Depreciable property refers to certain types of real or personal property that have a useful life of more than one year and are used in a trade or business or held for investment purposes. This type of property is subject to depreciation, which is the process of deducting a portion of the property’s cost each year until the entire cost is recovered.
Depreciation allows the owner to offset income generated by the property with the depreciation expense, thereby reducing their overall tax liability.
When a depreciable property is part of a 1031 exchange, the owner can defer capital gains tax that would ordinarily be due upon the sale of the property. A 1031 exchange, named after Section 1031 of the Internal Revenue Code, allows an investor to “exchange” one investment property for another of “like-kind” without incurring immediate tax liability.
However, one must take into consideration the depreciation recapture rules. The IRS requires investors to pay a tax on the amount of depreciation claimed when a property is sold. When conducting a 1031 exchange, this depreciation recapture can also be deferred, but it will be due when the replacement property is eventually sold without a subsequent 1031 exchange.