When Not to Do a 1031 Exchange: Using Cost Segregation and Bonus Depreciation Instead

1031 exchanges are an incredible tool. They let you defer capital gains and depreciation recapture, keep your equity working, and grow into larger, better properties over time.

However, sometimes the most tax-efficient move is not to do a 1031.

In certain cases, it can make more sense to:

Sell,
Pay the capital gains and depreciation recapture,
Buy a new property with a fresh, stepped-up basis, and
Use cost segregation and bonus depreciation on that new property to generate large deductions that can offset your taxable income (including some or all of the gain you just recognized).

In other words:
You “reset” your basis and then use accelerated depreciation as your new tax shield.

This isn’t the right answer for everyone, but it’s absolutely a lever sophisticated investors should understand.

1031 vs. “Sell, Pay, Reset” — What’s the Real Trade-Off?

With a classic 1031 exchange:

You defer:
- Long-term capital gains
- Unrecaptured §1250 gains (the 25% “depreciation recapture” bucket)
- State capital gains
Your basis carries over into the replacement property.
You keep your tax bill in the future — often at a bigger number.

With a sell–pay–reset strategy:

You recognize gains now (capital gains + recapture).
Your new property gets:
- A stepped-up basis equal to purchase price (plus certain costs),
- Fresh depreciation schedules, and
- The ability to run cost segregation and bonus depreciation from a clean slate.

If that fresh depreciation is big enough — and if you can use the deductions — it can dramatically soften or even neutralize the tax sting of not doing a 1031.

The question isn’t “1031 good / 1031 bad?”
It’s: “What combination of deferral and fresh depreciation puts me ahead over the next 5–10 years?”

Why a Stepped-Up Basis Can Be So Powerful

Let’s compare the two approaches at a high level.

Path A: Keep 1031’ing Forever

You roll an old, highly depreciated property into a new one.
Your basis stays low.
You still get some depreciation on the new property, but it’s limited by carryover basis and prior depreciation.
Your tax bill grows in the background like a balloon you’re promising to deal with “someday.”

This can be perfect if:

You’re planning to hold for life and let heirs get a step-up at death, or
You’re trying to keep all capital at work with minimal friction.

Path B: Pay Tax Now, Reset Basis, and Accelerate Depreciation

Now imagine:

You sell.
You pay your capital gains and recapture today.
You buy a new $X million property and run a cost segregation study.

A cost seg study might reclassify:

20–35% of the purchase price into shorter-lived assets (5, 7, 15-year property and land improvements) rather than 27.5 or 39 years.

Under current law, much of that shorter-lived property can qualify for bonus depreciation, allowing for very large first-year deductions (subject to the specifics of whatever bonus rules are in effect when you’re reading this).

If you can:

Use those deductions against your ordinary income, or
Strategically time them in years when your taxable income is high,

then paying the tax at the sale can be partially — sometimes substantially — offset by the fresh depreciation on the new asset.

When Might It Make Sense to Skip the 1031?

This is never a one-size-fits-all answer, but here are some scenarios to consider:

1. You’re Exiting a Heavily Depreciated, “Tired” Asset

Think:

You bought cheap, you’ve owned it for a long time, and
You’ve already taken a ton of depreciation.

A 1031 will carry that low basis forward, which:

Reduces the amount of new depreciation you get on your replacement property.
Keeps a big deferred tax bill hanging over your head.

In contrast, selling outright and buying a new building resets your depreciable basis and sets you up for:

A larger cost seg result, and
More meaningful bonus depreciation.

2. You Want to Upgrade the Asset Quality, Not Just Defer Tax

Let’s say you’re trading:

From a small C-class building in a weak submarket
To an institutional-quality asset in a stronger location, better tenant mix, and longer-term business plan.

If you’re going to be in that new asset for a long time, having a clean, high basis on day one may be more important than squeezing out every last bit of deferral today — especially if depreciation can heavily offset your next several years of income.

