Using Bonus Depreciation Funds Alongside or Instead of a 1031 Exchange

One tool removes the gain from your return; the other adds a deduction next to it

A 1031 exchange changes what is reported: no gain, no recapture, and a basis that carries forward on Form 8824 line 25. A bonus depreciation fund changes nothing about the gain; it puts a large deduction on the same return and hopes the two meet.

That distinction decides the comparison. If you can reinvest the full sale price in real property, the exchange defers 100% of the gain with no ceiling, no participation test and no income limit.

The fund is the answer when an exchange is unavailable or incomplete: a business or stock sale, boot you chose to take, a deal that fell apart after day 45, or a K-1 that will throw off passive income whether you like it or not.

Only components with recovery periods of 20 years or less get written off, so cost segregation comes first

Section 168(k) now writes off the full cost of qualified property that is both acquired and placed in service after January 19, 2025, and the Form 4562 instructions define qualified property as tangible property depreciated under MACRS with a recovery period of 20 years or less. The building itself is not on that list: residential rental recovers over 27.5 years and nonresidential over 39.

A cost segregation study is what separates the two. It reclassifies site work, landscaping, specialty electrical, flooring, cabinetry and similar items into 5-, 7- and 15-year classes, and those classes are what the fund can expense in year one.

This is why sponsors quote a first-year loss as a percentage of your investment rather than of the property price, and why the percentage varies by asset type. Ask for the study's allocation before you wire, and read our page on accelerated depreciation funds alongside the offering.

The gain you are chasing must itself be passive, or the K-1 loss never reaches it

Section 469(a) disallows a passive loss except against passive income, and section 469(c)(2) makes every rental activity passive by default. A fund interest you do not operate produces exactly that kind of loss.

So the question is not whether the deduction is large. It is whether the income you want to shelter is passive: gain on a rental where you were not materially participating, distributions from syndications, and other K-1 income all qualify.

Salary does not. Neither does gain from a property you handled as a real estate professional under section 469(c)(7)(B), because that gain is non-passive and a passive loss cannot touch it. The $25,000 allowance in section 469(i) is no help either, since it phases out entirely by $150,000 of adjusted gross income.

Year one and exit year on a hypothetical $300,000 passive gain

Hypothetical, round numbers: you recognize $300,000 of long-term passive gain and put $300,000 into a bonus depreciation fund that closes the same year. Assume the sponsor's cost segregation supports a first-year loss allocation of 60% of your capital, so your K-1 shows a $180,000 passive loss.

Year one: the $180,000 absorbs $180,000 of the gain. At 20% plus the 3.8% net investment income tax, that is about $42,840 of federal tax you do not pay this April, leaving $120,000 of the gain taxable.

Exit year: the deduction came out of the fund's basis, so when the fund sells, the same $180,000 comes back. The 5-, 7- and 15-year components are section 1245 property and return as ordinary income at your rate that year, up to 37%, and only the building layer keeps the 25% ceiling.

The same $300,000 routed through a 1031 into DST interests would have had no taxable gain, no recapture schedule and no participation test to satisfy.

The rate arbitrage can run backwards: 23.8 cents saved now, up to 37 cents repaid later

Watch which kind of income the deduction actually shelters. In the example above it absorbed long-term capital gain worth 23.8 cents on the dollar, and it created ordinary section 1245 recapture that can cost 37 cents on the dollar when the fund sells: $42,840 saved against as much as $66,600 repaid.

The trade improves when the sheltered income is itself ordinary. A K-1 heavy taxpayer offsetting ordinary passive income at 37% and repaying at 37% keeps the whole benefit of the deferral and loses nothing on rate.

It improves again if the fund's property is still held at death, because section 1014 resets basis and the recapture never happens. Run the rate on both ends with your CPA before you treat a first-year loss as a tax saving rather than a loan.

• Ordinary passive income sheltered at 37% and repaid at 37%: pure timing benefit.
• Long-term capital gain sheltered at 23.8% and repaid as §1245 ordinary income: a rate loss you have to outrun.
• Gain that a 1031 could have deferred in full: sheltering it with a deduction trades a permanent deferral for a temporary one.

Three caps that stop the loss before it reaches your gain

Size the investment against the limits, not against the sponsor's loss percentage. Each of these is applied after the passive-activity test, and any one of them can leave the deduction parked on a carryforward schedule instead of on this year's return.

• Excess business loss: section 461(l) caps the net business loss at $256,000, or $512,000 on a joint return, for tax years beginning in 2026, with the excess carried forward as a net operating loss.
• Timing: the fund must close and place the property in service inside the same tax year as the gain, because a passive loss cannot be carried back to meet it.
• Character mismatch: if you materially participated in the property that produced the gain, that gain is non-passive and stays outside the reach of the fund's loss.
• State conformity: several states decouple from section 168(k), so the same dollar can be deductible federally and not at the state level.
• Suspended losses you already have: §469(g)(1) frees them when an entire interest is disposed of in a taxable sale, which can make selling one property outright more efficient than buying into a fund.

Where a fund complements an exchange instead of replacing it

The most common pairing is the cleanest: exchange the real property, then use a bonus depreciation fund to absorb the boot you deliberately kept. That is covered in intentional boot planning and, for a deal that collapsed, in plan B after a failed 1031.

The second pairing is the business sale: the entity gain has no 1031 available, while the real estate under the business does. The third is an investor who has run out of exchanges to make and simply wants a deduction against recurring K-1 income.

Breakwater Exchange can size the exchange and the deduction together rather than one after the other, placing sellers into DSTs, cash out DSTs, direct title securities and bonus depreciation funds offered by vetted national sponsors. Ask your CPA or attorney to confirm the passive-activity treatment and the state result first.