Real estate investors know about bonus depreciation. They also know about 1031 like-kind exchanges. But not everyone realizes that the two rules can work together — sometimes in a surprisingly powerful way.
The Basic Idea
Bonus depreciation (IRC §168(k)) lets you immediately write off the cost of certain property with a recovery period of 20 years or less. You can think 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 Purchased Requirement.)
A 1031 exchange lets you defer gain when you swap one property for another of like kind. (We’ve also described how these work in past. For example, see Like Kind Exchange Rules Powerful But Tricky )
Here’s the twist: Treasury regulations say that when you exchange into a new property, the basis that carries over from the old property and any new money you invest can be eligible for bonus depreciation. The key cite is Reg. §1.168(k)-1(f)(5)(iii)(A). And the main thing to know: Combining these two laws can potentially result in gigantic tax savings.
A Simple Example
Let’s start with a practical but simple example. Suppose you:
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Buy a $1,000,000 rental property. A cost segregation study finds $300,000 of 15-year improvements. You claim 100% bonus depreciation = $300,000 deduction in Year 1.
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In Year 2, you exchange that property for a replacement worth $1,000,000. Basis carries over at $700,000.
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Regulations let you treat that $700,000 as if newly placed in service for bonus depreciation purposes. Another cost seg shows $210,000 of short-life property — and you get another big deduction.
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Do it again in Year 3, and the same mechanics apply (though the numbers shrink as the basis shrinks).
It’s a bit like a geometric series of deductions: $300K, then $210K, then $147K…
Obviously, transaction costs matter. The timing needs to work right. (You can’t both acquire and dispose of a property in the same year, for example, to point out one of the important requirements.)
But, wow, that’s surprising, right? If you’re a high income real estate investor, you may want to exchange existing properties for new properties simply to trigger bonus depreciation. Further, if you’re a high income taxpayer looking for a way to really dial down your federal tax burden? Now would not be a crazy time to look into this investment category.
Who Benefits?
This isn’t for everyone. To make it work you need:
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The right timing (properties bought and exchanged while bonus depreciation is available).
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A cost segregation study on each property.
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Enough participation in the rental activity to avoid falling into the passive activity category. (The three most practical ways to avoid passive losses are described here: real estate professional status, short-term rentals, and self-rentals to 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 gain through §1031 while still accelerating deductions with bonus depreciation.
The Bottom Line
Most investors think they must choose between a 1031 exchange or a large depreciation deduction. The truth? Under the right circumstances, you can have both.
As always, details matter. Talk with your tax advisor before trying to apply this in your situation.