The 1031 exchange and depreciation are the two tax rules that most change what a rental property earns after tax. Depreciation lets a landlord deduct the cost of a residential building over 27.5 years even while its market value rises [1], and a 1031 like-kind exchange lets the owner sell and buy replacement real estate without paying tax on the gain at that time, provided the replacement is identified within 45 days and received within 180 days [2][3]. On a typical U.S. home valued at $370,079 in July 2026 [4], the two rules together can shelter more than $10,000 of income a year and defer a five-figure tax bill at sale. This note shows the arithmetic and the limits.
How depreciation shapes rental returns
The IRS treats a rental building as an asset that wears out. Residential rental property placed in service after 1986 is depreciated under MACRS over 27.5 years using the straight-line method and a mid-month convention [1]. Land is never depreciated because it does not wear out or get used up [5]. The deduction is a non-cash expense: the owner receives rent in full but reports less taxable income.
Consider the typical U.S. home, valued at $370,079 by Zillow's index in July 2026 according to DataPorium's housing market data, renting for $1,944.17 per month, or $23,330 a year [4]. If 20% of the price is allocated to land (an illustrative assumption; the split depends on the local assessment), the depreciable basis is $296,063 and the annual deduction is $10,766. With mortgage interest, property tax, insurance and repairs also deductible as ordinary rental expenses [1], many leveraged rentals report a taxable loss in the early years while producing modest positive cash flow.
Two limits apply. First, rental activity is passive for most owners, and passive losses normally offset only passive income. Owners who actively participate may deduct up to $25,000 of rental losses against wages or other income, but that allowance phases out between $100,000 and $150,000 of modified adjusted gross income and disappears above $150,000 [1]. Second, the deduction is not free: it lowers the property's tax basis, and the reduction comes back as taxable gain when the property is sold.
Depreciation recapture at sale
When a rental is sold at a gain, the part of the gain attributable to depreciation on real property (unrecaptured Section 1250 gain) is taxed at a maximum rate of 25%, while the remaining long-term gain is taxed at 0%, 15% or 20% depending on taxable income [6]. For 2025 returns, the 15% bracket runs from $48,350 to $533,400 of taxable income for single filers and from $96,700 to $600,050 for married couples filing jointly, with 20% above those amounts [6]. After ten years of the illustrative $10,766 deduction, accumulated depreciation of $107,660 would face up to $26,915 of recapture tax on sale, before any tax on appreciation.
How the 1031 exchange defers that bill
Section 1031 allows real property held for business or investment use to be exchanged for other real property of like kind without recognizing gain or loss at the time of the exchange [2]. Since the 2017 tax law, the rule applies only to real estate; equipment, vehicles, artwork and intellectual property no longer qualify [2]. Real property in the United States is not like kind to real property outside the United States [2]. Improved and unimproved real estate are generally like kind to each other, so a rental house can be exchanged for an apartment building, a warehouse or land [2].
The deferred exchange has two hard deadlines. The replacement property must be identified in writing no later than 45 days after the transfer of the property given up, and it must be received by the earlier of the 180th day after that transfer or the due date of the tax return, including extensions [3]. Cash or other non-like-kind property received in the deal, known as boot, is taxable up to the amount of gain, and the exchange is reported on Form 8824 [2][3]. Exchanges with related parties carry a two-year holding requirement; if either party disposes of the exchanged property within two years, the deferred gain generally becomes taxable [3].
| Rule | Requirement | Source |
|---|---|---|
| Identification period | 45 days after transfer of relinquished property | Form 8824 instructions [3] |
| Exchange period | Earlier of 180 days or return due date with extensions | Form 8824 instructions [3] |
| Qualifying property | U.S. real property held for business or investment | IRS like-kind exchange guidance [2] |
| Related party | Two-year holding period after the exchange | Form 8824 instructions [3] |
| Recapture rate | Maximum 25% on unrecaptured Section 1250 gain when finally taxed | IRS Topic 409 [6] |
Worked example: the return with and without the two rules
Assume the typical home bought for $370,079 in 2026 and sold ten years later for 30% more, or about $481,000 (an assumption used only to show the mechanics). The illustrative gain has two parts: $107,660 of accumulated depreciation, taxed at up to 25% [6], and roughly $111,000 of appreciation, taxed at 15% or 20% [6]. Selling outright could cost about $43,600 to $49,100 of federal tax. Rolling the full proceeds into a like-kind replacement within the 45-day and 180-day windows defers all of it [2][3], leaving the entire $481,000 working in the next property.
- Deferral is not forgiveness: the replacement property inherits the low basis, so the gain and the recapture wait for a future taxable sale.
- Owners who hold until death currently pass property to heirs with a basis reset to market value, which is why many investors exchange repeatedly rather than sell.
- Investors may consider running each candidate replacement through the DataPorium property finder and the housing market data to check rents and values before the 45-day deadline [4].
The economic case for these rules is that they lower the tax penalty on moving capital from one building to another, keeping property in the hands of owners who can use it best. The fair criticism is complexity: the deadlines, the related-party rules and the recapture schedule all require professional help, and a simpler code with lower rates would do the same job with less paperwork. Until that changes, the rules as written are a large part of the return on direct real estate.
Depreciation lowers the tax on rent every year, and a 1031 exchange postpones the tax on the sale, so together they decide how much of a property's return the owner keeps.
Key takeaways
- Residential rental property is depreciated over 27.5 years, straight line, and the deduction on a typical $370,079 home is roughly $10,766 a year under an illustrative 80/20 building-to-land split [1][4].
- Active owners may deduct up to $25,000 of passive rental losses, phasing out between $100,000 and $150,000 of modified AGI [1].
- Depreciation taken on real property is taxed at up to 25% when sold; the rest of the gain is taxed at 0%, 15% or 20% [6].
- A 1031 exchange defers both taxes if replacement real property is identified within 45 days and received within 180 days [2][3].
- Since 2018 only real property qualifies, and U.S. property cannot be exchanged for foreign property [2].
Frequently asked questions
How many years do you depreciate a rental property?
Residential rental property is depreciated over 27.5 years using the straight-line method and a mid-month convention under MACRS [1]. Land is not depreciable [5].
What are the 45-day and 180-day rules in a 1031 exchange?
Replacement property must be identified in writing within 45 days of transferring the relinquished property and received within 180 days, or by the tax return due date including extensions if that comes first [3].
Is depreciation recapture taxed at 25%?
Gain attributable to depreciation on real property, called unrecaptured Section 1250 gain, is taxed at a maximum rate of 25%; the remaining long-term gain is taxed at 0%, 15% or 20% depending on income [6].
Can you do a 1031 exchange on a rental house for an apartment building?
Yes. Real properties held for investment are generally like kind regardless of whether they are improved or unimproved, so a rental house can be exchanged for an apartment building, a commercial property or land in the United States [2].
Sources & References
- [1] IRS Publication 527, Residential Rental Property
- [2] IRS: Like-Kind Exchanges, Real Estate Tax Tips
- [3] IRS: Instructions for Form 8824, Like-Kind Exchanges
- [4] DataPorium Housing Market Insights (Zillow home values and rents)
- [5] IRS Publication 946, How To Depreciate Property
- [6] IRS Topic No. 409, Capital Gains and Losses
