Trading Up in New York: Where the Tax Deduction Actually Comes From

Trading up from one investment property to another can look straightforward when you focus on the sale price, replacement property and financing. However, the tax calculation becomes more interesting once you consider a 1031 exchange, excess basis and depreciation. For a New York investor, those details affect how much taxable income is recognized today, how much depreciation is claimed and what happens when the property is eventually sold.

If you are researching how 100% bonus depreciation works, the key federal change came through the One Big Beautiful Bill Act (OBBBA), signed 4 July 2025. The law made a 100% additional first-year depreciation deduction permanent for qualifying property acquired and placed in service after January 19, 2025. Property acquired before January 20, 2025, remains on the phase-down schedule of 80% in 2023, 60% in 2024, 40% in 2025, 20% in 2026, and 0% from 2027. Qualified property generally includes tangible MACRS property with a recovery period of 20 years or less. The building itself generally remains subject to a 27.5-year residential or 39-year nonresidential recovery period.

The federal rules become clearer once the exchange and the depreciation are treated as separate things. The exchange defers qualifying gain on the relinquished property, while the replacement property's basis determines depreciation. Additional investment creates excess basis, which is treated separately for depreciation purposes after the replacement property is placed in service.

Where Excess Basis Creates the Deduction

A cost segregation study can identify components such as certain flooring, electrical installations, dedicated plumbing, fixtures and other shorter-lived assets within an investment property. Those components have shorter recovery periods than the main building and qualify for bonus depreciation when the applicable federal requirements are met.

An investor rolls $1,050,000 of deferred gain from a Brooklyn four-family into a $3,400,000 mixed-use building in Queens. Total basis in the replacement property is $2,350,000, split into $1,050,000 of carryover basis and $1,300,000 of excess basis representing the new money brought to the deal. Only the excess basis is treated as newly placed in service, and only that portion bonus depreciation can reach. 

With land allocated at 25%, the depreciable excess basis is $975,000. A cost segregation study reclassifies 27% of it - $263,250 - into 5- and 15-year property, deductible in full in year one. At a 37% federal marginal rate, that is $97,403 saved. New York decouples from Section 168(k) and requires an add-back, so the year-one state and city benefit is zero.

The Exchange Does Not Produce the Deduction

The 1031 exchange does not create the depreciation deduction. The deduction comes from depreciable tax basis in the replacement property. Carryover basis retains its existing tax characteristics, while excess basis represents new investment that enters the depreciation calculation. Cost segregation then identifies eligible shorter-lived components, and pairing a 1031 exchange with bonus depreciation pulls those qualifying federal deductions into year one.

The Passive-Loss Limitation

One caveat matters more than the arithmetic. A large first-year deduction does not automatically offset W-2 or business income. Under IRC Section 469, rental losses are passive unless the owner qualifies as a real estate professional under Section 469(c)(7) or the short-term rental exception applies, and the owner materially participates. If neither is met, the loss is suspended and carried forward until there is passive income to absorb it or the property is sold.

Section 1245 and the Exchange

There is also a limit on what the exchange defers. A 1031 exchange defers gain on qualifying real property, and since the Tax Cuts and Jobs Act, Section 1031 applies to real property only. Genuine personal property identified in a cost segregation study - appliances, furniture, carpeting, removable fixtures - is not like-kind replacement property, so gain attributable to those components can be recognised as ordinary income under Section 1245 even in an otherwise fully deferred exchange. Classification for depreciation purposes and classification as real property under Reg. 1.1031(a)-3 are separate tests and the analysis is fact-specific.

New York Changes the Calculation

Federal and New York depreciation must be modeled separately. New York has decoupled from federal bonus depreciation under Section 168(k), requiring an add-back of the federal bonus depreciation deduction and a separate state depreciation calculation. As the worked example shows, a significant federal first-year deduction does not necessarily produce a corresponding New York State or New York City tax benefit in that same year.

Depreciation also reduces adjusted basis, which affects the taxable gain when property is eventually disposed of. Depreciation-related recapture rules therefore belong in the initial analysis rather than being considered only at exit. For an investor trading up, the calculation should account for carryover basis, excess basis, cost segregation, federal depreciation, New York treatment and the passive-loss limitations together.

This is general information, not tax advice, and readers should consult their own CPA.