Depreciation deductions you took for years come back as a tax bill when you sell. Here's how 1031 defers them.
When you own investment real estate, the IRS allows you to deduct a portion of the building's value each year as a non-cash expense called depreciation. Residential property depreciates over 27.5 years; commercial over 39 years.
When you sell, the IRS "recaptures" those deductions. For typical straight-line-depreciated real property, the depreciation-related portion of long-term gain is generally unrecaptured §1250 gain, taxed at a maximum 25% federal rate. This differs from ordinary-income recapture under §1245 or §1250 where applicable. NIIT and state tax may add to federal liability.
You buy a rental house for $400,000. Over 10 years, you take $109,000 in depreciation deductions. Your adjusted basis is now $291,000.
You sell for $550,000. Your gain is $259,000. But it's not all taxed the same:
Without a 1031 exchange, you'd potentially owe ~$27,250 in recapture tax plus ~$22,500–$30,000 in capital gains tax.
A qualifying real-property exchange can defer eligible gain, including unrecaptured §1250 gain, when no recognition rule requires current tax. Boot and mixed-asset recapture rules can trigger recognition; personal property is not automatically eligible. Track deferred gain and replacement basis using Form 8824 and Publication 544.
This is one of the most powerful aspects of 1031 exchanges, you're not just deferring 15–20% tax, you're deferring the full stack including the 25% recapture.
When you complete a 1031 exchange, your replacement property does not start with a fresh basis. Instead, you inherit the adjusted basis from your relinquished property (plus any additional cash invested or boot paid).
This means your replacement property has a lower basis than its purchase price, which means higher future depreciation recapture if you eventually sell without exchanging.
Here's the good news: you can still depreciate the replacement property. Depreciation does not simply restart on the full replacement purchase price. Apply the exchanged/carryover-basis and excess-basis rules under Treas. Reg. §1.168(i)-6, allocating land and depreciable assets correctly. Exchanged basis generally continues the applicable old schedule; qualifying excess basis follows the replacement asset's applicable recovery rules.
Work with your CPA to properly set up the depreciation schedule on your replacement property: it affects your annual tax deductions going forward.
Qualifying inherited assets may receive a basis adjustment under §1014 that removes embedded gain, but ownership, estate inclusion, entity-level basis, and statutory exceptions matter. The adjustment can be upward or downward and is not a guaranteed elimination of every tax. Review the actual estate plan with qualified professionals.
Depreciation recapture is a significant but often overlooked component of the tax benefit of 1031 exchanges. When calculating whether an exchange makes sense, always run the numbers on both capital gains and recapture, and the combined deferral is almost always substantial.
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