Depreciation After an Exchange, a Worked Example: Exchanged Basis and Excess Basis

Basis comes first: section 1031(d) gives the replacement the old basis plus any new money

Hypothetical: you placed a rental house in service in 2015 with $440,000 of building basis and $110,000 of land, and have taken about $176,000 of depreciation at $16,000 a year. The building has $264,000 of depreciable basis and 16.5 years of its 27.5-year recovery period left, so adjusted basis is $374,000. You sell for $900,000 net and defer a $526,000 gain.

You buy a $1,400,000 apartment property with the $900,000 and a $500,000 loan. Under section 1031(d), the basis is the old $374,000 plus the $500,000 of new borrowing, or $874,000, which equals the $1,400,000 price less the $526,000 deferred gain. Basis in replacement property covers that formula in more detail.

That basis is then split between land and building. If the land is 25% of value, a common approach puts $218,500 on the land and $655,500 on the building. Land is never depreciated, so only the $655,500 enters the schedules below. The $500,000 loan matters here: without it, the building's share of basis would be about $280,500, barely more than the old building's remaining $264,000, and almost nothing would start a fresh schedule.

The default rule runs two schedules side by side

Reg. section 1.168(i)-6(b)(7) defines exchanged basis as the lesser of the replacement's basis under section 1031(d) or the relinquished property's adjusted depreciable basis. Here that is the lesser of $655,500 and $264,000, so $264,000. Where both buildings are residential, paragraph (c) depreciates it over the old building's remaining recovery period with the same method: $16,000 a year for 16.5 years.

Paragraph (b)(8) makes the rest, $391,500, excess basis, and paragraph (d)(1) treats it as placed in service in the year of replacement, on its own 27.5-year schedule: $14,236 a year.

If the recovery periods differ, the regulation adjusts. Exchanging a rental house for an office building, which has a longer 39-year period, depreciates the exchanged basis over what remains of 39 years measured from when the house was placed in service. Exchanging an office building for apartments keeps the exchanged basis on the office building's longer remaining period.

• Years 1 to 16.5: $16,000 + $14,236 = $30,236 a year.
• Years 16.5 to 27.5: $14,236 a year, from the excess basis only.
• Total over the life: $655,500. Figures ignore the mid-month convention.

Electing to treat the whole basis as new gives a flatter schedule with the same total

Paragraph (i)(1) lets you elect out of these rules for an exchange. The exchanged and excess basis are then treated together as property placed in service at the time of replacement: $655,500 over 27.5 years, or $23,836 a year.

The comparison is pure timing. The default deducts $6,400 a year more for the first 16.5 years, $105,600 in all, and $9,600 a year less for the last 11, which gives the $105,600 back. If you expect higher income in the next decade, the default usually helps; if you expect a sale soon or lower income ahead, the flatter schedule can suit you better. Either way, every deduction reduces basis and adds to the 25% layer when you finally sell for cash. Run your own numbers with your CPA.

Paragraph (j) requires the election to be made on Form 4562 by the due date, including extensions, of the return for the year of replacement, separately for each exchange. It cannot be made later through an accounting method change, and it can be revoked only with IRS consent, granted in extraordinary circumstances.

Cost segregation on the replacement reaches the excess basis, and the excess basis only

Public Law 119-21 restored 100% bonus depreciation for qualifying property acquired after January 19, 2025. A cost segregation study can move parts of the building, such as appliances, carpet and site improvements, into 5-, 7- and 15-year classes that qualify, as Publication 946 describes for 15-year land improvements.

For a building someone else used before you, Reg. section 1.168(k)-2(g)(5)(iii) allows bonus only on the remaining excess basis, not on the exchanged basis. If a study put 20% of this building into short-lived classes, the bonus would reach 20% of $391,500, about $78,300, in the first year.

The cost comes at sale. Section 1245 components are recaptured as ordinary income, not at the 25% cap, as section 1245 recapture on real estate explains. Cost segregation and the 1031 strategy weighs whether a study pays for itself.

DST owners use the same split, applied to their share of the trust's property

A DST interest is treated as an undivided interest in the trust's real estate, so the exchanged-basis and excess-basis rules apply to your share. The sponsor's purchase price allocation among land, building and any short-lived components determines what your CPA can depreciate, as DST depreciation and bonus explains.

Excess basis in a DST exchange usually comes from your share of the trust's loan being larger than the debt you paid off, or from cash you add. If your carried-over basis is small, as with a fully depreciated rental, most of the building basis in the replacement may be excess basis on a new schedule.