When you conduct a 1031 exchange in the United States, you have two primary options for depreciating the property you receive in the exchange. These options are crucial in managing your tax liabilities and maximizing the benefits of the exchange.
- Option 1: Two Schedules Depreciation This is the method preferred by the IRS. It involves continuing the depreciation schedule of the relinquished property while also establishing a new depreciation schedule for the replacement property based on its cost basis. The remaining depreciation life of the relinquished property is carried over to the replacement property, and a new depreciation schedule is started for the cost basis of the replacement property. This method allows for a higher depreciation shield, which can be beneficial for tax purposes.
- Option 2: Single Schedule Depreciation Alternatively, you can opt for a simpler approach and depreciate the replacement property on a single schedule. This involves taking the new adjusted cost basis of the replacement property and dividing it by the applicable recovery period (27.5 years for residential property or 39 years for commercial property). This method is straightforward but may result in a lower depreciation expense compared to the two-schedule method.
The choice between these two options depends on your specific circumstances, including the properties involved in the exchange, your tax situation, and your long-term investment goals.
Here's a hypothetical example of how the two schedules depreciation method works in a 1031 exchange:
- Original Property Information:
- Purchase price: $500,000
- Land value: $100,000
- Building value: $400,000
- Annual depreciation: $400,000 / 27.5 years = $14,545
- Held for 7 years: 7 x $14,545 = $101,815 in total depreciation
- Cost basis: $500,000 - $101,815 = $398,185
- Sale price: $700,000
- Gain: $700,000 - $398,185 = $301,815
- 1031 Exchange Information:
- Replacement property cost: $900,000
- Additional funds added to the exchange: $200,000 (i.e., $900,000 - $700,000)
- New adjusted basis: $398,185 + $200,000 = $598,185
- Depreciation Calculation:
- First Schedule (Continuation of Relinquished Property Depreciation):
- Remaining depreciation life: 27.5 years - 7 years = 20.5 years
- Annual depreciation: $398,185 / 20.5 years = $19,429
- Second Schedule (New Depreciation for Additional Funds):
- New cost basis for additional funds: $200,000
- Annual depreciation: $200,000 / 27.5 years = $7,273
An example of single schedule depreciation in a 1031 exchange involves depreciating the replacement property on a single schedule based on its cost basis. This method is simpler and more straightforward than the two schedules depreciation method, but it may result in a lower depreciation expense.
- Original Property Information:
- Purchase price: $500,000
- Land value: $100,000
- Building value: $400,000
- Annual depreciation: $400,000 / 27.5 years = $14,545
- Held for 7 years: 7 x $14,545 = $101,815 in total depreciation
- Cost basis: $500,000 - $101,815 = $398,185
- Sale price: $700,000
- Gain: $700,000 - $398,185 = $301,815
- 1031 Exchange Information:
- Replacement property cost: $900,000
- Additional funds added to the exchange: $200,000 (i.e., $900,000 - $700,000)
- New adjusted basis: $398,185 + $200,000 = $598,185
- Depreciation Calculation (Single Schedule Method):
- New cost basis for the replacement property: $598,185
- Annual depreciation: $598,185 / 27.5 years = $21,752
By using the two schedules depreciation method, the investor can maximize their depreciation expense, which can be beneficial for tax purposes. This method allows for a higher depreciation deduction compared to using a single schedule depreciation method.
For more information or to chat more about 1031 exchanges, reach out to Chris Ostler, CPA today.