One of the joys of owning real estate with improvements is that you get to take a non-cash loss or deduction on your tax return for the theoretical wear and tear on the property. A residential rental property or apartment building is depreciated over 27 and a half years, and a commercial building is depreciated over 39 years. Every year, even if the property is going up in value, you get to take a tax deduction for the wear and tear.
The downside to recaptured depreciation is that incrementally each year your basis is being reduced in the property. So at the end of that 27 and a half years, your apartment building will have a zero basis on the improvements because you depreciated it down to zero (unless you add basis by making capital improvements).
Impact on a 1031 Exchange
So how does this impact a 1031 exchange? The answer is that if you weren’t to do a 1031 exchange, all of that gain that’s attributable to the depreciation is taxed at a higher rate than normal capital gains rates. The maximum depreciation rate is 25% federal (compared to the maximum normal capital gains rate of 20%), so you pay the piper at a higher rate for all of that depreciation you’ve taken.
The good news is you can defer that gain, even the depreciation gain, by doing a 1031 exchange and keep all of your hard earned equity working for you by rolling it into a replacement property to defer the gain.
Most real property is Section 1250, however, if you have some components of your relinquished property that are classified as 1245 property for more rapid deprecation such as sheds, out-buildings, barns, agricultural storage bins, pens and silos then you need to be careful to match up enough like-kind 1245 replacement property to fully defer all of your gains.