Real estate investing offers plenty of benefits: inflation protection, the ability to use leverage, and cash flow creation. But the most significant benefit might be the tax advantages real estate affords.
One of those benefits is depreciation expense, which lowers your tax burden without any outlay of cash. Many new and first-time investors are surprised by a tax bill for depreciation recapture when a property is sold, but using astute planning and a 1031 like-kind exchange can defer that recapture tax, along with any gain, by rolling it into the new property.
Why the IRS Cares About Depreciation Method
According to the Journal of Accountancy, the IRS noticed inconsistencies in how depreciation was being treated on replacement properties. Some taxpayers used the same depreciation method, recovery period, and convention as the property they exchanged out of, while others depreciated the replacement property as if it were newly placed in service. To clarify things, the Treasury Department issued Decision 9314, spelling out how modified accelerated cost recovery system (MACRS) depreciation should be treated in connection with 1031 like-kind exchanges.
Two-Schedule vs. Single-Schedule Depreciation
The guidelines lay out a preferred two-schedule depreciation method, but they also allow a single-schedule method if an investor prefers it. Because the two-schedule method is more complex, most investors opt for the simpler single-schedule approach, though that simplicity can come at the cost of some real benefits.
With the two-schedule method, depreciation on the original property continues on its original schedule, while the new property’s added basis is depreciated on a separate, new schedule. Total depreciation is the sum of those two calculations.
With single-schedule depreciation, the basis of the new property is adjusted for depreciation already taken on the first property, and then a single new schedule begins, 27.5 years for residential property or 39 years for non-multifamily commercial property.
A Worked Example
Consider an investor who buys a multifamily property for $5,000,000. After five years, they sell it for $6,000,000 in a 1031 exchange and use the proceeds to buy another multifamily property, also for $6,000,000.
Single Schedule
- Original purchase: $5,000,000
- Total depreciation taken: $727,270
- Adjusted basis: $4,272,730
- Capital gain: $1,000,000
- New purchase: $6,000,000
- New basis: $5,272,730
- Depreciation schedule: 27.5 years
- Annual depreciation: $191,735
Two Schedule
- Original purchase: $5,000,000
- Total depreciation taken: $727,270
- Adjusted basis: $4,272,730
- Capital gain: $1,000,000
- New purchase: $6,000,000
- 1st schedule: adjusted basis $4,272,730, remaining term 22.5 years, annual depreciation $189,899
- 2nd schedule: new basis $1,000,000, term 27.5 years, annual depreciation $36,363
- Total two-schedule depreciation: $226,262
In this example, the two-schedule method produces $226,262 in annual depreciation for the first 22.5 years, compared to $189,899 under the single-schedule method. The single-schedule method would eventually catch up in the final five years, but the present value of the two-schedule method’s accelerated tax benefits generally makes it the more optimal choice. It’s also common for the second property to be exchanged again before that catch-up phase of the single-schedule method ever kicks in.
While most investors do opt for the single-schedule method, there are real benefits to the two-schedule approach. These simplified examples don’t fully capture the complexity involved in building basis, and when properties are rolled into a third or fourth exchange, the accounting and record-keeping can get cumbersome fast.
More complex accounting can sometimes mean greater benefits down the road. It’s crucial to work with your accountant and tax planner to choose the method that fits your circumstances best.
