A §1031 defers depreciation recapture (taxed at up to 25% under §1250) alongside the capital gain. The depreciation basis carries forward to the replacement property — you don't lose it, but the accumulated depreciation rides along and will eventually be recaptured if you sell without another exchange. The 'recapture bomb' on a final non-exchanged sale is often larger than the capital-gain portion of the bill, especially after long depreciation runs.
Depreciation recapture is the often-ignored half of a 1031 deferral. Investors fixate on the capital-gain side because it is the bigger headline number, but for a long-held rental the recapture portion is frequently larger and taxed at a higher rate. Understanding how recapture moves through a 1031 chain is essential to modeling the lifetime tax outcome.
What Depreciation Recapture Actually Is (§1250 Rules)
When a taxpayer owns a rental property, IRS rules require depreciation deductions over the property's useful life — 27.5 years for residential rentals, 39 years for commercial. Each year's depreciation reduces taxable rental income, which is the immediate tax benefit. But it also reduces the property's basis, which becomes a future tax cost.
When the property is eventually sold, the IRS "recaptures" some or all of those past depreciation deductions. The mechanics:
- Subtract original cost from sale price to get total gain.
- Allocate the gain between (a) depreciation recapture (up to the cumulative depreciation taken) and (b) capital gain (the appreciation above original cost).
- Tax the recapture portion at up to 25% under IRC §1250.
- Tax the appreciation portion at standard long-term capital gains rates (15% or 20% depending on income).
Example: Bought a rental in 2010 for $300,000, depreciated $100,000 over the holding period, sells in 2026 for $700,000.
- Adjusted basis: $300,000 - $100,000 depreciation = $200,000.
- Total gain: $700,000 - $200,000 = $500,000.
- Depreciation recapture: $100,000 (taxed at up to 25%).
- Capital gain: $400,000 (taxed at 15-20%).
The 25% Maximum Recapture Rate vs Capital Gains
The recapture rate caps at 25% under §1(h)(1)(E), which is meaningfully higher than the 15-20% long-term capital gains rate. The taxpayer's actual effective rate may be lower if they're in a low-bracket year, but for most investors with significant rental income, recapture pushes the marginal rate to its 25% ceiling.
Why 25% rather than ordinary income? Section 1250 was a compromise. For pure §1245 personal property, recapture is at full ordinary income rates (up to 37%). Section 1250 (real property) uses a 25% cap because Congress treated long-held real estate more favorably. Even so, 25% recapture plus 20% capital gains plus 3.8% NIIT plus state tax can produce combined rates north of 50% on a final non-exchanged sale.
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Call (725) 224-5008How Basis Carries Over in a 1031
The §1031 deferral mechanism is basis carryover. The replacement property takes the relinquished property's adjusted basis (with adjustments for boot, additional cash paid, and assumed mortgages):
- Carryover basis = Adjusted basis of relinquished + cash paid + new debt assumed - cash received - debt relieved.
For pure tax-deferred trades (no boot either direction), the carryover basis equals the adjusted basis of the relinquished property. Continuing the example:
- Adjusted basis at exchange: $200,000 ($300K cost - $100K depreciation).
- Replacement property bought for $700K with $0 boot.
- New basis: $200,000.
The new $200K basis carries forward into the replacement. It does not reset to $700K (the new property's market value). This is the key reason §1031 is "deferral, not forgiveness" — the eventual sale is computed against the carryover basis, not the new market value.
New-Basis Portion on Trade-Up (and Its Separate Depreciation)
When the taxpayer trades up — buying a more expensive replacement — the difference between the relinquished value and the higher replacement value creates "excess basis" that depreciates separately:
- Relinquished sold for $700K (adjusted basis $200K).
- Replacement bought for $1,200K (adding $500K of fresh cash or new debt).
- Total basis in replacement: $200K (carryover) + $500K (excess) = $700K.
- The $200K carryover basis continues to depreciate on the original schedule (27.5 years from original 2010 purchase).
- The $500K excess basis depreciates on a fresh 27.5-year schedule starting at exchange.