3. You Have High Ordinary Income You’d Like to Offset

This is where things get fun.

If you (or a spouse) qualify as a real estate professional or can otherwise treat losses as non-passive, the bonus depreciation from a new, fully stepped-up asset can offset:

W-2 income (in some structures),
Active business income,
Other rental income.

Even if your losses stay passive, they can:

Offset passive income from other properties,
Or accumulate to offset future passive income or gains.

In that context, paying tax now and locking in huge first-year deductions might move you ahead on an after-tax, after-cash-flow basis.

How Cost Segregation and Bonus Depreciation Fit In

Here’s the key idea:

A stepped-up basis is the raw material;
cost segregation and bonus depreciation are the machines that turn it into deductions.

Cost Segregation in Plain English

A cost segregation study:

Dissects a building into components:
- 5-year (carpets, fixtures, some equipment),
- 7-year,
- 15-year (land improvements: parking lots, landscaping),
- and the remaining 27.5 or 39-year structure.
This reclassification front-loads your depreciation deductions into the early years.

Bonus Depreciation

Bonus depreciation then allows you to:

Immediately expense a large chunk of that shorter-life property in year one, instead of spreading it over 5–15 years.

The details (and percentages) depend on:

The year you place the property in service,
How the most recent tax law applies at that time,
Whether your property and its components meet the qualified property rules.

But the general pattern is:

More short-life property → more bonus-eligible basis → bigger year-one deduction.

So… Is This Better Than a 1031?

Sometimes. Not always.

You’re basically solving a multi-variable puzzle:

How big is the gain you’d recognize if you skip the 1031?
How much new depreciation can you realistically create on the replacement property?
Can you actually use those losses (passive vs. non-passive, real estate professional status, income mix, etc.)?
What are your state tax rules?
What’s your time horizon for the new asset?

A 1031 might still be the clearly superior choice if:

You want to keep all equity working with zero current tax hit,
You’re planning to hold until death and rely on a step-up for your heirs,
You’re already sitting on large passive losses and don’t need more.

But if:

Your existing property is over-depreciated,
You expect strong income you’d like to shelter, and
You’re comfortable modeling and possibly pre-paying some tax now,

then skipping the 1031 and leaning into stepped-up basis + cost seg + bonus depreciation is absolutely worth modeling.

How to think about this

“What combination of deferral, basis reset, and depreciation puts you in the strongest after-tax, after-cash-flow position over the next 5–10 years?”

Practically, that looks like:

Clarify the facts
- Purchase price, current basis, accumulated depreciation
- Expected sale price, estimated gain, state of residence
- Your income profile (W-2, business, other rentals)
- Whether you or a spouse might qualify as a real estate professional
Model Scenario A: 1031 Exchange
- Deferred federal & state taxes
- Basis and depreciation for the replacement property
- Impact on future cash flow and exit scenarios
Model Scenario B: Sell–Pay–Reset
- Immediate tax cost (capital gains + recapture)
- New basis for the replacement property
- Estimated cost seg outcome and bonus depreciation
- How much of that deduction you can actually use in the near term
Compare the paths
- Short-term tax impact
- 5–10 year cash flow
- Flexibility for future exits, 721 UPREIT options, and estate planning

Sometimes 1031 is the obvious winner.
Sometimes the cost-seg + fresh-basis play is surprisingly attractive.
And occasionally, a hybrid approach (partial exchange, partial cash-out, future 721, DST/UPREIT, etc.) is the sweet spot.

This Is Strategy, Not a One-Click Answer

All the usual caveats apply:

This is not tax or legal advice.
Every situation depends on your specific numbers and your CPA’s interpretation of current law.
Federal and state rules change, and “bonus depreciation” and special expensing rules can shift over time.

What matters is that you:

Know this lever exists (you aren’t trapped in 1031-or-nothing thinking), and
Run the numbers before you lock yourself into an exchange or a taxable sale.