This article reports changes to depreciation schedules for §1031 replacement properties.
The cost basis for a replacement property acquired in a §1031 transaction is depreciated, in part, based on the depreciation schedules used for the property sold. Initially, the annual amount of the depreciation deduction taken on the property sold and the years remaining on that depreciation schedule continue to be reported for the replacement property acquired in the §1031 transaction when both legs are residential property and a trade-up in price occurs. [26 Code of Federal Regulations 1.168(i-6)]
The cost basis for replacement property, as always, is built by first carrying forward the remaining (adjusted) cost basis in the property sold. Upward adjustments to that basis are made for additional cash invested or increased amounts of debt assumed or created to fund the replacement property’s purchase. Alternatively, downward adjustments are made for a trade-down in debt and any withdrawal of cash, carryback paper, or un-like kind property received for the property sold. [See first tuesday Form 354]
The cost basis established on a trade-up into greater debt (or due to an additional investment of cash or execution of a note) to acquire the replacement property is then allocated between improvements (to set the depreciable cost basis) and land. The amount of the depreciable (exchange) basis which remained in the property sold is separated from the replacement property’s newly established depreciable basis for its improvements. That separated depreciable exchange basis continues to be depreciated (recovered) at the same rate for the years that remained for depreciating the property sold.
In a trade-up situation, the amount of the replacement property’s depreciable basis remaining after separating the depreciable exchange basis from the property sold is classified as excess depreciable basis for the replacement property. The excess depreciable basis is depreciated based on the 27.5- or 39-year recovery period allowed for residential and non-residential properties respectively.
When a residential replacement property has an excess depreciable basis, the total annual depreciation deduction is calculated by adding the amount of the annual exchange basis depreciation deduction continued from the property sold to the annual 27.5- or 39-year straight-line depreciation deduction scheduled for the excess depreciable basis.
The seller of residential property is now allowed to write off his cost basis in the residential replacement property faster than if he wrote off the entire depreciable basis (improvements) in the replacement property over the normal 27.5 years. Note that both legs of this §1031 transaction are residential income properties.
Consider the owner of residential property who wishes to sell and acquire replacement residential property of greater value. He has owned the property and taken an annual depreciation deduction for 15 years. The remaining cost basis in the property sold is $1,000,000, which represents $700,000 allocated to improvements (depreciable) and $300,000 allocated to land (non-depreciable).
The owner sells the property, and acquires residential property at a price $1,000,000 more than the sales price he received for the property he sold. In doing so, he assumes an amount of mortgage debt equal to (or greater than) the amount he owed on the property sold, adds cash, or executes a carryback note to the seller, all in addition to reinvesting the net proceeds of his sale. The adjusted cost basis in the replacement property is $2,000,000, allocated $1,500,000 to improvements and $500,000 to land.
To calculate the annual depreciation deduction, he will bifurcate the $1,500,000 depreciable cost basis to create two separate depreciation schedules for calculating his annual depreciation deduction:
- the depreciation deduction schedule for the depreciable exchange basis brought forward from the property sold with a remaining recovery period of 12.5 years (27.5 years less 15 years of prior ownership); and
- the residential depreciation schedule of 27.5 years for the excess depreciable basis resulting from the price trade-up. [See first tuesday Form 355 §5, 6]
Editor’s Note — The example §1031 transaction with the separate depreciable exchange basis and excess depreciable basis involves an owner selling a residential income property and buying another residential income property. If, however, the owner sells a residential property and replaces it with a non-residential property, the recovery period for the depreciable exchange basis brought forward from the property sold will be extended. The amount of the depreciation deduction on this portion will be reset at a lower amount over a greater number of years.
The remaining life from the property sold – 12.5 years in our residential example – is extended 11.5 years (to 24 years), the difference between residential and non-residential depreciation schedules (27.5 years versus 39 years). That is, the 15-year period of prior ownership of the residential property the owner sold is subtracted from the 39-year non-residential recovery period for the non-residential replacement property. Thus, the remaining recovery period for the $700,000 remaining depreciable exchange basis from the property sold will be 24 years, lowering the annual depreciation deduction for this portion of the basis below the amount taken annually during ownership of the residential property.
The second step is to calculate the annual depreciation deduction of the excess depreciable basis resulting from a trade-up in price. The excess depreciable basis is the replacement property’s additional depreciable cost basis over and above the remaining depreciable exchange basis from the property sold. In this case, the excess depreciable basis is $800,000 ($1,500,000 minus $700,000). The excess depreciable basis is deducted annually from income over the 27.5-year recovery period for residential properties. In our residential-to-residential example, the annual depreciation deduction on the $800,000 of excess depreciable basis in the $1,500,000 cost basis to improvements in the replacement property is $29,091.
The total annual depreciation deduction for the $1,500,000 depreciable cost basis is then calculated by adding the annual depreciation deduction brought forward as the depreciable exchange basis from the property sold ($56,000) and the annual depreciation deduction ($29,091) generated by the excess depreciable basis for a total annual depreciation deduction for the replacement property of $85,091.
Compare this with a $54,545 annual depreciation deduction available prior to the new regulations, a write-off of the $1,500,000 depreciable cost basis in the replacement property over 27.5 years. Now, the new depreciation rules allow the owner to take a greater annual depreciation deduction during the first years of ownership of the replacement period than he would have been able to take under the old depreciation rules.
