How to Shelter Rental Income from Taxes Using a 1031 Exchange
For investors with fully depreciated properties, a 1031 exchange into a leveraged DST can create new depreciable basis that potentially shelters 66% or more of rental income from current taxation.
Key Takeaway
For investors with fully depreciated properties and no debt, a 1031 exchange into a leveraged DST can create new depreciable basis that potentially shelters 66% or more of rental income from current taxation. Results vary based on individual circumstances. Consult your CPA to evaluate this strategy for your situation.
This article explains how long-term investors facing fully taxable rental income can potentially use a 1031 exchange to create new depreciation deductions, potentially reducing their current tax burden while maintaining passive income. The hypothetical example in this article illustrates how this can work.
How Is Rental Income Taxed? [IRS Rules]
Rental income is classified as ordinary income by the IRS under IRC Section 61(a)(5). This means rental income is added to your other income and taxed at your marginal tax rate, which ranges from 10% to 37% for federal taxes in 2026, depending on your total taxable income and filing status.
The amount you actually pay tax on is your net rental income, calculated as:
Net Rental Income = Gross Rent - Operating Expenses - Mortgage Interest - Depreciation
- Gross Rent: Total rental payments received
- Operating Expenses: Property management, repairs, insurance, utilities, HOA fees, property taxes
- Mortgage Interest: Deductible portion of loan payments (principal is not deductible)
- Depreciation: Annual deduction for building wear and tear (27.5 years for residential, 39 years for commercial)
For example, if you collect $60,000 in annual rent but have $10,000 in expenses, $5,000 in mortgage interest, and $12,000 in depreciation deductions, your net rental income is $33,000. If you're in the 32% tax bracket, you'd owe approximately $10,560 in federal tax on that rental income, plus applicable state taxes.
The depreciation deduction is critical because it's often the largest single deduction available to rental property owners. However, after 27.5 or 39 years, depreciation is exhausted. Once your property is fully depreciated, you lose this valuable tax shield—turning previously tax-sheltered income into fully taxable income. This is the problem that the Increased Basis Strategy addresses.
Common Ways to Reduce Taxes on Rental Income
Before discussing the Increased Basis Strategy, it's important to understand the standard tax reduction methods available to rental property owners:
Operating Expense Deductions
Property management fees, repairs and maintenance, insurance premiums, utilities, HOA fees, and property taxes are all deductible against rental income under IRC Section 162. Most investors already maximize these deductions.
Depreciation Deductions
Under IRC Section 168, you can deduct the building's cost (not land) over 27.5 years (residential) or 39 years (commercial). This is a powerful deduction, but it eventually runs out.
Cost Segregation Studies
This strategy accelerates depreciation by reclassifying building components (electrical, plumbing, fixtures) into shorter recovery periods of 5, 7, or 15 years. This works well for properties with remaining depreciable basis.
Qualified Business Income (QBI) Deduction
Under IRC Section 199A, some rental property owners may qualify for a 20% deduction on qualified business income, subject to income limitations and whether the rental activity qualifies as a trade or business.
The Limitation for Fully Depreciated Properties
However, for investors with fully depreciated properties, these common strategies may not solve the fundamental problem: you've run out of depreciable basis entirely. Once depreciation is exhausted, you can't accelerate what doesn't exist. This is where the Increased Basis Strategy becomes valuable.
The Problem: Fully Depreciated Properties Equal Fully Taxable Income
Investors who have held rental property for 27.5 years (multifamily) or 39 years (commercial) face a depreciation cliff. Under IRC Section 168, once the building is fully depreciated, no further depreciation deductions are available. The result: 100% of net rental income becomes taxable.
Consider an investor who purchased a multifamily property for $400,000 thirty years ago. The property is now worth $1,000,000, the mortgage is paid off, and the entire building value has been depreciated. This investor has excellent cash flow but faces a significant tax burden. Every dollar of net rental income is now taxable.
