In a 1031 exchange, the depreciation you already claimed on the property you gave up does not disappear and is not taxed at closing. It rides along with you. Your accumulated depreciation, adjusted basis, and the recapture tax it will eventually trigger all carry forward into the replacement property, which the IRS treats as a continuation of the old asset rather than a fresh purchase. So what happens to depreciation in a 1031 exchange is best described in two parts: the depreciation you’ve already taken stays attached to the investment as a deferred liability, and the depreciation you’ll take going forward is split between the old schedule and a new one.
Prior Depreciation Carries Forward as Deferred Recapture
Every year you depreciate an investment property, you build a future tax liability called depreciation recapture. In a standard sale, the IRS collects that tax at closing. A 1031 exchange changes the timing by rolling the liability into the replacement property instead of triggering it.1Internal Revenue Service. Like-Kind Exchanges Under IRC Section 1031 The gain is deferred. It is not forgiven.
That deferral continues through subsequent exchanges. An investor who trades through five properties over three decades accumulates the depreciation recapture from every one of them. The moment the chain breaks with a taxable sale, the entire stack comes due at once. This is the surprise that catches investors who exchanged repeatedly without tracking how much recapture had piled up behind the current property.
The Rate That Applies to That Recapture
Depreciation recapture on real property is not taxed at ordinary income rates, which is the most common misconception on this topic. Straight-line depreciation claimed on real estate is classified as “unrecaptured Section 1250 gain” and taxed at a maximum rate of 25%.2Office of the Law Revision Counsel. 26 USC 1250 Gain From Dispositions of Certain Depreciable Realty If your regular tax bracket is below 25%, you pay your lower rate instead.
Any gain above the recapture amount is taxed as long-term capital gain at 0%, 15%, or 20% depending on your income. A profitable sale after years of depreciation splits into two buckets: the recapture piece (up to 25%) and the appreciation piece (up to 20%). A 1031 exchange defers both.
How Basis Transfers to the Replacement Property
The basis of a replacement property acquired through a 1031 exchange starts with the adjusted basis of the property you gave up, not the purchase price of the new one.1Internal Revenue Service. Like-Kind Exchanges Under IRC Section 1031 The IRS describes this as the “basis of the property given up with some adjustments.” The same number can be reached by taking the purchase price of the replacement property and subtracting the deferred gain from the exchange.
Suppose you sell a property with an adjusted basis of $300,000 for $500,000, deferring $200,000 in gain, and buy a replacement for $600,000, adding $100,000 in new cash. Your basis in the replacement is $400,000: the $600,000 purchase price minus the $200,000 in deferred gain. That lower basis is why your future depreciation deductions and eventual gain calculations reflect the fact that you have not yet paid tax on that $200,000.
Cash spent above the exchange proceeds increases basis dollar for dollar. Closing costs paid on the replacement purchase are added to the amount treated as spent, which can incrementally increase your depreciable basis. Getting this number wrong cascades through every tax return you file for as long as you hold the property.
Two Depreciation Schedules Going Forward
The IRS requires a dual-tracking approach to depreciation on the replacement property under IRS Notice 2000-4 and related Treasury Regulations.3Internal Revenue Service. Notice 2000-4 Exchange of MACRS Property for MACRS Property The replacement property’s basis splits into two pieces, each with its own schedule.
Carryover Basis Continues the Old Schedule
The portion of the new property’s basis that equals the adjusted basis of the old property stays on the old property’s depreciation schedule. If your relinquished property was a residential rental on a 27.5-year timeline with 10 years remaining, the carryover portion depreciates over those remaining 10 years using the same method and convention.4Federal Register. Depreciation of MACRS Property That Is Acquired in a Like-Kind Exchange or as a Result of an Involuntary Conversion You step into the shoes of the old schedule rather than starting a new one.
Excess Basis Gets a Fresh Schedule
If the replacement property costs more than the relinquished property’s adjusted basis, the difference is treated as a brand-new asset placed in service on the exchange date. This excess basis gets a fresh depreciation schedule: 27.5 years for residential rental property or 39 years for nonresidential real property.5Office of the Law Revision Counsel. 26 US Code 168 Accelerated Cost Recovery System This is the only portion where you genuinely benefit from a restart.
