is depreciated from the date you placed the replacement in service, over the full recovery period for the new property.

How does that look with numbers?

Suppose you sell a residential rental with an adjusted basis of 300,000 dollars that has 10 years of depreciation remaining on its original 27.5 year schedule. You buy a new residential rental for 1 million dollars, of which 200,000 dollars is land.

The depreciable portion of the new building is 800,000 dollars. Of that, 300,000 dollars is carried over basis, which continues to be depreciated over the remaining 10 years or so of the old schedule. The other 500,000 dollars is excess basis, depreciated over a fresh 27.5 year schedule.

In practice, the calculations are more detailed, and land allocations apply to both old and new properties.

Is there an election to simplify this?

Yes. Taxpayers can generally elect to treat the entire basis of the replacement property as newly acquired, depreciated over a fresh recovery period from the date placed in service. This simplifies record keeping.

The trade off is that the carried over basis would then be depreciated over a longer new period instead of the shorter remaining period, which usually means smaller annual deductions from that portion. For most investors, keeping the two schedules produces larger deductions in the early years.

What if the old and new properties have different recovery periods?

If you exchange residential rental property, with a 27.5 year life, for commercial property, with a 39 year life, or the reverse, the rules generally require adjustments to reflect the new property's recovery period. Your CPA will apply the specific rules to the carried over portion.

Does cost segregation change this?

A cost segregation study can reclassify parts of the replacement property into shorter lived components. It is most clearly applied to the excess basis. Accelerated depreciation increases deductions now but increases depreciation recapture when the property is eventually sold in a taxable sale.

Why does this matter for recapture?

Depreciation claimed on both schedules reduces your basis. When you eventually sell in a taxable sale, accumulated depreciation, including depreciation from earlier properties in your exchange chain, is subject to recapture. Keeping accurate depreciation records for each schedule matters for decades.

What if your CPA has been depreciating it as a fresh purchase?

If the replacement property has been depreciated incorrectly, for example with the full basis on a new schedule without making the election, your CPA may be able to correct it through an accounting method change. Review this early rather than after several years of returns.

What about property received with boot?

If you received boot in the exchange, part of your gain was recognised, and the replacement property's basis is adjusted accordingly. Recognised gain increases basis, while cash or debt relief received reduces it. Those adjustments flow into the depreciation calculations.

What about land?

Land is not depreciable, on either the relinquished or the replacement side. When allocating the replacement property's basis between land and building, use a reasonable method, such as the property tax assessment ratio or an appraisal. A higher land allocation reduces depreciation, so it deserves attention rather than a default guess.

How does this apply to DST investors?

Investors in a Delaware Statutory Trust generally receive depreciation information from the sponsor, reported as part of their share of the trust's results. The same carried over and excess basis concepts can apply to the investor's own basis. Ask your CPA how to reconcile the sponsor's reporting with your exchange basis.

What to do first

Give your CPA the Form 8824 calculation, the depreciation schedule of the relinquished property, and the closing statements for the replacement. Ask whether keeping two schedules or electing a single new schedule gives the better result for your situation.

Nothing here is tax, legal or investment advice. Depreciation rules are technical and depend on your facts. Confirm your approach with your CPA.