Among real estate investors and tax professionals, few topics generate as much discussion, or misunderstanding, as depreciation recapture in the context of 1031 like-kind exchange. While a properly structured 1031 exchange can defer capital gains taxes, depreciation introduces a more nuanced layer of tax considerations. Understanding when and how depreciation recapture applies is critical for structuring transactions and advising clients.
The Basics: Depreciation and Its Tax Treatment
Depreciation allows owners of business or investment property to recover the cost of income-producing real estate over time. For residential property, this typically means a 27.5-year schedule, and for commercial property, 39 years. Over years of ownership, depreciation deductions reduce taxable income – but they also reduce the property’s adjusted basis. Note that only the structures are depreciated, not the land on which the improvements are made.
When a property is sold, the IRS requires taxpayers to “recapture” prior depreciation deductions. This amount is generally taxed as Section 1250 recapture at a federal rate of 25%. State treatment of depreciation recapture varies somewhat. Investors are advised to discuss their unique transactions with their personal tax advisors.
The Role of a 1031 Exchange
A 1031 exchange, when structured correctly, defers recognition of gain on the sale of real estate held for productive use in a trade or business or for investment. Importantly, this deferral also includes depreciation recapture, as well as the deferral of the Net Investment Income Tax, and state taxes, if applicable.
Here’s the key principle:
- If you fully exchange into like-kind replacement property of equal or greater value, reinvest all net equity, and replace any debt, you can defer both capital gain recognition and depreciation recapture.
In other words, depreciation recapture is not triggered simply because you’ve depreciated the property. It is triggered when gain is recognized – either because you sell without exchanging, or because your exchange leaves you with taxable “boot.”
When Is Depreciation Recapture Is Triggered?
For a 1031 exchange property, depreciation recapture becomes taxable when:
- Partial Exchange
If the Replacement Property is worth less than the Relinquished Property, or if the net equity is not fully reinvested, the difference can generate a taxable event. This amount is first subject to depreciation recapture to the extent of prior depreciation, with any excess treated as capital gain. - “Boot” is Received
- “Boot” is any non-like-kind property received in the exchange – commonly cash, a note, or even a reduction in mortgage liability not offset by new debt or replaced by additional cash. Boot could also include non-real estate assets included in the replacement property (i.e., equipment included in the acquisition of a farm).
- To the extent boot is received, depreciation recapture is the first tax applied. The IRS allocates this as depreciation recapture up to the amount of depreciation previously taken. Any excess boot beyond the amount of depreciation previously taken would then be treated as capital gain.
- Sale Without Exchange
If a property owner sells property outright without using a 1031 exchange, all prior depreciation is subject to recapture in that tax year.
When Depreciation Recapture Is Deferred
Depreciation recapture is deferred – along with capital gain – if all of the below occur:
The Exchanger acquires Replacement Property equal or greater in value to the Relinquished Property.
- All exchange proceeds are reinvested in qualifying real estate.
- Debt is replaced with new debt or additional cash investment.
In this scenario, the total accumulated depreciation carries over into the Replacement Property. The Exchanger’s adjusted basis in the new property reflects the deferred gain and the prior depreciation taken. This is often referred to as a “carryover basis.”
Practical Example
Assume an investor purchased property for $500,000, claimed $150,000 in depreciation over several years, and later sold the property for $800,000.
- Adjusted basis (Original Purchase Price minus Depreciation Taken): $350,000 ($500,000 – $150,000).
- Gain realized (Sales Price minus Adjusted Basis): $450,000 ($800,000 – $350,000).
- Of that gain, $150,000 is attributable to depreciation recapture.
If the Exchanger completes a full 1031 exchange into qualifying Replacement Property worth $800,000, or more, while reinvesting all proceeds and replacing any debt with new debt or cash, the tax impact of the entire $450,000 – including depreciation recapture – is deferred.
If, instead, the Exchanger exchanges into a $750,000 property and pockets $50,000 in cash, then $50,000 must be recognized as a taxable event – and the IRS will treat that as depreciation recapture up to the extent of the $150,000 accumulated depreciation. At a tax rate of 25%, the Exchanger would incur a $12,500 tax bill.
Key Takeaways for Professionals
- Depreciation recapture is not automatically triggered in a 1031 exchange – it is deferred if the exchange is structured properly.
- Any recognized gain due to boot or a downsize is first subject to depreciation recapture.
- The prior depreciation doesn’t disappear – it carries forward into the Replacement Property’s basis, waiting to be recaptured upon a future taxable disposition.
- An accurate understanding of tax deferral requires close attention to Replacement Property value, debt structure, and whether any boot will be received.
Depreciation recapture in a 1031 exchange is best thought of as “not forgiven, just postponed.” A properly structured like-kind exchange defers both Capital Gains and Depreciation Recapture, but failure to meet all of the reinvestment requirements can trigger immediate tax consequences. Professionals guiding clients through exchanges should carefully model the transaction to identify potential exposure and ensure that deferral goals are achieved. Investors should consult with their tax and legal advisors early in the planning process and include their Qualified Intermediary in those discussions.