The practical result is that trading up into a more expensive property generates larger annual depreciation deductions than staying in the original property would have. The carryover portion keeps ticking down on the old schedule while the excess portion adds a new deduction stream on top of it. Tracking these two schedules separately is mandatory, and it is the part of 1031 accounting that trips up the most investors and preparers.
Splitting Value Between Land and Building
Only the building is depreciable. Land does not wear out, so the IRS never lets you depreciate it. When you acquire a replacement property through a 1031 exchange, you have to allocate basis between land and improvements before you can calculate depreciation on either the carryover or excess portion.
The IRS accepts two primary methods. The preferred approach uses the fair market value ratio: determine what percentage of the total property value belongs to the building versus the land, then apply those percentages to your basis. If independent appraisals are not available, the ratio from the local property tax assessment works as a reasonable approximation.6Internal Revenue Service. Publication 527 (2025) Residential Rental Property
Getting this allocation wrong has outsized consequences. Overallocating to land under-depreciates the building and leaves deductions on the table every year. Overallocating to the building inflates depreciation now and creates a larger recapture bill later. For high-value exchanges, an independent appraisal that supports your allocation is cheap insurance against an audit adjustment.
Cost Segregation on the Replacement Property
A cost segregation study breaks a building into components and reclassifies certain items (electrical systems, specialized fixtures, site improvements) into shorter recovery periods of 5, 7, or 15 years instead of 27.5 or 39. That accelerates depreciation and front-loads deductions. How it interacts with a 1031 exchange depends on which depreciation method you elect.
Under the standard step-in-the-shoes approach, a cost segregation study can only be applied to the excess basis. The carryover portion stays locked into the old property’s schedule regardless of how you reclassify the new building’s components. Under an alternative simplified method, the taxpayer treats the entire basis, carryover and excess combined, as newly placed in service on the exchange date, which lets cost segregation apply to the full amount. Bonus depreciation only qualifies for the excess basis portion under either method.
The choice between these methods depends on the relative size of carryover and excess basis, the remaining life on the old schedule, and how aggressively you want to accelerate deductions.
When Boot Forces Partial Recapture Now
Receiving cash or debt relief during the exchange that is not reinvested in like-kind property creates what the IRS calls “boot.” Boot breaks the full deferral and forces you to recognize gain up to the amount of boot received.7Office of the Law Revision Counsel. 26 US Code 1031 Exchange of Real Property Held for Productive Use or Investment That recognized gain triggers depreciation recapture up to the boot amount, even though the rest of the exchange still qualifies for deferral.
Boot shows up two ways:
- Cash boot. You trade down in value and pocket the difference, or the exchange generates net proceeds that are not fully reinvested.
- Mortgage boot. The debt on the replacement property is lower than the debt paid off on the relinquished property. The debt relief is treated as cash received. Avoiding it requires taking on equal or greater financing on the replacement or adding cash to close the shortfall.
The distinction between realized gain (total profit on paper) and recognized gain (the portion actually taxed) matters here. You might have $200,000 in realized gain but only $30,000 in recognized gain if that is the amount of boot received. The remaining $170,000 stays deferred, with the recapture liability continuing to ride along.
The Step-Up That Erases Deferred Recapture
Under Section 1014, when a property owner dies, heirs inherit the property at its fair market value on the date of death.8Office of the Law Revision Counsel. 26 US Code 1014 Basis of Property Acquired From a Decedent That stepped-up basis wipes out the deferred depreciation recapture and capital gains accumulated across every exchange in the chain. The tax liability disappears.
This is the endgame many 1031 investors plan for: keep exchanging throughout life, defer recapture indefinitely, and pass the property to heirs who receive it with a clean basis at current market value. Those heirs can sell immediately with little or no tax, or hold the property and begin depreciating it fresh from the stepped-up basis. The depreciation you claimed on the first property in a long exchange chain never gets recaptured at all if the chain ends this way.