1031 Exchange and Depreciation: The Complete Guide

How depreciation works on investment property

Own a rental and the tax code hands you a yearly deduction for the building wearing out. Structures don't last forever, so you get to write off a slice of their cost each year. Land is the exception. It doesn't wear out, so it's never depreciable - only the improvements on top of it are. And you don't set the pace yourself. The recovery period, the number of years you spread the cost over, is fixed by what kind of property you own:

You have to take the deduction even if you'd rather skip it. Under the "allowed or allowable" rule, the IRS reduces your basis by the depreciation you should have claimed, whether or not you actually claimed it. Basis is the number subtracted from your sale price to work out taxable gain, so a smaller basis means a larger gain later.

That's the catch built into depreciation. Every year's write-off trims your taxable rental income now, but it also lowers your adjusted basis - your remaining investment in the property for tax purposes - and a lower basis means a bigger gain when you sell. On top of that, the deductions you took come back as depreciation recapture: the IRS taxes that slice of the gain separately when you exit.

What a 1031 exchange does to your depreciation

A 1031 exchange lets you sell one investment property, move the proceeds into another, and defer the tax you'd otherwise owe. Depreciation comes along for the ride, and it behaves in a way that catches people off guard: it doesn't start over.

Take the recapture first. On an ordinary sale, the depreciation you've claimed, or should have, is taxed when you sell: at up to 25% for the building itself, and at ordinary rates for shorter-lived components such as carpet or appliances. In an exchange, that tax is deferred right alongside your capital gains.

Your basis is what carries forward, and it splits into two pieces. Whatever depreciable basis is left on the property you sold transfers to the replacement and keeps running on its original schedule. If you trade up, the part of the replacement building's basis above that leftover amount starts a second schedule from scratch. Because the gain you deferred comes off the replacement's basis, that part comes mostly from the extra money you put in, not from the full difference in price. Those two pieces have names: carryover basis and excess basis.

Carryover basis and excess basis

Carryover basis is what's left to depreciate from the property you gave up. It resumes right where it stopped, across whatever remains of the original 27.5- or 39-year term.

Excess basis is the part of the replacement building's depreciable basis above that carryover amount. It comes mostly from the extra money you put in: new cash or new debt beyond what you got for the old property. It begins a new schedule on the day you buy.

Put real numbers on it. Say you bought the old property for $375,000 ($300,000 building, $75,000 land), claimed $109,091 of depreciation, sold it for a net $500,000, and bought a $600,000 replacement. The $234,091 gain you deferred comes off the replacement's basis, so its basis is $365,909, not $600,000:

You now have two schedules running at once:

• Schedule A: $190,909 over the remaining 17.5 years = $10,909/year
• Schedule B: $101,818 over 27.5 years = $3,702/year
• Total annual depreciation: $14,611

When the replacement has a longer recovery period

The two-schedule example above assumes both properties are residential rentals on 27.5-year schedules. Swap a rental house for an office building, which is depreciated over 39 years, and the carryover basis does not keep its old schedule.

Under Treas. Reg. §1.168(i)-6(c)(4)(i), the carryover basis moves to the replacement's longer 39-year period, counted as though the replacement had been placed in service in the same year the old property was. You keep credit for the years already used; you don't get the shorter clock. In the example, 10 years were used, so the $190,909 would run over roughly the remaining 29 years of a 39-year period: about $6,583 a year instead of $10,909 (ignoring the mid-month convention). The excess basis starts its own 39-year schedule.

The rule runs one way. Trade an office building for a rental house and the carryover basis keeps the 39-year period it already had (§1.168(i)-6(c)(4)(ii)). Only the excess basis gets 27.5 years.

The election to start one fresh schedule

You can skip the split entirely. Treas. Reg. §1.168(i)-6(i)(1) lets you elect to treat the replacement's whole depreciable basis, carryover and excess together, as property placed in service on the day you acquire it. You get one schedule that starts over on the replacement's full 27.5- or 39-year period.

