Depreciation of replacement assets after 1031 exchange - Combine or keep separate?

[Dave918]

The property that I sold in a 1031 Exchange included an improvement (an HVAC unit) that was a separate asset from the main structure which was purchased earlier and depreciated separately. Both are 27.5 year residential but the original purchase has been depreciated more since it was purchased earlier. I will be transferring these assets and their basis to the replacement property as the exchanged basis to continue depreciated them. Should I keep them as separate assets for the replacement property or should I combine them? Thank you in advance for your response.

[AmyC]

There are a couple of ways to handle the depreciation after the 1031 exchange. Here is a great article explaining the options along with pros and cons.

The program prefers the simplest method - which would be for you to eliminate the HVAC and main structure to depreciate only the new property. The cost basis of the new property = cost of new property - deferred gain from original property. In your case, HVAC deferred gain will also be subtracted from the new property.

For example:

• Buy building A, original cost $250,000, depreciated $150,000, sold $400,000
• if sold, A would have gain of $300,000 but instead did a 1031 exchange.
• Buy building B for $500,000.
• Cost basis for new property B is $500,000 -  prop A gain $300,000 = $200,000

The adjusted basis of building A is the exchange basis.

Excess basis = cost basis for new property  - adjusted basis of building A

For example:

• Building A adjusted basis is $250,000 -dep $150,000 = $100,000 = exchange basis
• Building B $500,000 purchase price
• Excess basis = purchase -exchange
• Excess = $500,000 - $100,000 = $400,000 excess basis

The adjusted cost basis is the purchase price minus the deferred gain from the property sold. 

From my example above:

Cost basis for new property B is $500,000 -  prop A gain $300,000 = $200,000

See also:

• Where do I enter a like-kind or Section 1031 exchange (Form 8824)?
• What is a like-kind (Section 1031) exchange?
• IRS 8824 Instructions
• Another post of mine with pictures to help with entry

[Dave918]

Good Evening Amy,

Thank you for your response. I agree that the single asset method of depreciating the replacement property is the simplest and the easiest, but it means that the amount that I can depreciate each year will be significantly less than if I use the more complex 2 asset method (exchanged basis asset from the old property which is depreciated on it's remaining depreciation schedule  plus excess basis asset which is new money depreciated on new 27.5 year schedule). I thought the sale pitch for Turbotax is that it gives you the biggest refund but the single asset method your are advocating will give me smaller refunds for 20 years because I will need to depreciate the exchanged basis from the old property over 27.5 year when I could depreciate it over it's remaining depreciating schedule (20 years in my case) if I use the more complex 2 asset method that you seem to be discouraging me from using.

Is Turbotax able to support the 2 asset method? I would need Turbotax to add a new asset  for the exchanged basis which is depreciated over its remaining depreciation schedule (20 years in my case). How would Turbotax do this?

Also, I think you didn't understand my original question. My old property had an improvement (HVAC) that was a separate asset that acquired after the original property so it is on a different depreciation schedule (even though both are 27.5 year residential real estate) . So do I need to depreciate 3 assets (the exchanged basis of the original property on it's remaining depreciation schedule, the exchanged basis of the improvement (HVAC) on it's remaining depreciation schedule, and the excess basis (new money) on a new 27.5 year depreciation schedule? Or can I combine the exchanged basis of the original property with the exchanged basis of the HVAC so that I only have 2 assets to depreciate (exchanged basis of combined assets plus excess basis of new asset)?

Thank you again for your help. I know it is a complicated question.

[DianeW777]

Yes, you will have assets exactly as you describe.  You can choose to add the HVAC to the cash-up (new money) to make one additional asset after the exchange using the 27.5 year real residential property category.  TurboTax can handle the new assets, you simply add the new asset(s) in your rental activity.

[ychenxx]

If you use the second method, treating the exchanged property and new property separately, how can you defer the capital gain? the method one removed the capital gain to get you a lower depreciation bass.

[DianeW777]

Capital gain is deferred because you are using the same cost basis as the original property, then adding a new asset for the 'buy-up' in the exchange. The original cost basis doesn't change and becomes part of the new asset. The difference is that only the buy-up portion becomes a new asset with a date placed in service in the year of the exchange.

If there has been any boot received on the exchange, then there would also have been taxable gain in the exchange.

@ychenxx