Cost Segregation After a 1031 Exchange With Boot: Offsetting the Taxable Part

Why the boot year is the year to look at a new study

A 1031 exchange defers gain only on the value you roll into like-kind real estate. Cash you pocket at closing, debt relief you do not replace, or a smaller replacement property is boot, and gain is recognized up to the boot in the year of the exchange (IRC 1031(b)). The rest of the gain carries into the replacement through a lower basis (IRC 1031(d)).

The replacement property is placed in service in that same year, and bonus depreciation is a first-year deduction. That timing is the whole idea: a cost segregation study on the replacement can produce a large deduction in exactly the year the boot shows up on your return. If you already know you will take money off the table, the study, the closing date and the tax year can be planned together instead of discovered at filing time.

For the boot mechanics themselves (cash, mortgage relief, netting), see 1031 boot. This page covers what a new study can and cannot do about it.

How the boot is taxed, and why it is usually the 25% layer

Two details decide how much tax the boot creates.

• A new loan does not cancel cash you take. Debt you pay off on the old property can be offset by debt you take on for the new one, but cash received is not offset by a new mortgage. The regulation's own example treats only the cash as boot even though the taxpayer took on more debt than he shed (Treas. Reg. 1.1031(d)-2, Example 2). In our example the new $600,000 loan does nothing to the $300,000 of cash boot.
• The boot gain usually comes out of the depreciation first. Unrecaptured Section 1250 gain is the gain that would be ordinary if all depreciation were recaptured (IRC 1(h)(6)), and in an exchange the 1250 amount is limited by the gain recognized (IRC 1250(d)(4)). When past depreciation exceeds the boot, the whole recognized gain is typically taxed at up to 25% (IRC 1(h)(1)(E), 2026), not at 15% or 20%.

Most landlords also owe the 3.8% net investment income tax on the boot gain above $250,000 of modified AGI for joint filers (IRC 1411, threshold not indexed, 2026), and states tax it on top.

Exchanged basis vs excess basis: what a new study can touch

The depreciation regulations split the replacement property's basis in two (Treas. Reg. 1.168(i)-6(b)(7) and (8)):

• Exchanged basis: the lesser of the replacement's basis or the old building's remaining depreciable basis. It keeps depreciating on the old building's schedule.
• Excess basis: everything above that, typically funded by new debt or new cash when you trade up. It is treated like newly purchased property.

For bonus depreciation the split is decisive. If the replacement is used property bought from an unrelated seller, only the remaining excess basis is eligible for bonus; if it is brand-new (original use), both pieces are (Treas. Reg. 1.168(k)-2(g)(5)(iii)(A)). In our example the building basis after the exchange is $1,100,000: $500,000 exchanged basis and $600,000 excess basis, so the study's bonus can only come from the $600,000.

A study can still re-label parts of the exchanged basis, but under the shorter-recovery-period rule those dollars keep the old building's remaining recovery period (Treas. Reg. 1.168(i)-6(c)(4)(ii)). The alternative is the election to treat the whole basis as newly placed in service (Treas. Reg. 1.168(i)-6(i)(1)). It lets the study assign 5-, 7- and 15-year lives to the carried-over dollars too, still without bonus on used property (1.168(k)-2(g)(5)(iii)(D)), but it also restarts a fresh 27.5- or 39-year clock on the building portion, which can be slower than the old schedule. It is worth modeling both ways before electing.

Bonus depreciation in 2026: 100% again, with a date test

The One Big Beautiful Bill Act (P.L. 119-21, section 70301, signed July 4, 2025) restored 100% bonus depreciation permanently for qualified property acquired after January 19, 2025. Property is not treated as acquired after that date if a written binding contract was signed earlier. IRS Notice 2026-11 says taxpayers apply rules consistent with Treas. Reg. 1.168(k)-2 to that property, so the exchanged-versus-excess basis rule above still governs replacement property in an exchange.

Property acquired before January 20, 2025 stays on the old phase-down: 40% for property placed in service during 2025 (IRS Notice 2026-11, describing IRC 168(k)(6) before the 2025 amendments). A 2026 exchange will almost always involve a replacement acquired after the cutoff, but check the contract date on a deal that was signed early and closed late.

Bonus applies only to property with a recovery period of 20 years or less (IRC 168(k)(2)(A)). That is why the study matters: the building shell stays at 27.5 or 39 years, and only the components the study identifies (5- and 7-year personal property, 15-year land improvements) can be written off in year one.

The passive loss rules: why boot gain can absorb the deduction

For most owners, rental depreciation is a passive deduction, usable only against passive income (IRC 469). That usually limits cost segregation. A boot year is different, because gain recognized on the disposition of property used in a passive activity is passive activity gross income for the year it is recognized (Treas. Reg. 1.469-2T(c)(2)(i)(A)). The $300,000 of boot gain from the old rental is passive income, and the passive loss created by the study on the new rental can be netted against it, even though they are different properties.