In the example, the election trades simpler records for slower deductions: one schedule of $292,727 over 27.5 years comes to about $10,645 a year, against $14,611 under the two-schedule default. It can work the other way when you move from an office building into a rental house, because the carryover basis would otherwise stay on the longer 39-year clock.

• How: attach a statement to your return reading "Election made under section 1.168(i)-6(i)" and figure the depreciation in Part III of Form 4562.
• When: by the due date, including extensions, of your return for the year you acquire the replacement. Each exchange needs its own election.
• Who: each owner elects separately. A partnership or S corporation makes the election itself, not its partners or shareholders.
• Undoing it: only with IRS consent, which the regulation says is granted only in extraordinary circumstances.

The election changes depreciation only. It does not change the gain you defer under Section 1031 or how the recapture rules of Sections 1245 and 1250 apply to the property you gave up.

Calculating your new depreciation schedules

Nailing down those two schedules takes four numbers:

1. The remaining basis on the property you sold - its original depreciable basis minus all the depreciation you've claimed.
2. The years left on its recovery period - what's still to run on the original 27.5- or 39-year schedule.
3. The replacement's total depreciable value - purchase price minus the gain you deferred, then minus the land allocation.
4. The exchange calculation itself - which sets the carryover basis and flags any boot (cash or other non-like-kind value you receive, which is taxable) or gain you have to recognize now.

Your CPA usually handles this as part of filing Form 8824, the IRS form for like-kind exchanges. The two-schedule result then flows onto Schedule E, where you report rental income and expenses, in every year that follows.

One input carries outsized weight: the land allocation on the replacement property. Land isn't depreciable, so the more of the price you assign to it, the less excess basis you have left to depreciate. Give that allocation a basis you can defend - assessor records, an appraisal, or a comparable sales analysis - rather than a number picked for convenience.

Serial exchanges and stacking depreciation

Every exchange adds a layer. Trade properties a few times over the years and you can end up with several schedules running side by side, each on its own clock. After three exchanges spread across 25 years, your books might carry:

• Carryover Schedule A from Property 1, with 5 years left
• Carryover Schedule B from Property 2, with 12 years left
• Excess Schedule C from Property 2, with 20 years left
• Excess Schedule D from Property 3, with 27.5 years left

Each has its own annual amount and its own remaining life. None of it is unmanageable with good software and a CPA who knows 1031 exchanges, but every deal raises the cost of sloppy records.

Cost segregation after a 1031 exchange

A cost segregation study takes a building apart on paper and reclassifies its shorter-lived pieces - carpet, appliances, some electrical and plumbing fixtures - out of the 27.5- or 39-year category and into 5-, 7-, or 15-year schedules. The write-offs come faster.

After an exchange, a study can reach only the excess basis. The carryover basis stays on its original schedule no matter what. So the benefit grows with the size of the excess basis, which is largest when you trade up to a considerably more expensive property.

Bonus depreciation can push this further - it lets you deduct a large share of qualifying property in the first year. It had been phasing down toward zero, but the One Big Beautiful Bill Act restored the rate to a permanent 100% under Section 168(k) for qualifying property acquired and placed in service after January 19, 2025. Where it applies, combining it with cost-segregated excess basis can produce sizable first-year deductions.

What records to keep, and for how long

For each exchange, hold on to:

• Closing statements (HUD-1 or ALTA) for both the sale and the purchase
• Exchange documents from your qualified intermediary, such as the exchange agreement and identification letters
• Form 8824 as filed with your return
• Depreciation schedules showing carryover basis, remaining life, and excess basis
• Land allocation documentation for both properties
• Capital improvement records for the relinquished property

Keep them permanently. Most tax records you can discard after three to seven years, but 1031 records have to survive as long as you own the replacement property, plus three years after you eventually sell it. For serial exchangers, that means holding on to the paperwork from every exchange in the chain, which can stretch across decades.