1031 Exchange and Depreciation Recapture
A properly completed 1031 exchange defers depreciation recapture right along with your capital gain — the recapture rules in IRC §1245(b)(4) and IRC §1250(d)(4) contain explicit exceptions for like-kind exchanges. But the deferral only holds if you recognize no gain: take boot, trade down, or transfer section 1245 personal-property components that no longer qualify for §1031, and the recapture-flavored portion of your gain generally comes out first, at less favorable rates than ordinary capital gain.
What depreciation recapture actually is
Every year you depreciate a rental or commercial property, you deduct part of its cost against ordinary income — and each deduction lowers your adjusted basis (see how 1031 exchange basis works). When you sell, the gain attributable to those past deductions doesn’t get the standard long-term capital gains treatment. The tax code splits it into categories:
| Category | What it covers | Federal rate on sale |
|---|---|---|
| §1245 recapture | Depreciation/amortization on section 1245 property (equipment, fixtures, and cost-segregated components such as 5- and 7-year property) | Ordinary income rates, up to the depreciation taken (IRC §1245(a)) |
| §1250 recapture | ”Additional depreciation” on real property — depreciation taken in excess of straight-line (IRC §1250(b)) | Ordinary income rates on the excess |
| Unrecaptured §1250 gain | Gain attributable to straight-line depreciation on real property that isn’t recaptured as ordinary income (IRC §1(h)(6)) | Maximum 25% (IRC §1(h)(1)(E); IRS Topic 409) |
| Remaining appreciation | Gain above your original cost | 0% / 15% / 20% long-term capital gains |
Two practical points for real estate investors:
- Most buildings today produce unrecaptured §1250 gain, not ordinary-income recapture. Real property placed in service under MACRS is depreciated straight-line, and §1250 only recaptures depreciation in excess of straight-line. With no excess, there’s no §1250 ordinary income — but the straight-line depreciation still gets pulled out of your gain and taxed at up to 25% as unrecaptured §1250 gain, per IRC §1(h)(6) and IRS Topic 409.
- Recapture applies to depreciation “allowed or allowable.” Skipping the deduction doesn’t avoid it — §1245(a)(2)(A) counts deductions allowed or allowable, so the basis reduction happens either way.
State income tax treatment of recognized gain varies as well — see the state-by-state 1031 guides.
How a 1031 exchange defers recapture
Both recapture statutes defer to §1031 when no gain is recognized:
- §1245 property: in a like-kind exchange, ordinary-income recapture “shall not exceed the sum of the amount of gain recognized on such disposition (determined without regard to this section), plus the fair market value of property acquired which is not section 1245 property” (IRC §1245(b)(4)).
- §1250 property: recapture taken into account is capped by reference to the gain otherwise recognized on the disposition and the extent to which additional depreciation exceeds the fair market value of §1250 property received (IRC §1250(d)(4)).
In a fully deferred exchange — equal-or-greater value, all proceeds reinvested, debt replaced, zero boot — recognized gain is zero, so recapture is zero. The depreciation history doesn’t disappear, though: it carries into the replacement property through your exchanged basis under IRC §1031(d) and comes back out whenever you eventually sell in a taxable transaction.
When recapture IS triggered despite an exchange
1. Boot and trading down
Receive cash, trade down in value, or walk away with net debt relief, and you recognize gain up to the boot received under IRC §1031(b). The Form 8824 instructions route the recapture component to a dedicated line (line 21, ordinary income under the §1245/§1250 recapture rules, carried to Form 4797), and the depreciation-attributable portion of what you recognize is generally taxed first — as ordinary income if §1245 or excess-depreciation §1250 recapture applies, or as unrecaptured §1250 gain at up to 25% for straight-line real estate — before any of it reaches the 0/15/20% brackets. That’s why a “small” partial exchange can carry a higher effective tax rate than investors expect.
2. Personal-property components after the TCJA
Since 2018, §1031 applies only to real property: “section 1031 like-kind exchange treatment applies only to exchanges of real property held for use in a trade or business or for investment” (Form 8824 instructions; IRC §1031(a)). Personal property transferred with a building — furniture in a furnished rental, restaurant equipment, machinery — can no longer be deferred, so gain on those §1245 assets, including full ordinary-income recapture, is recognized in the year of sale.
Cost segregation adds a wrinkle. The regulations define real property for exchange purposes broadly — land, improvements, inherently permanent structures, and their structural components (Treas. Reg. §1.1031(a)-3) — and expressly state that this definition applies “only for purposes of section 1031,” with “no inference… with respect to the classification or characterization of property for other purposes of the Code, such as depreciation and sections 1245 and 1250.” A cost-segregated component can therefore be real property that qualifies for the exchange while remaining §1245 property for recapture. Under §1245(b)(4), recapture on §1245 property is triggered to the extent you receive property that is not §1245 property in return — a real risk when a heavily cost-segregated building is exchanged for one without comparable §1245 components. If you’ve taken accelerated or bonus depreciation through cost segregation, model this with a CPA before closing.
3. Failed or late exchanges
Miss the 45-day identification or 180-day closing deadline and the sale is simply taxable — gain and recapture recognized in full. Track your dates with the 1031 exchange calculator.
Depreciation after the exchange: carryover basis and the elect-out
Your replacement property’s basis is a carryover basis under IRC §1031(d): generally the basis of what you gave up, decreased by money received and increased by gain recognized and new money added. Form 8824 (line 25) computes it. Because that basis is lower than the purchase price, your future depreciation deductions shrink — that’s the flip side of the deferral.
