Real estate investors often use smart strategies to grow wealth while saving on taxes. One key method is the 1031 exchange. It lets investors sell a property and buy another without paying tax right away. But there is another important part to learn, 1031 exchange depreciation. Knowing how depreciation works in an exchange can help you plan better and save more over time.
Below are five ways to understand and use 1031 exchange depreciation for long-term tax savings.
Know how depreciation carries over
When you use a 1031 exchange, the IRS does not reset your depreciation. Instead, the depreciation from the old property carries over to the new one. This is called a “carryover basis.” If your old property was mostly used up for depreciation, you cannot start fresh. You need to understand this rule to avoid surprise tax bills later.
Be aware of depreciation recapture
Depreciation helps lower your taxable income while you own the property. But when you sell it, the IRS wants some of that back. This is called “depreciation recapture.” If you do not do a 1031 exchange, you may owe taxes on this amount. By using an exchange, you delay paying this tax. Knowing this helps you hold on to more cash.
Plan for the long-term effects
Because depreciation carries forward, each exchange builds on the last one. Over time, you might have a property with very low remaining basis. This can lead to large gains when you finally sell without an exchange. That is why it is important to plan for your future tax situation and talk to a tax advisor.
Use cost segregation carefully
Cost segregation is a method used to speed up depreciation on certain parts of a property. This can lower taxes now but can also affect your 1031 exchange later. If you are using cost segregation, make sure you know how it impacts your depreciation and what happens if you exchange that property.
Keep good records
Since depreciation carries over, keeping good records is a must. You need to know how much depreciation you claimed on the old property. This will affect your tax filings and help your accountant set the correct basis for the new property. Poor records can lead to errors and tax problems.
The conclusion
Understanding 1031 exchange depreciation is key to making the most of your real estate deals. With the right knowledge, you can grow your wealth and protect it too.
