But the effect of Depreiscation is an essential concept for understanding the true benefits of a 1031 exchange and where the taxes ultimately catch up, to the investor.
This is Key:
Depreciation is the percentage of the cost of an investment property that is written off every year, recognizing the effects of wear and tear. Before you sell, or even list a property, you should know what the amount you have deprecated is, and what you can expect as part of the depreciation “recapture.”
When a property is sold, capital gains taxes are calculated based on the property’s net-adjusted basis, which reflects the property’s original purchase price, plus capital improvements minus depreciation.
If a property sells for more than its depreciated value, you may have to recapture the depreciation. That means the amount of depreciation will be included in your taxable income from the sale of the property.
Since the size of the depreciation recaptured increases with time, you may be motivated to engage in a 1031 exchange to avoid the large increase in taxable income that depreciation recapture would cause later on.
Depreciation recapture will be a factor to account for when calculating the value of any 1031 exchange transaction—it is only a matter of to what degree.