This scenario is increasingly common among investors approaching or in retirement. They built wealth through real estate appreciation and mortgage paydown, but now face higher effective tax rates because their depreciation shield is exhausted.
Many investors don't realize they've depreciated their property to zero until their CPA delivers an unexpectedly high tax bill. The common strategies used to reduce rental income taxes don't solve this fundamental problem.
Common Tax Strategies and Why They May Fall Short
Several strategies exist to reduce taxes on rental income. However, none address the core problem facing investors with fully depreciated properties: they have no remaining depreciable basis.
Operating Expense Deductions
Property management fees, repairs, insurance, and utilities are deductible against rental income. Most investors already maximize these deductions. For a fully depreciated property, operating expenses alone can't offset the full tax burden.
Accelerated Depreciation (Cost Segregation)
Cost segregation studies accelerate depreciation by reclassifying building components (electrical, plumbing, fixtures) into shorter recovery periods of 5, 7, or 15 years. This powerful strategy works for properties with remaining depreciable basis. For fully depreciated properties, there is nothing left to accelerate.
The core problem
Anchor1031 explains that these common strategies may not solve the fundamental issue for fully depreciated properties: you've run out of depreciable basis entirely. The solution requires creating new basis, not maximizing deductions on exhausted basis.
The Increased Basis Strategy Explained
A 1031 exchange under IRC Section 1031 allows investors to defer capital gains taxes by reinvesting sale proceeds into like-kind replacement property. What many investors don't realize is that a 1031 exchange can also create new depreciable tax basis, even when exchanging a fully depreciated property.
The key is understanding how debt allocation works in the replacement property.
When you exchange into a property with more debt than your relinquished property, the excess debt becomes part of your new basis. Under IRS Revenue Ruling 2004-86, beneficial interests in properly structured Delaware Statutory Trusts qualify as like-kind property for 1031 exchange purposes. DST investors are treated as directly owning their pro-rata share of the underlying real estate and its nonrecourse debt.
How the Increased Basis Strategy Works:
- You sell your fully depreciated, low-leverage property
- You identify a DST replacement property with higher leverage, typically between 40-60% LTV
- Your share of the DST's nonrecourse debt is allocated to your investment
- The debt allocation becomes new depreciable basis
- You can depreciate the building portion over 27.5 or 39 years
According to Anchor1031
Investors can potentially increase their depreciable tax basis by 1031 exchanging a fully depreciated property with little to no leverage, into a DST with higher leverage than their relinquished property. The institutional debt creates new depreciable basis without personally borrowing. Consult your CPA to determine how this strategy may apply to your specific tax situation.
The investor doesn't take on a personal mortgage. The DST holds the debt at the entity level. The investor simply benefits from the tax basis created by their allocated share of that debt.
How DST Leverage Can Potentially Create New Depreciable Basis
Under Revenue Ruling 2004-86, DST beneficiaries are treated as owning an undivided fractional interest in the underlying real property for federal tax purposes. This treatment extends to the property's nonrecourse debt. Each investor is allocated their pro-rata share of the DST's debt, which increases their tax basis in the investment.
Only the building portion of this basis is depreciable. Land is not depreciable under IRC Section 167. Most DST properties allocate 85-90% of value to building/improvements and 10-15% to land, based on appraisal at acquisition.
Example Calculation
The example calculation above is a hypothetical illustration of how an investor can create new depreciable tax basis from a $1 million equity contribution, assuming zero debt on their relinquished property. The investor didn't personally borrow $1 million—the DST secured institutional financing at favorable rates typically unavailable to individual investors. The investor benefits from the tax basis created by their allocated share of that debt without managing the loan or making mortgage payments directly. Use the Portfolio Builder to model different leverage scenarios for your situation. The next section walks through this example in more detail, showing how the increased basis affects taxable income.
