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Handling Depreciation in a 1031 Exchange

According to data from the Census Bureau, there are an estimated 20 million rental properties in the US.

If you're an investor looking to sell an investment property, then you may be wondering how depreciation works in a 1031 exchange.

Once a property sells, depreciation may cause extensive expenses. Although it often increases cash flow, it also costs you money in the event of a property's sale price being higher than its cost basis. In this situation, the IRS recaptures depreciation deduction from the property, similar to how it would with capital gains taxes.

However, depreciation recapture is deferrable through a 1031 exchange, just like capital gains. To develop the best investment strategy, you must keep depreciation in mind, understanding its influence on your investments and how 1031 exchanges work. This helpful guide walks you through the best ways to handle depreciation in a 1031 exchange, so keep reading for information every investor needs to know.

1031 Exchange and Types of Depreciation

Following a 1031 exchange, there are two types of depreciation methods: single schedule depreciation and two schedule depreciation. Here's how the two types of 1031 exchanges compare.

Single Schedule Depreciation

When pursuing single-schedule depreciation, you essentially opt out of the preferred method for tax codes, favoring simplicity while foregoing two-schedule depreciation's added benefits.

Throughout the depreciation calculation process, single schedule depreciation is a fairly simple method. Take your property's newly adjusted cost bases and divide it by 27.5 years (divide by 39 for commercial properties). The result is the property's annual depreciation moving forward.

Two Schedule Depreciation

Two schedule depreciation, also referred to as "Step-in-the-Shoes" depreciation, has substantial benefits and is the IRS-preferred method for tax codes. Although complex, the benefits are well worth it. However, the abdicated property's remaining depreciation has to remain on its original schedule for depreciation, adhering to this method the entire time.

If, for example, an investor holds a property for three years prior to the exchange, their remaining funds would depreciate at a steady rate for the following 24.5 years, following the original schedule. The replacement property remaining has a cost basis depreciating on a new, separate schedule over 27.5 years. The cost basis is usually the difference between the acquired property's value compared to the relinquished property.

Two schedule depreciation is advantageous when comparing annual depreciation figures. Some investors believe gains are temporary, functioning as shields to protect higher depreciation from vanishing after a period of time.

However, these investors neglect the time value of money, with cash today having a greater value than future-dated cash. As such, leveraging two-step depreciation at scale has increased benefits.

Handling Depreciation and a 1031 Exchange

Weigh the pros and cons of single and two schedule depreciation, keeping in mind that, although two schedule depreciation is preferable, single schedule depreciation is more direct. However, its method of calculation isn't favored by the IRS tax code, and two schedule depreciation is often more beneficial.

Let 1031 Pros walk you through each step of your investment property's sale. We'll assist you while you enter into a contract until you finalize your exchange, answering all your questions along the way. Contact us today to achieve a completely tax-deferred 1031 exchange.

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