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1031 Exchange Depreciation Recapture and the 1245(b)(4) Trap

By Hans Goldstein · Updated 2026-09-27

A 1031 exchange defers depreciation recapture along with the rest of the gain, as long as you take no boot and the exchange avoids one trap. Boot (cash, debt relief you don't replace, or other non-like-kind property) is taxed up to your gain, and it tends to pull out your most expensive layers first. The trap is §1245(b)(4): if your old building was cost-segregated and the replacement has fewer short-life components, you can owe ordinary recapture with no boot at all.

First, what "recapture" means for a rental

Two kinds of depreciation come back when you sell, and they are taxed differently (from the book's five layers of tax):

Post-1986 buildings depreciated straight-line generally have no §1250 "additional depreciation," so for most rentals the building's depreciation is the 25% layer, not ordinary recapture. For a full walk-through of the layers, see selling rental property taxes.

A full 1031 defers recapture too

In a full exchange (all the equity reinvested, the debt replaced, nothing taken out), no gain is recognized, and that includes the recapture layers. They do not disappear. They ride into the replacement through its basis.

Carryover basis. The replacement's basis starts from the old building's basis (§1031(d)). Under Reg. §1.168(i)-6 it splits in two:

• Exchanged basis keeps the old building's depreciation schedule.
• Excess basis, funded by new cash or new debt, is treated as newly placed in service. Its short-life components can take bonus depreciation, which is 100% for property acquired after January 19, 2025.

So the depreciation history continues. Every dollar you took on the old building, plus every dollar you take on the new one, is still there when you eventually sell for cash. Under current law, only holding until death clears it: heirs generally take a stepped-up basis (§1014).

A simple example: You sell a building for $2,000,000 with a $500,000 adjusted basis, after $300,000 of straight-line depreciation. You exchange into a $2,000,000 replacement with no loans on either side and no boot. No gain is recognized now. Your replacement's basis is $500,000, and the $1,500,000 of deferred gain, including the $300,000 of depreciation, waits inside it (simple example).

Boot pulls recapture out first

Boot is taxable up to your realized gain; the rest stays deferred (§1031(b)). What kind of gain is recognized matters as much as how much.

• §1245 recapture is ordinary income and is recognized to the extent of the recognized gain (plus the §1245(b)(4) amount below).
• Unrecaptured §1250 gain comes next. On cash boot, the Schedule D worksheet generally treats recognized gain on a depreciated building as unrecaptured §1250 gain first. On a note, Reg. §1.453-12 takes it out of each payment first. See unrecaptured Section 1250 gain for how that 25% layer is figured.
• Plain long-term gain is whatever is left.

A simple example: Same building: $2,000,000 sale, $500,000 basis, $300,000 of straight-line depreciation, no loans. You buy a $1,600,000 replacement and keep $400,000 in cash. You owe tax on $400,000 now. The first $300,000 is unrecaptured §1250 gain at up to 25%; the other $100,000 is long-term gain at 0%, 15% or 20%. The replacement's basis is $500,000 ($500,000 old basis + $400,000 gain recognized - $400,000 cash received), and $1,100,000 of gain stays deferred (simple example).

That is why boot in a high-tax state is expensive. For a top-bracket Californian the book prices the building layer at up to 42.1 cents on the dollar (25% federal ceiling, 3.8% net investment income tax, 13.3% California), against up to 37.1 cents for plain long-term gain. Those are ceilings, not typical rates.

Debt boot counts too. Old loan $600,000, new loan $400,000, no cash added: the $200,000 drop is boot. New debt offsets debt relief, but it never offsets cash you receive; cash you pay in does offset debt relief (Reg. §1.1031(d)-2, Example 2). The 1031 boot guide covers netting in full.

The §1245(b)(4) trap

Cost segregation splits a building into parts: flooring, cabinets and fixtures (5 or 7 years), site work and parking (15 years), and the building shell (27.5 or 39 years). Many of those parts still count as real property for a 1031, so they can be exchanged. But the 5- and 7-year parts are §1245 property, and §1245 has its own rule for exchanges. (The 15-year land improvements, such as paving, fencing and landscaping, are §1250 property, not §1245 property. Depreciation on them in excess of straight line, including bonus, is recaptured as ordinary income under §1250(a), and in an installment sale it is recapture income taxed in year one under §453(i).)