Real Numbers: The $1 Million Exchange Example
To illustrate the Increased Basis Strategy, consider an investor with a fully depreciated $1 million property that they own outright with no remaining debt—all cash. This property generates $50,000 in annual net rental income.
| Item | Before Exchange | After 50% LTV DST |
|---|---|---|
| Property Value / Equity | $1,000,000 | $1,000,000 equity |
| Your Share of Property Value | $1,000,000 | $2,000,000 |
| Remaining Debt | $0 | $1,000,000 (allocated) |
| Depreciable Basis (90% building) | $0 | $900,000 |
| Annual Depreciation (27.5 yrs) | $0 | $32,727 |
| Annual Income/Distribution | $50,000 | $50,000 |
| Taxable Income | $50,000 | $17,273 |
| Est. Federal Tax (35%) | $17,500 | $6,046 |
Tax Savings Summary
- 66% of income sheltered ($32,727 of $50,000)
- Tax liability reduced by 65% ($17,500 to $6,046)
- Annual tax savings: $11,454
- Same $50,000 cash flow maintained
- Over 10-year hold: Cumulative savings potentially exceed $114,000
Anchor1031 demonstrates that this increased basis may potentially transform a fully taxable income stream into a substantially tax-sheltered one, without reducing cash flow. Individual results vary. Work with your tax advisor to evaluate this strategy for your circumstances.
Depreciation Schedules: Multifamily vs. Commercial DSTs
The depreciation recovery period affects how much income is sheltered annually. Under IRC Section 168, residential rental property (multifamily apartments) depreciates over 27.5 years, while nonresidential real property (office, retail, industrial) depreciates over 39 years.
| Property Type | Recovery Period | $900K Basis Annual Depreciation | % of $50K Sheltered |
|---|---|---|---|
| Multifamily (apartments) | 27.5 years | $32,727/year | 65.5% |
| Commercial (office, retail) | 39 years | $23,077/year | 46.2% |
Multifamily DSTs provide approximately 42% more annual depreciation shelter than commercial DSTs with the same depreciable basis. For investors prioritizing maximum current tax shelter, multifamily properties offer a clear advantage.
However, commercial properties may offer other benefits: longer lease terms, NNN lease structures with minimal landlord responsibilities, and different risk profiles. Anchor1031 notes that both multifamily and commercial DSTs can provide significant depreciation shelter. The key is matching property type to the investor's overall financial plan.
Running Two Depreciation Schedules
After completing a 1031 exchange where you still have basis to depreciate on your relinquished property, you may potentially have two separate depreciation schedules for the replacement property. This occurs because the IRS requires the deferred gain and depreciation recapture from the original property to be carried over to the new property, while any additional investment in the replacement property may create a new depreciation basis.
When you exchange one property for another in a 1031 exchange, the basis of the relinquished property generally carries over to the replacement property. The IRS views this as a continuation of the investment, meaning you may continue depreciating the portion of the replacement property that corresponds to the adjusted basis of the relinquished property.
Continuing the Original Depreciation Schedule
If the relinquished property was being depreciated for 10 years (out of a 27.5 or 39-year schedule), you would typically continue depreciating that portion for the remaining 17.5 or 29 years. This applies to both residential and commercial properties.
For example, if the relinquished property had an original value of $1 million and $300,000 of depreciation had already been claimed, you might continue depreciating the remaining $700,000 over the remaining life of the original depreciation schedule (17.5 years for residential or 29 years for commercial property).
If the replacement property is worth more than the relinquished property, the additional value (new equity and any new debt) may be treated as a new investment. This could potentially create a new depreciation schedule for the difference between the original basis and the total value of the replacement property.
The excess amount (new basis) may be depreciated over the full 27.5 years for residential properties or 39 years for commercial properties. This amount is essentially treated as a new asset for depreciation purposes.
Hypothetical Two-Schedule Example
Running two depreciation schedules after a 1031 exchange may be a common strategy for real estate investors. It could allow you to continue depreciating the carryover basis from the relinquished property while potentially starting a new depreciation schedule for the additional value in the replacement property. This approach may maximize tax deferral and provide ongoing tax benefits, potentially allowing for more efficient cash flow and tax management over time.
