Depreciation is a term used in the 1031 exchange industry to refer to the reduction in the value of a property over time due to wear and tear, deterioration, and obsolescence. It is an accounting concept that allows property owners to account for the declining value of their investment property as a tax deduction.
In the context of a 1031 exchange, depreciation plays an important role in calculating the property’s adjusted basis, which is used to determine the amount of gain or loss that will be recognized for tax purposes upon the sale of the property. The adjusted basis is calculated by subtracting the total amount of depreciation claimed on the property from the original purchase price.
When a property owner sells a property as part of a 1031 exchange, any accumulated depreciation that was previously claimed must be recaptured and taxed as ordinary income, up to a maximum rate of 25%. However, by completing a 1031 exchange and acquiring a replacement property, the property owner can defer paying taxes on the recaptured depreciation and any other gains from the sale of the relinquished property.