Real estate investors typically understand bonus depreciation and are familiar with 1031 like-kind exchanges. However, many don’t recognize that these two tax strategies can be combined—sometimes creating remarkably powerful results.

The Fundamental Concept

Bonus depreciation (IRC §168(k)) allows immediate write-offs for specific property with recovery periods of 20 years or less. This includes personal property, land improvements, and specific interior upgrades identified through cost segregation analysis. The cpa firm Evergreen Small Business wrote a helpful blog post explaining the Section 168(k) Bonus Depreciation Purchased Requirement.)

A 1031 exchange enables deferral of capital gains when exchanging one property for another qualifying like-kind property. They also wrote a helpful post explaining how Like-Kind Exchange Rules work. 

The Strategic Advantage

Here’s where it gets interesting: Treasury regulations specify that when exchanging into replacement property, both the basis transferred from the relinquished property and any additional cash invested may qualify for bonus depreciation. The crucial regulatory reference is Reg. §1.168(k)-1(f)(5)(iii)(A). The critical takeaway: strategically combining these provisions can potentially generate substantial tax savings.

A Practical Illustration

Let’s examine a straightforward example. Assume you:

1. Purchase a $1,000,000 rental property. A cost segregation study identifies $300,000 in 15-year qualifying improvements. You claim 100% bonus depreciation, generating a $300,000 deduction in Year 1.
2. Exchange into replacement property in Year 2 valued at $1,000,000. Your carryover basis is $700,000.
3. Treasury regulations permit treating that $700,000 as newly placed in service for bonus depreciation purposes. A new cost segregation study reveals $210,000 in accelerated depreciation assets—delivering another substantial deduction.
4. Repeat the exchange in Year 3, and the same principles apply (though deduction amounts decrease as basis diminishes).

This creates a cascading series of deductions: $300,000, then $210,000, then $147,000, and so on.

Important Considerations

Transaction costs are significant factors. Timing requirements must be carefully observed—for instance, you cannot acquire and dispose of a property within the same tax year, among other critical rules.

The Strategic Opportunity

Remarkable, isn’t it? High-income real estate investors may benefit from strategically exchanging existing properties for replacement properties specifically to trigger bonus depreciation benefits. For affluent taxpayers seeking meaningful federal tax reduction strategies, this investment approach warrants serious consideration, particularly in the current tax environment.      

Who Should Consider This Strategy?

This approach isn’t universally applicable. Successful implementation requires:

• Proper timing: Properties must be acquired and exchanged during periods when bonus depreciation remains available.
• Cost segregation analysis: Each property needs a professional cost segregation study.
• Active participation: Sufficient involvement in rental activities to avoid passive loss limitations. The three most effective methods are: qualifying for real estate professional status, utilizing short-term rental exceptions, or employing self-rental arrangements to businesses you control.

However, for active real estate investors—particularly those scaling up to larger properties—this strategy offers a compelling method to defer capital gains through §1031 exchanges while simultaneously accelerating tax deductions via bonus depreciation.

Key Takeaway

Most investors assume they must choose between executing a 1031 exchange or claiming substantial depreciation deductions. The reality? Under appropriate circumstances, you can capture both benefits simultaneously.

As with all sophisticated tax strategies, specifics matter tremendously. Consult with your tax advisor before implementing this approach in your particular situation to ensure proper execution and compliance. If you have questions reach out for a free consultation.