This produces a "split basis" with two parallel depreciation streams. Tax software handles it, but the year-of-exchange return usually requires CPA attention to set up correctly.
The Recapture Bomb on a Final Non-Exchanged Sale
The danger of long 1031 chains is the eventual recapture bomb. Each link in the chain accumulates more depreciation that rides along with the basis. After three or four exchanges over twenty-plus years, the cumulative depreciation can be enormous — and a final non-exchanged sale recaptures all of it at the 25% rate.
Worked example: An investor does four 1031 exchanges over 25 years, accumulating $800K of cumulative depreciation. The final sale produces $2M of total gain, of which $800K is recapture and $1.2M is capital gain.
- Depreciation recapture: $800,000 × 25% = $200,000.
- Capital gain: $1,200,000 × 20% = $240,000.
- NIIT: $2,000,000 × 3.8% = $76,000.
- California state tax (top rate): $2,000,000 × 13.3% = $266,000.
- Total federal + California: $782,000.
The two ways to avoid the recapture bomb at the end of a 1031 chain:
- Hold the final replacement until death. The §1014 step-up in basis at death eliminates the entire carryover basis, including all accumulated depreciation. Heirs receive the property at fair market value with no recapture exposure. This is the "swap till you drop" strategy.
- Continue exchanging indefinitely. Each new §1031 defers the recapture along with the gain. As long as the chain continues, no recapture is recognized. Most active investors plan their 1031s with this in mind.
For investors who do eventually need to recognize the gain (cash needs, end-of-life liquidation, divorce settlements), modeling the recapture exposure before the trigger event matters. A 25% recapture rate applied to twenty years of cumulative depreciation is rarely a small number.
Simple 1031 LLC documents the basis carryover and any boot in the exchange agreement, which gives your CPA the inputs needed to model recapture trajectories. We are a Qualified Intermediary and do not provide tax, legal, or investment advice — recapture modeling, basis tracking across the chain, and final-sale planning are CPA work.
Frequently Asked Questions
Why is depreciation recapture taxed at 25%?
IRC §1(h)(1)(E) caps the rate on §1250 unrecaptured gain at 25%, which is higher than the 15-20% long-term capital gains rate but lower than ordinary income rates (up to 37%). The 25% rate was a compromise — Congress treats real-estate depreciation more favorably than personal-property depreciation (which is recaptured at full ordinary income rates under §1245), but does not extend the long-term capital gain rate to recapture income.
Does a 1031 reset my depreciation schedule?
Not for the carryover basis. The portion of the replacement basis that came from the relinquished property continues to depreciate on the original schedule from the original acquisition date. Any excess basis (from cash paid or new debt assumed above the relinquished value) starts a fresh 27.5- or 39-year schedule from the exchange date. This produces a split-basis property with two parallel depreciation streams.
What's the 'new basis' on a trade-up?
When you buy a more expensive replacement than what you sold, the difference is 'new basis' — additional invested capital that depreciates separately from the carryover basis. Example: sell for $700K with $200K adjusted basis, buy replacement for $1.2M, total basis is $200K carryover plus $500K new = $700K. The $200K continues on the original schedule; the $500K depreciates fresh from the exchange date.
Can I avoid recapture by holding until death?
Yes — that's the swap-till-you-drop strategy. The §1014 step-up in basis at death resets the heir's basis to the property's fair market value at death, eliminating all accumulated depreciation that had ridden along through the §1031 chain. The recapture exposure vanishes. This is one of the strongest estate-planning arguments for §1031: continuous deferral during life, full step-up at death.
How is recapture calculated on boot received?
Boot is taxable to the extent of realized gain, and the IRS allocates boot between recapture and capital gain in a specific order. Recapture is treated as recognized first — meaning if you receive $100K of boot on a sale with $80K of accumulated depreciation, the first $80K of boot is recapture income (taxed at up to 25%) and the remaining $20K is capital gain (taxed at 15-20%). This 'recapture first' rule means even small amounts of boot can produce disproportionately high tax bills.
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