How you depreciate that basis is governed by Treas. Reg. §1.168(i)-6:
- Exchanged (carryover) basis — default rule: you step into your own shoes. Depreciation continues “using the same recovery period and depreciation method that were used for the relinquished MACRS property” — the old schedule keeps running on the new asset.
- Excess basis: any basis above the carryover amount (new cash or new debt) “is treated as property that is placed in service by the acquiring taxpayer in the year of replacement” and starts a fresh recovery period under the rules applicable to the replacement property.
- Elect-out option: under §1.168(i)-6(i)(1), you may elect not to apply the two-schedule rule, in which case “the sum of the exchanged basis and excess basis… is treated as property placed in service by the taxpayer at the time of replacement” — one new depreciation schedule for the entire basis. Simpler bookkeeping, but often slower cost recovery (e.g., a residential 27.5-year schedule restarts from year one); the tradeoff depends on the remaining recovery period of the old property and the type of the new one.
Worked example: gain composition (hypothetical)
Round, hypothetical numbers for illustration only — not a real transaction; closing costs, land-allocation nuances, and state tax are ignored.
An investor bought a residential rental for $350,000 ($275,000 allocated to the building, $75,000 to non-depreciable land) and has taken exactly 10 years of straight-line depreciation on the 27.5-year schedule ($275,000 ÷ 27.5 = $10,000 per year, so $100,000 total). She sells for $500,000.
| Item | Amount |
|---|---|
| Sale price | $500,000 |
| Original cost | $350,000 |
| Depreciation taken (10 × $10,000) | $100,000 |
| Adjusted basis (350,000 − 100,000) | $250,000 |
| Realized gain (500,000 − 250,000) | $250,000 |
That $250,000 gain is really two layers:
- $100,000 attributable to depreciation — because the depreciation was straight-line, there’s no §1250 ordinary-income recapture; this layer is unrecaptured §1250 gain taxed at up to 25% federally if recognized.
- $150,000 of appreciation — long-term capital gain at 0/15/20% if recognized.
Full exchange: she buys a $550,000 replacement with all exchange proceeds plus new financing and receives zero boot. Recognized gain: $0. Both layers — all $250,000 — are deferred, and the $100,000 depreciation history rides along inside her carryover basis.
Partial exchange: she instead trades down and pockets $60,000 of cash boot. She recognizes $60,000 of gain, and that recognized gain is generally treated first as unrecaptured §1250 gain — up to $15,000 of federal tax at the 25% rate (plus any net investment income tax and state tax) — while the remaining $190,000 stays deferred.
Deferral is not forgiveness — but it can become permanent
Each exchange rolls the accumulated depreciation forward; sell for cash someday and every deferred layer is recognized at once. The classic endgame is “swap ‘til you drop”: hold (or keep exchanging) until death, at which point heirs generally take a basis stepped up to fair market value under IRC §1014 — extinguishing both the deferred capital gain and the deferred recapture for income-tax purposes. See 1031 exchanges and inherited property for how that works.
Frequently asked questions
Yes. IRC §1245(b)(4) and §1250(d)(4) limit recapture in a like-kind exchange by reference to the gain actually recognized (plus, for §1245 property, the value of non-§1245 property received). In a fully deferred exchange with zero boot, recognized gain is zero, so recapture is fully deferred along with the capital gain.
It's the portion of long-term gain on depreciable real property attributable to straight-line depreciation that isn't recaptured as ordinary income, defined in IRC §1(h)(6). It's taxed at a maximum federal rate of 25% instead of the 0/15/20% capital gains rates. Most modern buildings generate this category because MACRS real property is depreciated straight-line.
Generally yes, and first in line. Recognized gain from boot is reported on Form 8824, which has a dedicated line for ordinary income under the §1245/§1250 recapture rules, and the depreciation-attributable portion is generally taxed before the lower-rate capital gain — at ordinary rates for §1245 recapture or up to 25% for unrecaptured §1250 gain.
Under Treas. Reg. §1.168(i)-6, the carryover (exchanged) basis by default continues the relinquished property's depreciation schedule — same method and remaining recovery period — while any excess basis is treated as new property placed in service in the year of the exchange. Alternatively, you can elect out under §1.168(i)-6(i)(1) and depreciate the entire basis as newly placed-in-service property.
Through exchanges alone, no — recapture is deferred, not forgiven, and it's recognized whenever you sell in a taxable transaction. But if you hold the property until death, your heirs generally receive a basis stepped up to fair market value under IRC §1014, which eliminates the deferred gain and recapture for income-tax purposes.
This article is for educational purposes only and is not legal or tax advice. Depreciation recapture involves IRC §§1245, 1250, 1(h), and 1031 and their regulations, and outcomes depend heavily on your depreciation history; consult a qualified tax professional or attorney about your specific situation.
Primary sources: IRC §1031 (Cornell LII) · IRC §1245 (Cornell LII) · IRC §1250 (Cornell LII) · IRC §1(h) (Cornell LII) · IRC §1014 (Cornell LII) · Treas. Reg. §1.168(i)-6 (Cornell LII) · Treas. Reg. §1.1031(a)-3 (Cornell LII) · IRS Form 8824 & Instructions · IRS Topic 409, Capital Gains and Losses