§1245(b)(4) limits recapture in a like-kind exchange to the gain recognized plus "the fair market value of property acquired which is not section 1245 property." In plain English: §1245 recapture on cost-segregated property is avoided only to the extent you acquire replacement §1245 property. The value of the new building shell (§1250 property) or land does not shelter it (Reg. §1.1245-4(d)). The analysis runs asset by asset.

A simple example: Your old building was cost-segregated. Its short-life parts had $200,000 of depreciation (bonus included) and are worth $120,000 at the exchange, with an adjusted basis of zero, so they carry $120,000 of gain. You exchange, with zero boot, into a replacement with no cost segregation: all building shell and land. The parts you gave up are matched only by non-§1245 property, so their gain is not sheltered. You recognize $120,000 of ordinary §1245 recapture (the lesser of the $200,000 of depreciation and the $120,000 gain) in the year of the exchange, with no cash to pay it (simple example). Had the replacement carried at least $120,000 of identified §1245 components, supported by its own cost segregation study, that recapture could have been avoided.

Three consequences:

1. It is year-one income. §1245 recapture is recapture income under §453(i), so even if the exchange includes an installment note, it cannot be spread.
2. It can surprise a trade-down or a trade into land. A cost-segregated apartment building traded for raw land or a simple building is the classic setup.
3. Plan it before you pick the replacement. Compare the §1245 property going out with the §1245 property coming in, and ask your CPA whether the replacement's cost segregation study should be ordered with that comparison in mind.

Personal property is not like-kind anymore

Since 2018 only real property qualifies for a 1031 (Reg. §1.1031(a)-3). Appliances, furniture and similar personal property sold with the building are a separate taxable sale, and the gain on them is usually §1245 recapture. Allocate the price with the replacement's cost segregation in mind, and remember the value of personal property you receive in the replacement is not like-kind property either.

Spreading boot you can't avoid

If some boot is unavoidable (a trade-down, or money you want out of real estate for good), you can take it as an installment note instead of cash. Under §453(f)(6), the like-kind property is excluded from the contract price and payments, so each note dollar is nearly all gain, and the unrecaptured §1250 layer comes out of the early payments first. Any §1245 recapture, including the §1245(b)(4) amount, still lands in the year of the exchange.

The note can be seller financing (the buyer's note, with the buyer's credit and prepayment risk) or a structured installment sale, where the obligation is assigned to a company usually funded by a fixed annuity it owns. In a structured sale you are an unsecured creditor of that company, no IRS ruling specifically approves the arrangement, and the commission is built into the pricing. Either way, the slice must be set in the purchase contract and carved out at closing; money that passes through the exchange intermediary can't be structured afterward and can put the whole exchange at risk. Details are in using an installment sale for 1031 boot.

When it does not help. In the book's Case 13 (an illustrative composite; engine output), a California couple traded down with cash and no new loan. With no excess basis there was no new depreciation to meet the boot, and spreading still beat cash boot by $208k after ten years, but entirely from brackets and deferral. And if you don't need money out, a full 1031 usually beats both: in Case 3 the full exchange ended at $5.34M against $5.07M with the boot spread and $4.90M with cash boot.

Bottom line

A full 1031 defers recapture; it does not erase it. Boot pulls out the most expensive layers first, and a cost-segregated building traded for one with fewer short-life parts can trigger ordinary recapture with zero boot. Map the §1245 property going out and coming in before you choose the replacement. Model your boot in the 1031 boot calculator, and read the ISC guide to installment sale depreciation recapture. The free book has the full 1031 boot decision system.

Questions to ask your CPA

• How much of my depreciation is ordinary recapture (§1245 on 5- and 7-year parts and personal property, §1250(a) on bonus taken on 15-year land improvements) and how much is straight-line building depreciation?
• Does my replacement have enough §1245 property to avoid §1245(b)(4) recapture, asset by asset?
• Should the replacement get its own cost segregation study before closing?
• If I take boot, how much of it is unrecaptured §1250 gain at up to 25%?
• How much excess basis will the replacement have, and what can it depreciate or bonus?
• Would taking unavoidable boot as a note, carved out at closing, lower my tax, and what does my exchange intermediary allow?

Educational only, not tax, legal or investment advice. Examples are illustrative. Have your CPA or tax attorney review your facts before you act. Hans Goldstein is a licensed insurance agent (CA Insurance License #4273294) and is not a CPA or attorney. He is paid a commission only if a structured installment sale is funded; seller financing pays him nothing. Disclosures.