Real estate investors know about bonus depreciation. They also know of 1031 similar exchanges. But not everyone realizes that the two rules can work together, sometimes in surprisingly powerful ways.
The basic idea
Bonus depreciation (IRC §168(k)) allows you to immediately write off the cost of certain property with a payback period of 20 years or less. You might think about personal property, land improvements, and some interior improvements identified in a cost segregation study. (We talked about this in our last blog post: The Section 168(k) Bonus Depreciation Purchase Requirement.)
A 1031 exchange allows you to defer gain when you exchange one property for another of the same type. (We’ve also described how they work in the past. For example, see Powerful but Complicated Similar Sharing Rules.)
Here’s the twist: Treasury regulations say that when you trade in new property, the basis that’s transferred from the old property and any new money you invest may be eligible for additional depreciation. The key quote is Reg. §1.168(k)-1(f)(5)(iii)(A). And the most important thing to know: combining these two laws can potentially generate huge tax savings.
A simple example
Let’s start with a practical but simple example. Suppose that:
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Buy a rental property worth $1,000,000. A cost segregation study finds $300,000 in improvements over 15 years. Claim 100% bonus depreciation = $300,000 deduction in year 1.
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In year 2, you exchange that property for a replacement property worth $1,000,000. The basis moves to $700,000.
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The regulations allow you to treat that $700,000 as if it were newly placed in service for bonus depreciation purposes. Another cost segment shows $210,000 in short-lived properties, and you get another big deduction.
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Do it again in year 3 and the same mechanics will apply (although the numbers will shrink as the base shrinks).
It’s a bit like a geometric series of deductions: $300k, then $210k, then $147k…
Obviously, transaction costs matter. The timing must work correctly. (You cannot acquire and dispose of property in the same year, for example, to point out one of the important requirements).
But wow, that’s surprising, right? If you are a high-income real estate investor, you may want to exchange existing properties for new properties simply to activate bonus depreciation. Also, if you are a high-income taxpayer looking for a way to really reduce your federal tax burden. Now wouldn’t be a crazy time to look at this investment category.
Who benefits?
This is not for everyone. For it to work you need:
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The right time (properties purchased and exchanged while bonus depreciation is available).
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A cost segregation study for each property.
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Sufficient participation in the rental activity to avoid falling into the passive activity category. (Here are the three most practical ways to avoid passive losses: professional real estate status, short-term rentals, and self-rental for a business you own.)
But for active real estate investors, especially those moving up in property size, this can be a powerful way to defer gains through Section 1031 while also accelerating deductions with bonus depreciation.
The conclusion
Most investors think they must choose between a 1031 exchange either a large depreciation deduction. The truth? Under the right circumstances, you can have both.
As always, details matter. Talk to your tax advisor before trying to apply this to your situation.
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