Important Considerations
The Increased Basis Strategy offers substantial benefits but requires understanding its limitations and risks.
Depreciation Recapture
Depreciation reduces taxable income today but is recaptured when the property is eventually sold. Under IRC Section 1250 and Section 1(h)(6), "unrecaptured Section 1250 gain" is taxed at a maximum 25% rate at disposition. This is tax deferral, not tax elimination. For a complete overview, see Tax Implications of Selling Investment Property.
However, recapture can be deferred indefinitely:
- Subsequent 1031 Exchange: Exchange the DST interest into another replacement property
- 721 Exchange (UPREIT): Contribute DST interest to a REIT for operating partnership units under IRC Section 721
- Hold Until Death: Heirs may receive stepped-up basis under IRC Section 1014, potentially eliminating recapture
Leverage Risk
DST debt service continues regardless of property performance. In severe economic downturns or high vacancy periods, distributions may be reduced or suspended while debt service continues. Investors should understand the DST's debt terms, including interest rate type (fixed vs. floating), maturity date, and lender flexibility before investing.
Illiquidity
DST interests are typically illiquid securities with hold periods of 5-10 years. There is no public market for DST interests. Investors should only commit capital they can afford to have locked up for the expected hold period.
Accredited Investor Requirement
DST investments are typically offered under Regulation D and require investors to be accredited. Under SEC Rule 501, accredited investors must have: $200,000 individual income ($300,000 joint) in each of the past two years with expectation of the same, or $1 million net worth excluding primary residence.
According to Anchor1031
Investors may potentially defer depreciation recapture indefinitely through proper planning, or eliminate it entirely if the property passes to heirs with stepped-up basis. Consult your CPA and estate planning attorney to evaluate these strategies for your situation.
Who Should Consider the Increased Basis Strategy
This strategy is designed for a specific investor profile.
Ideal Candidates
- Own fully or mostly depreciated rental property
- Have low or no remaining mortgage debt
- Approaching or in retirement
- Meet accredited investor requirements
- Want passive income without active management
Not Ideal For
- Investors who want active control over property decisions
- Those with significant remaining depreciable basis
- Investors needing liquidity (DSTs are illiquid)
- Properties with negative equity or underwater mortgages
Anchor1031 recommends that accredited investors with fully depreciated properties who seek passive income explore the Increased Basis Strategy with their CPA to determine if it aligns with their financial goals.
Bottom Line
Key Takeaway
For investors with fully depreciated properties generating fully taxable rental income, the Increased Basis Strategy offers a path to potentially shelter more of their income. By 1031 exchanging into a leveraged DST, you potentially create new depreciable basis from institutional debt without personally borrowing. To explore current offerings, browse available DST investments.
The depreciation clock resets on the replacement property. Your rental income becomes substantially tax-sheltered again. And you transition from active landlord to passive investor.
According to Anchor1031, this strategy may be particularly valuable for investors approaching retirement who want to maintain real estate income while eliminating property management responsibilities. Consult your CPA to determine how this approach may reduce your tax burden based on your specific situation.
How Anchor1031 Helps Investors Execute the Increased Basis Strategy
If your CPA advises that the Increased Basis Strategy may benefit your tax situation, Anchor1031 helps 1031 exchange investors find and evaluate leveraged DST investments designed to create new depreciable basis while transitioning to passive ownership.
Investment Selection and Portfolio Construction
Anchor1031's platform helps investors build diversified DST portfolios across multiple property types and sponsors. Our approach focuses on selecting leveraged properties that may create increased basis while managing risk through diversification:
Multifamily DSTs
Leveraged apartment properties offering 27.5-year depreciation schedules for maximum annual depreciation deductions. Potential for strong cash flow fundamentals with residential demand.
Retail Properties
Net-lease retail with institutional tenants, typically featuring longer lease terms and minimal landlord responsibilities. Creates basis through leverage while offering potential for stable income.
