Last week we introduced depreciation and mentioned that a 1031 exchange could save you from the immediate cost of depreciation recapture. To fully understand depreciation, including how the year you purchased the property and various depreciation methods factor into your calculations, consult your tax advisor or IRS publication 946. Today, we’d like to look at some additional basics you should know.
How is depreciation calculated?
When it comes to the basic calculation for your depreciation deduction of real estate, we must consider how long the property has been determined to last. Rather than deducting the actual costs incurred by wear and tear on the property each year, deductions are averaged over the valuable life of the property. Most commercial real estate improvements are presumed to last 39 years while residential property improvements are presumed to last 27.5 years.
The Cost Basis
Depreciation considers the cost basis of the depreciation-eligible portion of the property and divides that amount by the established valuable lifespan of the property to determine the annual deductible amount.
- Therefore, if improvements of a standard commercial property have a cost basis of $200,000 at the time the property is placed into service, then the $200,000 cost basis is divided by 39 years, resulting in a depreciation deduction of $5,128 annually until the investor has recovered their cost or retires the property from service.
- The investor of a residential property with the same cost basis, alternatively, could deduct $7,272 annually.
- Your deduction amount may differ for the first year if the property was not in service the entire year and may change in later years if a significant change in cost basis or lifespan occurs.
Depreciation after a 1031 exchange
A 1031 exchange allows you to defer taxes owed for depreciation recapture. Under standard circumstances after a 1031 exchange, your annual depreciation amount remains the same for your replacement property as it was for your relinquished property. Regardless of market value, your new property’s cost basis is equal to that of the old property and the useful life term continues from where you left off with the old property. Therefore, if you had depreciated your relinquished property for 10 of 39 years, you have another 29 years of eligible depreciation for your replacement property.
The Depreciation Calculation
Now, it’s not always that easy because it’s possible you’ve exchanged your previous property with a different type of property that requires a depreciation calculation based on a different lifespan or convention of calculation.
In this case, the IRS requires you to use the calculation method that results in the least amount of depreciation.
Another benefit to a 1031 exchange is that deferred depreciation, like deferred capital gain, is eliminated at the time your investment property is transferred to your heirs when you continue the cycle of exchanging throughout your lifetime. Because heirs inherit property at the current market value, they receive a step-up in cost basis, and the accumulated depreciation is no longer relevant.