• Old suspended losses count too. A 1031 exchange is not the fully taxable disposition that frees all suspended losses under IRC 469(g), but suspended losses from prior years are allowed against the boot year's passive income like any other passive deduction.
• Real estate professionals who materially participate (IRC 469(c)(7)) have nonpassive rental losses that can offset wages and business income as well, subject to the excess business loss limit (IRC 461(l)).
• The 3.8% tax: depreciation on the rental reduces net investment income, so the deduction also lowers the net investment income tax on the boot (IRC 1411(c)(1)(B), 2026).

Worked example: a $2,000,000 sale with $300,000 taken out

Without a study, the $300,000 of boot costs this Texas couple $84,543 in federal income tax and net investment income tax for 2026. With a study that finds $150,000 of 5-, 7- and 15-year property inside the $600,000 of excess basis, the boot-year tax falls to $41,700, a difference of $42,843. The net investment income tax piece alone drops from $11,400 to $5,700.

Because deductions come off ordinary income first, the study's deduction is effectively used at the couple's 24% bracket (Rev. Proc. 2025-32, 2026 brackets), while the boot gain itself is taxed at up to 25%. The deduction does not need to match the gain in character to lower the year's tax.

Had the couple lived in California, the same boot would add $27,900 of state tax, and most of that would remain, as covered below. Numbers are illustrative engine output from labeled assumptions, not a forecast; a real study's percentage depends on the building.

1031 replacement depreciation: three checks before you file

Whether or not you took boot, every exchange into depreciable property raises the same three questions, and two of them have deadlines.

1. Bonus on excess basis only. On used replacement property, bonus depreciation reaches only the excess basis, whether or not you make the election below (Treas. Reg. 1.168(k)-2(g)(5)(iii)(A) and (D)). An equal-value swap with no new money has little or none, so size the study to the excess basis, not the purchase price.
2. The election to restart the clock. The Treas. Reg. 1.168(i)-6(i) election treats the whole replacement basis as newly placed in service, so a study can give 5-, 7- and 15-year lives to the carried-over dollars too, at the cost of a fresh 27.5- or 39-year schedule on the building portion. It is made on Form 4562 by the due date, including extensions, of the return for the year of replacement, separately for each exchange; it cannot be made later through a Form 3115 accounting method change, and revoking it needs IRS consent (Treas. Reg. 1.168(i)-6(j)). Model it before the replacement-year return is filed.
3. The Section 1245(b)(4) check on the property you gave up. If the relinquished building was cost-segged, recapture on its 5- and 7-year components is deferred only to the extent the replacement carries enough Section 1245 property; the shortfall is ordinary income in the exchange year even with no boot (IRC 1245(b)(4)). See Section 1245 recapture in a 1031.

The trade-off: ordinary recapture later

Bonus depreciation lowers basis dollar for dollar. On the 5- and 7-year components it is Section 1245 depreciation, recaptured as ordinary income when you sell (IRC 1245(a)); on 15-year land improvements, bonus above straight line is additional depreciation recaptured under IRC 1250(a). If the replacement is sold for cash in 2031 with similar other income, our engine shows about $41,700 of tax on the recaptured $150,000, compared with the $42,843 saved in 2026. The value of the study is mostly the years of use of that money and any drop in your bracket by the time you sell.

• Another exchange later does not automatically shelter it: Section 1245 recapture is recognized to the extent you receive property that is not 1245 property, such as a plain building (IRC 1245(b)(4)). The next replacement needs enough 1245 property of its own.
• Seller financing later does not spread it: recapture income is taxed in the year of sale even on an installment sale (IRC 453(i)). See recapture in an installment sale.
• Holding until death resets basis for heirs (IRC 1014), which is the one path where the recapture never comes due.

California and other states that do not follow bonus

California has not conformed to federal bonus depreciation under IRC 168(k) (FTB 2025 Form 3885A instructions), so a California resident gets only regular depreciation on the reclassified components for state purposes. In the boot year, most of the $27,900 of California tax in our example stays, and you keep a separate state depreciation schedule with a different basis for years. California taxes all gain as ordinary income, so the 25% federal layer does not exist at the state level. If the replacement is outside California, the state also requires an annual information return on the deferred California gain (FTB Form 3840 instructions, 2025).

Several other states decouple from bonus too, so run the state layer separately; see your state's page under capital gains tax by state.

Other ways to soften the boot year

• Installment treatment of boot. If part of the price is a buyer's note held through the qualified intermediary, that boot can be reported as payments arrive (IRC 453(f)(6); Treas. Reg. 1.1031(k)-1(j)(2)). Watch the mismatch: if the boot moves to later years, a big study deduction in the replacement year may have no passive income to land on and simply carry forward. See Section 453 installment sale.
• Capital loss carryforwards net against the boot gain, including the 25% layer, before any bracket math (see carryovers and suspended losses).
• Reinvesting the cash into a larger replacement removes the boot entirely, at the cost of keeping the money in real estate.
• Sizing the study to the boot. For a non-professional, a deduction far larger than the year's passive income only carries forward, so the study's timing and the elections above matter as much as its size.

Get the Big Sale Tax Analysis to model the boot, the study and the later recapture side by side with your other options.

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