If you’re thinking of doing a 1031 exchange, you need to understand how depreciation is handled before you move forward. Otherwise, you could lose out on money without even realizing it.
Did you know that when you complete a 1031 exchange, there are two different ways you can treat the depreciation rollover into the next property? Most investors do not realize this, and it can make a meaningful difference in your future tax benefits.
Standard Depreciation Rollover
Typically, your accountant may take the depreciation you’ve already claimed on the property you’re selling and simply roll that amount into the depreciation schedule of the replacement property.
What does that mean in practical terms?
It means you are not starting fresh. Instead of receiving the full depreciation benefit on the new property, you are carrying forward the old depreciation. As a result, you get less depreciation going forward than you otherwise could.
Many investors assume this is just how it works. In reality, it is only one option.
Two-Step Depreciation Schedules
What you need to tell your accountant is that you want to use a two-step depreciation schedule.
With this approach, you separate the depreciation tied to the relinquished property from the new basis of the replacement property. In simple terms, you get the full allotment of depreciation on the new property you are purchasing as part of the 1031 exchange.
That difference matters. Depreciation is one of the primary tax benefits of owning real estate. If you reduce the amount of depreciation available to you on the new property, you are reducing one of the most powerful advantages of the investment.
Why It Matters
The tax benefits of real estate are one of the main reasons people invest in it. Cash flow is important. Appreciation is important. But depreciation often plays a major role in reducing taxable income.
If you go through the effort of structuring a 1031 exchange to defer capital gains taxes, it makes sense to also ensure you are maximizing the depreciation benefits available on the replacement property.
Using a two-step depreciation schedule allows you to do that. It ensures you are not unintentionally giving up future deductions simply because of how the rollover is handled.
Final Thoughts
Before you complete a 1031 exchange, make sure you have a clear conversation with your accountant about how depreciation will be handled. A two-step depreciation schedule can allow you to receive the full allotment of depreciation on the replacement property instead of simply carrying forward the old schedule. Given how significant depreciation can be to your overall returns, this is not a detail to overlook.
Many investors we work with appreciate having clarity around how 1031 exchanges and depreciation strategies affect their long-term tax position. If you are considering selling or exchanging an investment property, contact us to discuss how to structure your next move in a way that protects and maximizes your benefits.
