Sell, Pay the Tax and Buy With 100% Bonus Depreciation, or Do a 1031?

Two ways to stay in real estate

A 1031 exchange defers the whole gain, but the replacement inherits your low basis. The depreciation regulations split its basis into exchanged basis, which keeps depreciating on the old building's schedule, and excess basis, which is treated as newly bought (Treas. Reg. 1.168(i)-6(b)(7) and (8)). On used replacement property, only excess basis can take bonus (Treas. Reg. 1.168(k)-2(g)(5)(iii)(A)). An equal-value swap with no new money creates little or none.

The other path is a taxable sale followed by a separate purchase. You pay tax on the sale, but the new property's basis is its full cost. With 100% bonus depreciation permanent for property acquired after January 19, 2025 (P.L. 119-21 section 70301; IRS Notice 2026-11), a cost segregation study on that purchase can turn a quarter or more of the building cost into a first-year deduction, in the same year the gain is taxed.

Why the deduction can land on the sale gain

For most owners, rental depreciation is passive and can only offset passive income (IRC 469). The sale year is the exception. Gain 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 new rental's bonus depreciation is a passive deduction, so it nets against the old rental's sale gain even though they are different properties. A fully taxable sale of your entire interest in the old activity also frees its own suspended losses (IRC 469(g)), which stack on top.

Real estate professionals who materially participate (IRC 469(c)(7)) have nonpassive rental losses, but large losses are then subject to the excess business loss limit: $512,000 for joint filers in 2026, with the excess carried forward as a net operating loss (IRC 461(l); Rev. Proc. 2025-32).

Worked example: $2,000,000 sale, $2,000,000 purchase

A plain cash sale of the apartment building costs this Texas couple $356,535 in 2026 federal income tax and net investment income tax. If they buy a $2,000,000 rental in the same year and a study finds $400,000 of 5-, 7- and 15-year property, the sale-year tax falls to $222,425, a drop of $134,110. The 3.8% net investment income tax alone falls from $49,400 to $34,200, because rental deductions reduce net investment income (IRC 1411(c)(1)(B), 2026).

Compare that with a 1031: tax today would be zero, and the new property would carry over the $700,000 basis. The sell-and-buy route costs $222,425 now in exchange for a new $2,000,000 basis, a fresh 27.5-year schedule on $1,200,000 of remaining building cost and no deferred gain hanging over the next property. Whether that is worth it depends on how long you hold, your bracket later and whether heirs will inherit (IRC 1014 resets basis at death either way). Numbers are illustrative engine output from labeled assumptions; a real study's percentage depends on the building.

What has to be true for the bonus

• Acquired after January 19, 2025. A written binding contract signed earlier disqualifies the property from the 100% rate (IRS Notice 2026-11).
• Used property is fine if it is new to you. You cannot have used it before, and you cannot buy it from a related person or a member of your controlled group, or get a carryover basis or an inherited basis (IRC 168(k)(2)(E)(ii); IRC 179(d)(2)).
• Placed in service in the sale year. The deduction has to land in the same tax year as the gain. A December sale with a January purchase misses it.
• Only short-life components qualify. Bonus applies to property with a recovery period of 20 years or less (IRC 168(k)(2)(A)); the building shell stays on 27.5 or 39 years.
• The study has to hold up. The IRS audit guide lists 13 principal elements of a quality study, from preparer expertise to reconciliation with actual cost (IRS Publication 5653, rev. 2-6-2025).

California and other decoupled states

California does not allow federal bonus depreciation under IRC 168(k) (FTB 2025 Form 3885A instructions), so the state keeps taxing the full gain: $141,239 of California tax in our example, which the federal bonus does not reach, while the federal saving of $134,110 is the same as in Texas. California also taxes all gain as ordinary income, so the state cost of the cash sale is large either way. A California seller who does a 1031 instead defers the state tax too, and if the replacement is outside California the state tracks the deferred gain through an annual information return (FTB Form 3840 instructions, 2025). For many California owners that tilts the comparison back toward an exchange. Check your own state's page under capital gains tax by state.

The trade-off: recapture later

Bonus on 5- and 7-year property is Section 1245 depreciation, recaptured as ordinary income when you sell (IRC 1245(a)); bonus on 15-year land improvements is 1250 additional depreciation recaptured under IRC 1250(a). If the new rental is sold for cash in 2031 with similar income, our engine shows about $131,501 of tax on the recaptured $400,000. A later sale on seller financing does not spread it, because recapture is recognized in year one (IRC 453(i)). A later 1031 needs enough 1245 property in that replacement to defer it (IRC 1245(b)(4)); see Section 1245 recapture in a 1031.

When each path tends to win

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