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800-795-0769
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Your Nationwide Qualified Intermediary for Tax-Deferred Exchange of Real Estate Since 1990
Depreciation of 1031Replacement Property
By: Ed Horan, Certified Exchange Specialist®
When a taxpayer completes an exchange, we are often asked how to figure the depreciation on
the new replacement property. What if one property is exchanged for two properties? Some
taxpayers think the starting basis in the 1031 replacement property is what they paid for it.
Unfortunately, that is not correct, and for some folks this is shocking news. The total new
starting basis in the replacement property is what the replacement property cost less the gain
deferred in the exchange.
Let’s say our taxpayer purchased a rental property ten years ago for $500,000. While repairs
were made, no depreciable improvements were made to the property. The taxpayer took
$150,000 in depreciation over the ten year period. The adjusted basis for the relinquished
property is now $350,000. If the relinquished property is sold for $1 million and the taxpayer
has selling and exchange expenses of $80,000, the taxpayer’s realized gain would be $1 million
less the adjusted basis of $350,000 and less exchange expenses of $80,000, for $570,000 of
realized gain.
If the taxpayer meets the 1031 reinvestment requirements and purchases replacement
property of say $1.2 million, the total new basis for the replacement property received would
be $630,000. This total new basis is computed by taking the $1.2 million cost of the new
property and subtracting the $570,000 of gain deferred in the exchange. When an exchange is
completed, an IRS Form 8824 is filed with the IRS along with your tax return for the year the
relinquished property was transferred. The new total replacement property basis will be
shown on Line 25 of the form and is labeled “Basis of like-kind property received.”
New IRS Rules. In January 2000 IRS Notice 2000-4 described the way a new replacement
property was to be depreciated. Then in early 2004 the IRS published in T.D. 9115 detailed
temporary and proposed regulations for figuring replacement property depreciation. Under the
new Temporary Regulation Section 1.168(i)-6T, the general rule remains that the taxpayer must
depreciate the remaining relinquished property’s adjusted basis (called the exchanged basis)
over the remaining recovery period using the same depreciation method as if it were a
continuation of the relinquished property depreciation schedule.
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Realty Exchange Corporation
Your Nationwide Qualified Intermediary for Tax-Deferred Exchange of Real Estate Since 1990
800-795-0769 ● www.1031.us
To develop the replacement property depreciation schedules, the Temporary Regulations split
the new total basis of the replacement property between the “exchanged basis” and the
“excess basis.” The exchanged basis is the remaining basis carried over from the relinquished
property. The excess basis is the resulting increase in basis from the taxpayer’s trading up in
value.
The excess basis will be treated as newly acquired property and will be depreciated over 27.5
years for residential property or over 39 years for nonresidential real property using a new
straight line depreciation schedule. No depreciation may be claimed for the period between the
transfer of the relinquished property and the receipt of the replacement property.
Example: Using our numbers above, a taxpayer has been taking depreciation for 10 years on a
residential rental purchased for $500,000. He has taken $150,000 in total depreciation, leaving
an adjusted basis of $350,000. The residential rental property purchased for $1.2 million has a
new starting basis after the exchange of $630,000. Of this $630,000, the remaining carried over
exchanged basis is $350,000, and the excess basis is $280,000.
The two depreciation schedules for the replacement property would be (1) continuation of the
original relinquished property schedule for the remaining 17.5 years, and (2)a new schedule to
cover the increase in value reflected in the excess basis. If the depreciable improvements
were deemed 80% of the full value of the replacement property, then 80% of the excess basis
of $280,000 would be depreciated over 27.5 years.
Elect-out of Using New Rules. The new regulation does permit the taxpayer to elect-out of the
rules and to treat the entire replacement property as a new asset. To make the election to not
use the new rules, see the instructions for IRS Form 4562, Depreciation and Amortization at
www.irs.gov. The election is made on IRS Form 4562 with your on-time tax return for the year
the replacement property is received. Also, the 2004 regulations do not address how the
depreciation rules work with exchanges of multiple replacement properties. The simplest
approach would be to elect out of using the new rules and depreciate each property using a
new depreciation schedule. The starting basis for the individual multiple replacement
properties is the ratio of its value to the total value of all the replacement properties multiplied
against the total new basis for all the replacement properties as reported on Form 8824.
Longer Recovery Period. What if the replacement property has a longer recovery period as in
the exchange of residential rental property for a commercial property with a 39 year recovery
period? Instead of the relinquished property depreciation allowance continuing as in our
example for 17.5 years, the remaining amount of the exchanged basis to be depreciated would
be spread out over the longer recovery period of 29 years (39 years minus 10 years).
Unfortunately, the reverse is not true. If the exchange was from commercial to residential, the
longer relinquished property depreciation schedule would continue to be used.
This article can only provide the basics for developing 1031 replacement property depreciation
schedules. Taxpayers should consult with their tax advisors and CPAs.
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Realty Exchange Corporation
Your Nationwide Qualified Intermediary for Tax-Deferred Exchange of Real Estate Since 1990
800-795-0769 ● www.1031.us
-Ed Horan, CES® is Senior Exchange Consultant for Realty Exchange Corporation,
Gainesville, VA, and author of How to Do a Like Kind Exchange Using a Qualified Intermediary.
This publication is designed to provide accurate information on tax-deferred exchanges. The publisher is not
engaged in rendering legal or accounting services. If legal or tax advice is required, the services of a competent
professional should be sought.