Industrial Buildings
Leveraged warehouse and distribution properties benefiting from e-commerce trends. Combines basis creation with potential for exposure to growing logistics sector.
Explore available DST investments or schedule a consultation to discuss how Anchor1031 can help you evaluate whether the Increased Basis Strategy aligns with your financial goals.
Frequently Asked Questions
How can I avoid paying taxes on rental income?
This information is for educational purposes only and should not be considered tax advice. Every investor's situation is unique, and tax strategies must be evaluated by a qualified tax professional. For investors with fully depreciated, low-leverage properties, one strategy worth discussing with your CPA is 1031 exchanging into a replacement property with higher leverage (such as a DST with 50% LTV) to potentially create new depreciable basis. The key consideration is whether you're increasing your leverage position—if your relinquished property already has significant debt, this approach may provide less benefit. For a debt-free, fully depreciated property exchanging into a 50% LTV DST, this strategy might potentially shelter 66% or more of annual distributions. Consult your CPA to evaluate which strategies may apply to your specific situation and tax profile.
What happens when my rental property is fully depreciated?
Once your property is fully depreciated (27.5 years for residential, 39 years for commercial), you lose the depreciation deduction entirely. Net rental income is no longer reduced by depreciation, increasing your taxable income. Many investors don't realize this until they receive an unexpectedly high tax bill. The common tax strategies—operating expense deductions, QBI deduction, or cost segregation—don't solve this problem because there's no remaining depreciable basis to work with. A 1031 exchange into a new property with more leverage than your current property may reset the depreciation clock by creating new depreciable basis from the allocated debt. However, if you exchange into a property with similar leverage, you won't gain new depreciable basis. Work with your tax advisor to understand your options based on your current leverage position.
Can I 1031 exchange a fully depreciated property?
Yes. Full depreciation does not prevent a 1031 exchange—the exchange is based on property value, not remaining basis. However, whether the exchange creates new depreciable basis depends on the leverage difference between your relinquished and replacement properties. Fully depreciated properties with little or no debt are ideal candidates for the Increased Basis Strategy because exchanging into a leveraged replacement property (like a 50% LTV DST) creates substantial new depreciable basis from the allocated debt. If your fully depreciated property still carries significant debt, you'll have less room to increase leverage and therefore less new basis created. The new depreciable basis comes from the increase in your allocated debt position, not simply from exchanging into a new property. Consult your CPA to confirm eligibility and calculate the potential tax benefit based on your specific leverage positions.
How does DST leverage create new depreciation?
When you invest in a DST, you may be allocated your pro-rata share of the property's nonrecourse debt under IRS Revenue Ruling 2004-86. That allocated debt could potentially become part of your cost basis in the investment. The building portion of this basis (typically 85-90% of property value, with 10-15% allocated to land) may be depreciated over 27.5 years for multifamily or 39 years for commercial properties. The key mechanism: if your relinquished property had little or no debt and you exchange into a DST with leverage, your share of the DST's debt may become new depreciable basis. For example, in a hypothetical scenario where $1 million equity is invested into a 50% LTV DST, the investor could receive $1 million in allocated debt, of which roughly $900,000 (90% building) might become depreciable—potentially yielding approximately $32,727 per year in depreciation deductions for a multifamily DST. If your relinquished property already had significant leverage, there may be little or no net increase in debt allocation and therefore minimal new depreciable basis created. Your CPA can help you calculate the potential benefit based on your specific current and proposed leverage positions.
What is the Increased Basis Strategy?
The Increased Basis Strategy involves 1031 exchanging a fully or mostly depreciated, low-leverage property into a replacement property with higher leverage, typically a DST with 40-60% loan-to-value. The increase in your allocated debt position creates fresh depreciable basis, allowing you to shelter rental income again. This strategy works specifically because you're increasing leverage—exchanging a paid-off property into one with institutional debt. According to Anchor1031, this may potentially shelter approximately 66% of distributions in a hypothetical scenario where an investor exchanges a debt-free property into a 50% LTV multifamily DST. Important nuances: The benefit is proportional to your leverage increase. In a hypothetical example, if your current property has 30% LTV and you exchange into 50% LTV, you would only create new basis from the 20% difference. If your current property already has 50% LTV, this strategy may not provide any additional depreciation benefit. Consult your CPA to evaluate this strategy based on your current leverage position and tax circumstances.
