One of the major benefits of owning income producing real estate is that we can take advantage of numerous tax deductions to reduce our taxable income. Perhaps the most significant deduction permitted by federal and state tax authorities is one that allows investors to deduct the value of the rental building that they own over a period of years. That’s right - even though the property may be appreciating in value over time, investors are able to deduct a portion of the value each year as if the building was declining in value.
As an example, if you own a rental property that produces $5,000 in annual income after expenses, $3,000 in depreciation expense will reduce your property’s taxable income to just $2,000.
While depreciation can be an investor’s best friend and result in significant annual tax savings, it can be complex to calculate. In this article, we will cover the basic concepts and define several terms that can, at first, be confusing.
When you first purchase a rental property, the price that was paid less the value of the land is called the “cost basis” of the investment. For tax purposes, buildings have a finite lifespan and decline in value over time, but land does not. Each year you can generally depreciate the building portion of the property over 27.5 years if it is a residential property e.g., single family rental or apartment or over 39 years if it is a commercial property e.g., retail store, commercial office. If you make any capital improvements to the property, they must be added to the cost basis of the property and your annual depreciation deductions will change.
The calculation of depreciation after a 1031 exchange is completed is more complex due to changes in your cost basis when the replacement property is acquired.
How cost basis changes after a 1031 exchange
The new cost basis that is used to determine the amount you can depreciate after you complete a 1031 exchange is generally composed of 1) the remaining depreciation on the property you sold, and 2) new basis in the property that you acquire. If the new property that you acquire costs more than the property you sold, the difference will add to the cost basis and your depreciation deductions will change accordingly.
For example, let’s consider the purchase of a single-family rental property 10 years ago for a net purchase price of $100,000. Over the holding period, let’s presume there was $30,000 in applicable depreciation deductions. The cost basis of the property would therefore be reduced to $70,000.
We now decide to sell our property for an appreciated value of $150,000. The sale of our property would result in a capital gain of $150,000 less the cost basis of $70,000 or $80,000. To defer the substantial taxes that may be owed on the capital gain, we decide to complete a 1031 exchange and reinvest the proceeds in a new residential property valued at $200,000.
The $70,000 adjusted cost basis from the property that we sold will carry over and the $50,000 in additional money that was invested to purchase the replacement property will be added together resulting in a new adjusted cost basis of $120,000 in the replacement property.
Two depreciation options
The IRS allows two options for calculating new depreciation deductions after completing a 1031 exchange.
Option 1: Separate depreciation schedules
- Under this approach, the investor would calculate their total deductions using two depreciation schedules: 1) continuation of the depreciation of $70,000 from the sold property for the remaining 17.5 years, and 2) begin a new 27.5-year depreciation schedule to cover the increase in value of $50,000 in the new residential rental property.
Option 2: Treat the entire replacement property as a new asset
- Under this alternative approach you would treat the combined cost basis of $120,000 as a newly acquired property and divide that total by 27.5 years to calculate your annual depreciation deduction. To take advantage of this option, you will need to file IRS Form 4562 (depreciation and amortization) along with your tax returns for the year in which you close on your replacement property.
Option 2 is less complicated but might result in a smaller deduction than Option 1 (until the sold property is fully depreciated).
Residential to commercial exchanges
If you decide to sell a residential rental property and acquire a commercial property (or vice versa), there are additional rules to follow:
- Residential to commercial – You will use the longer commercial depreciation time period (39 years) for the new property, even if you choose the two-schedule option. The remaining depreciation on your sold property would be converted to a 39-year schedule for the remaining amount of depreciation.
- Commercial to residential -- If you sell a commercial property and acquire a residential one, the remaining cost basis in the sold property would still be depreciated over 39 years while any additional basis from the acquired residential property would be depreciated over 27.5 years.
The foregoing discussion is a simplified summary of real estate depreciation concepts. Real estate depreciation and related tax calculations can be more complex, and readers are encouraged to seek the advice of a qualified real estate tax advisor to determine the most suitable strategies that may be appropriate for their personal situation.
Please contact us if you are seeking referrals to real estate tax professionals or have any other general questions on real estate investments and tax deferral strategies.