Your basis in a rental property is not fixed at the moment you close — it moves, and after five years of claiming depreciation, it moves in exactly the wrong direction for your tax bill.
How Basis Is Built on Day One
IRC Section 1012 sets the rule plainly: the basis of purchased property is its cost. Buy that duplex for $285,000, add $10,000 in acquisition costs, and your starting basis is $295,000. Spend $30,000 on improvements before tenants move in, and basis rises to $325,000. That number is your anchor — every calculation that follows starts there.
Land Comes Out First
Not all of that $325,000 can be depreciated. The land under the building is never depreciable, so you have to separate it out before you can calculate a single year’s deduction. Assign $50,000 to the lot, and what remains is a depreciable basis of $275,000. That $275,000 is spread over 27.5 years, producing an annual depreciation allowance of $10,000.
The arithmetic here is tidy by design — the underlying logic is what matters. Whatever your actual land value, the split is real and it determines every depreciation deduction you will ever take on that property.
The Quiet Shrinkage Over Five Years
Each year you rent the duplex and claim your $10,000 depreciation deduction, the IRS subtracts it from your basis. After five years and $50,000 in depreciation claimed, your basis in the property has dropped from $325,000 to $275,000. The property may be worth more than the day you bought it. Your basis is worth less. That gap — current market value minus reduced basis — is the taxable gain waiting for you if you ever sell.
This is how depreciation creates what investors call a “phantom gain.” You took deductions against real rental income year by year, which was entirely legitimate. But the accounting doesn’t forget. The basis reduction is permanent, and when a sale triggers it, depreciation recapture enters the picture alongside the capital gain.
The Exit That Resets Everything
A Section 1031 exchange lets you defer both the capital gain and the depreciation recapture by rolling the property into a like-kind replacement. Keep exchanging over a lifetime, and you defer the tax bill indefinitely — a tax-deferred outcome on every property in the chain.
But deferred is not the same as eliminated. The accumulated liability travels with you.
Where Tax-Deferred Becomes Tax-Free
IRC Section 1014 is where the math finally breaks in the investor’s favor. When a property owner dies and leaves real estate to an heir, the basis of that property is stepped up to its fair market value as of the date of death. The compressed basis, the years of depreciation claimed, the deferred gain from every prior exchange — all of it is wiped away. The heir’s new basis is whatever the property is worth on that day.
That is the transformation the source text names directly: stepped-up basis turns “tax-deferred” into “tax-free.”
How You Hold Title Changes What Your Heirs Receive
The step-up is not automatic in every structure. In Community Property states — Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin — a surviving spouse who inherits the property receives a stepped-up basis on the entire property, including the share they already owned. In a Joint Tenancy state, only the deceased spouse’s share steps up; the survivor’s original cost basis stays put.
For property held in an LLC or partnership, a Section 754 election made upon a partner’s death allows the entity to step up the basis of the property for the beneficiary. Corporations offer no equivalent — a shareholder’s death does not step up the basis of corporate property.
The structure you choose today determines what your heirs inherit tomorrow — a full step-up, a partial one, or none at all.