1031 exchanges and cost segregation

Carryover basis vs. excess basis

When you acquire a single-tenant net-lease pad through a §1031 like-kind exchange, the IRS does not let you start the replacement property's depreciation from a clean slate. Instead, the basis of the property you sold generally follows you into the property you bought. That carried-forward amount is the carryover basis — the adjusted basis of the relinquished property (original cost, less the depreciation you already claimed on it), transferred to the replacement asset. It keeps the deferral the exchange was designed to deliver: you did not recognize gain, so you do not get a fresh, stepped-up basis to depreciate.

If you paid more for the replacement pad than the basis you carried over — you added cash, took on larger debt, or traded up into a more expensive asset — the additional amount creates a second layer. This excess basis is the portion of your investment that exceeds the carryover figure. Plainly: carryover basis is the old money that rode along with the deferral, and excess basis is the new money you put into the deal on top of it. A typical trade-up produces both layers at once, and how your purchase price splits between them is the single most important input to what a cost segregation study can accelerate. Your CPA computes the exact allocation for your return, because it depends on the closing figures, the debt relief, and any boot recognized in the exchange.

How a study treats each layer

A cost segregation study works the same way on a net-lease pad whether or not an exchange is involved: an engineering-based review of the landlord's cost basis identifies the building components — site improvements, specialty electrical and plumbing, finishes, and other shorter-lived assets — that qualify for 5-, 7-, or 15-year recovery instead of the 39-year default. What changes after a 1031 is not the engineering. It is which dollars the engineering gets applied to.

The study still only reclassifies the owner's depreciable basis. Tenant-funded build-out, fixtures the tenant installs, and ongoing operating costs the tenant carries under the net lease are not yours to depreciate and do not enter the analysis. Within the basis that is yours, the two layers behave differently:

• Carryover basis. This layer generally continues the depreciation profile of the property you relinquished — its remaining recovery period and method ride forward. New reclassification opportunities here are narrower, because the carried-over assets are already mid-life on a schedule that began on the old property.
• Excess basis (and any replacement-specific additions). This is treated as newly placed-in-service property on the replacement pad. It is the layer where a study has the most room to reclassify components into shorter recovery classes — and the layer where bonus depreciation can apply.

Because the excess layer is where most of the acceleration lives, the carryover-vs-excess split largely sets the ceiling on your result. A deal that is nearly all carryover has a thinner reclassifiable base than a substantial trade-up. These are modeled, estimated outcomes — the actual recovery on each layer depends on §481(a) treatment, your entity structure, the §1031 basis allocation, and state conformity, and your CPA confirms how all of it lands on your specific return.

Depreciation continuation and the catch-up

The practical rule of thumb for the carryover layer is continuation: it generally keeps depreciating on the relinquished property's remaining schedule rather than restarting at 39 years. That is consistent with the IRS guidance a study relies on — IRS Publication 946 on how to depreciate property and the Cost Segregation Audit Techniques Guide, Publication 5653, on the engineering method used to classify components.

The replacement-specific and excess-basis components are where a study introduces newly reclassified shorter-life assets, and where bonus depreciation under §168(k) can come into play. Bonus is governed by the asset's placed-in-service date, not the date you closed the exchange or signed the study. The applicable bonus rate is set by when the property is placed in service — and for 2025 specifically there is a split tied to the January 20 date, so a single flat assumption for the whole year is wrong. We walk through the year-by-year rates and the date rule in the bonus depreciation by PIS year guide. Any catch-up depreciation captured through a method change is an estimated, §481(a)-dependent figure your CPA computes and reports for your return.

Why NNN owners ask this most

Single-tenant net lease is where exchanges naturally land. NNN assets — a freestanding pharmacy, a quick-service restaurant pad, a dollar-store box, an auto-service building — are passive, credit-backed, and easy to trade into, which makes them the default replacement property for investors stepping out of management-intensive real estate. So the carryover-basis question is the one net-lease buyers raise more than any other: I exchanged into this pad — how much can a study actually accelerate?

The honest answer is that it depends on your split between carryover and excess basis, your placed-in-service date, and your own tax posture — and that is exactly what a study is built to quantify. A net-lease pad acquired in a trade-up is a strong candidate, not a marginal one: the excess layer gives the engineering real components to work with. To see the modeled, estimated reclassification on your specific asset, start an estimate at costsegsmart.com/order. For the underlying mechanics, see what reclassifies on a net-lease pad and our example study, and confirm the final treatment with your CPA before filing.