How much tax do I pay on rental income?
Rental income is taxed as ordinary income at your marginal tax rate (10%-37% federal for 2026, depending on income level). Net rental income (gross rent minus operating expenses, mortgage interest, and depreciation) is added to your other income and taxed accordingly. As a hypothetical example, an investor in the 32% tax bracket with $50,000 in net rental income after all deductions could potentially owe approximately $16,000 in federal tax, plus applicable state taxes. The actual amount will vary significantly based on your total taxable income, filing status, and available deductions. Consult your CPA to calculate your specific tax liability.
About the Author
Trevor Sybertz, Partner
Trevor Sybertz is a Partner at Anchor1031, where he specializes in educating clients about 1031 exchanges, private real estate offerings, and REITs. With over a decade of experience in commercial real estate and capital markets, Mr. Sybertz has helped clients invest more than $100M in equity across a wide range of real estate assets and markets.
Related Articles
Sources
This article references the following IRS publications and Internal Revenue Code sections:
- Depreciation:26 U.S.C. § 167;26 U.S.C. § 168;IRS Publication 946;IRS Publication 527
- 1031 Exchanges:26 U.S.C. § 1031;Treas. Reg. § 1.1031(k)-1
- DST Structure:IRS Revenue Ruling 2004-86
- Depreciation Recapture:26 U.S.C. § 1250;IRC § 1(h)(6)
- Stepped-Up Basis:26 U.S.C. § 1014
Explore the Increased Basis Strategy
See how 1031 exchanges into leveraged DSTs can help shelter your rental income while transitioning to passive ownership.
Disclosure
Tax Complexity and Investment Risk
Tax laws and regulations, including but not limited to Internal Revenue Code Section 1031, bonus depreciation rules, cost segregation studies, and other tax strategies, contain complex concepts that may vary depending on individual circumstances. Tax consequences related to real estate investments, depreciation benefits, and other tax strategies discussed herein may vary significantly based on each investor's specific situation and current tax legislation. Anchor1031, LLC and Great Point Capital, LLC make no representation or warranty of any kind with respect to the tax consequences of your investment or that the IRS will not challenge any such treatment. You should consult with and rely on your own tax advisor about all tax aspects with respect to your particular circumstances. Please note that Anchor1031 and Great Point Capital, LLC do not provide tax advice.
The information contained in this article is for general educational purposes only and does not constitute legal, tax, investment, or financial advice. This content is not a recommendation or offer to buy or sell securities. The content is provided as general information and should not be relied upon as a substitute for professional consultation with qualified legal, tax, or financial advisors.
Tax laws, regulations, and IRS guidance regarding 1031 exchanges are complex and subject to change. Information herein may include forward-looking statements, hypothetical information, calculations, or financial estimates that are inherently uncertain. Past performance is never indicative of future performance. The information presented may not reflect the most current legal developments, regulatory changes, or interpretations. Individual circumstances vary significantly, and strategies that may be appropriate for one investor may not be suitable for another.
All real estate investments, including 1031 exchanges, are speculative and involve substantial risk. There can be no assurance that any investor will not suffer significant losses, and a loss of part or all of the principal value may occur. Before making any investment decisions or implementing any 1031 exchange strategies, readers should consult with their own qualified legal, tax, and financial professionals who can provide advice tailored to their specific circumstances. Prospective investors should not proceed unless they can readily bear the consequences of potential losses.
While the author is a partner at Anchor1031, the views expressed are educational in nature and do not guarantee any particular outcome or create any obligations on behalf of the firm or author. Neither Anchor1031 nor the author assumes any liability for actions taken based on the information provided herein.