CPA-led 1031 exchange guide
Depreciation Recapture in a 1031 Exchange
Depreciation recapture is often the largest single tax exposure on the sale of investment property — and the one investors most often overlook until closing. The good news for property owners: a properly executed 1031 exchange handles capital gains and depreciation recapture taxes together, deferring capital gains and the recapture into the basis of the replacement property. Here's what depreciation recapture is, why it matters, and how Section 1031 tax deferral works in practice. Pair this with your CPA or other tax professionals before signing anything.
Why property owners care
For property owners holding investment property, depreciation has been the quiet workhorse of every year's return — a non-cash depreciation deduction reducing taxable rental income. At sale, the IRS asks for some of that benefit back in the form of recapture, taxed at up to 25% federal. A 1031 exchange is the standard tool tax professionals use for deferring capital gains and recapture in the same transaction.
What depreciation recapture is
When you own residential or commercial rental property, the tax code lets you deduct depreciation every year — typically 27.5 years straight-line for residential rental and 39 years for commercial. Those deductions reduce taxable rental income each year. When you sell, the IRS recaptures the portion of the gain attributable to that depreciation at a higher rate — up to 25% federal on Section 1250 unrecaptured gain — on top of regular capital gains tax on the appreciation above your original cost.
Why it matters on a straight sale
Consider a $600,000 rental originally purchased for $400,000 with $80,000 of depreciation taken. On a straight sale, the realized gain is $280,000 ($600,000 − $320,000 adjusted basis). Of that, $80,000 is unrecaptured Section 1250 gain taxed at up to 25% federal — roughly $20,000 in federal recapture tax alone. State tax, regular capital gains on the remaining $200,000 of appreciation, and the 3.8% net investment income tax stack on top.
How a 1031 exchange defers it
A 1031 exchange defers the entire gain — capital gains and depreciation recapture together. The deferred gain doesn't disappear; it carries into the replacement property's basis. When you eventually sell the replacement property (without doing another exchange), the deferred depreciation recapture is taxed at that point.
Basis carryover and the replacement schedule
The replacement property's basis is typically your adjusted basis in the relinquished property, plus any new cash or debt added, minus any boot received. Depreciation on the replacement property continues from where it left off on the carryover-basis portion, with any new basis depreciated as a separate addition. This is where CPA coordination is essential — getting the new depreciation schedule right protects the future tax picture.
When recapture sneaks in anyway
Two scenarios commonly create unexpected recapture even inside a 1031 exchange.
- Boot received on the exchange — recapture is recognized first, up to the amount of boot
- Exchanges into property of a different type where Section 1245 personal-property components were involved (less common in pure real-property exchanges post-TCJA)
- Failed or partially failed exchanges where the deferral is lost
Why CPA review matters
Recapture math depends on your full depreciation history, the relinquished and replacement closing statements, and any boot. Brandon's CPA-led guidance helps surface that exposure before closing, while i1031 separately executes the Qualified Intermediary workflow.
Frequently Asked Questions
Is depreciation recapture taxed differently from capital gains?
Yes. Unrecaptured Section 1250 gain on real property is taxed at up to 25% federal — higher than the 0/15/20% long-term capital gains rates that apply to the appreciation above your original cost.
Does a 1031 exchange eliminate depreciation recapture?
It defers it. The recapture exposure carries into the replacement property's basis and is recognized if you ever sell the replacement without doing another exchange.
What happens to depreciation on the replacement property?
You continue depreciating the carryover-basis portion under the original schedule and depreciate any new basis (added cash or debt) as a separate addition. Your CPA handles the split on the next depreciation schedule.
Can boot trigger recapture?
Yes. When boot is received in an exchange, recapture may be recognized first, up to the amount of the boot. Review the facts with your filing CPA before relying on an estimate.