What's Depreciation in a 1031 Exchange?

 

Depreciation is a tax concept that allows real estate investors to recover the cost of an income-producing property over time. The IRS assumes that buildings (not land) lose value over the years due to physical wear and tear, aging, and functional obsolescence. To account for this, the IRS lets investors deduct a portion of the property’s value each year from their taxable income. This deduction is known as depreciation, and it can significantly reduce the amount of income tax an investor owes.

For residential rental properties, depreciation is typically taken over 27.5 years, and for commercial properties, it's taken over 39 years. While depreciation provides a great tax benefit while you hold the property, it can lead to a tax liability when you sell.

 

What's Depreciation Recapture?

​

When you sell a depreciated property, the IRS requires you to "recapture" the depreciation deductions you've taken over the years. This means the amount you deducted is added back into your taxable income and is taxed at a rate of up to 25%, even if your overall capital gains are taxed at a lower rate.

For example, if you purchased a property for $500,000 and claimed $100,000 in depreciation over the years, that $100,000 is subject to depreciation recapture tax when you sell. That can result in a hefty tax bill if not handled strategically.

​

How a 1031 Exchange Helps You Defer Depreciation Recapture

​

This is where a 1031 exchange comes in. A 1031 exchange allows you to defer both capital gains tax and depreciation recapture tax by reinvesting the proceeds from the sale of your investment property into another "like-kind" investment property. Instead of paying taxes upon sale, the IRS allows you to roll over your cost basis and continue deferring taxes until a future taxable sale (or potentially avoid them altogether through estate planning strategies). It’s important to note that the deferred depreciation doesn’t go away—it carries over to the new property. So, your adjusted basis in the replacement property reflects the original property's basis, minus any depreciation already taken. This keeps your tax liability deferred until you sell without doing another exchange.

​

Why Depreciation Matters to Investors

 

Understanding how depreciation works—and how it’s treated in a 1031 exchange—is key to making smart, tax-efficient investment decisions. By using depreciation to reduce taxable income while deferring depreciation recapture through 1031 exchanges, investors can maximize cash flow, grow their portfolio, and build long-term wealth.  That’s the power of combining depreciation with a well-executed 1031 exchange strategy.