Depreciate Property in Like-Kind Exchanges Consistently
Practitioners must give special scrutiny and apply new depreciation matching rules.
The Treasury has issued final regulations (Treasury Decision 9314) explaining how to depreciate modified accelerated cost recovery system (MACRS) property that has been acquired in a section 1031 like-kind exchange or through a section 1033 involuntary conversion when both the acquired and relinquished property are subject to MACRS in the hands of the acquiring taxpayer. The regulations apply to all such exchanges, including those between members of the same affiliated group. However, the regulations do not apply to like-kind exchanges of tax-exempt-use MACRS property under Treas. Reg. § 1.168(h)-1. See also Treas. Reg. § 1.168(i)-6(a).
The regulations are a response by the IRS to the inconsistent depreciation treatment by taxpayers of property that has a basis determined under section 1031(d) or section 1033(b) (replacement property). Certain taxpayers were depreciating the replacement property using the same depreciation method, recovery period and convention as the exchanged or involuntarily converted property (relinquished property), while other taxpayers were depreciating the replacement property as if it were newly placed in service.
The final regulations retain the rule in proposed regulations that the properties involved must be MACRS properties. It did not, as one commentator urged, extend the treatment to other types of property because “it is anticipated that the vast majority of like-kind exchanges and involuntary conversions occurring after the effective date of the final regulations will involve the exchange of MACRS property.”
However, the final regulations (Treas. Reg. § 1.168(i)-6(i)(2)) do allow a taxpayer to elect to treat the sum of the exchanged basis and excess basis of the replacement property as MACRS property that is placed in service at the time of replacement if the tangible depreciable property acquired by a taxpayer in a likekind exchange or involuntary conversion replaces tangible depreciable property for which the taxpayer made a valid section 168(f)(1) election to exclude it from the application of MACRS. For example, a taxpayer who exchanges a machine depreciated under the unit-of-production method for a used machine may depreciate under MACRS the sum of the exchanged basis and excess basis of the used machine (replacement property) as a machine placed in service at the time of replacement.
A PERSISTENT ATTRACTION
These regulations merit particular attention by tax advisers because like-kind exchanges, authorized under section 1031, have long enjoyed popularity in planning commercial real estate transactions. This persistent attraction for 1031 exchanges stems from the tax deferral of any gain that would otherwise be recognized. A recent example of the ongoing, dynamic activity in this area is Revenue Procedure 2008-16 involving the application of section 1031 to vacation homes (see “Tax Practice Corner: Vacation Home Swaps Get Safe Harbor,” JofA, July 08, page 84).
The tax deferral is accomplished by using the basis of the property exchanged as the replacement property’s basis, possibly followed by certain adjustments. Therefore, when the replacement property is sold, the gain not recognized upon the exchange is finally recognized. If, however, the replacement property is held until the owner’s death, the appreciation may escape tax entirely due to a steppedup basis.
Section 1031 requires that the property being exchanged and received be of a “like kind” and must be held either for investment or for productive use in the taxpayer’s trade or business. If the seller in the exchange receives nonqualifying property (“boot”) such as cash, the taxpayer must recognize gain but not loss on the boot received.
It should be noted that the depreciation treatment of the replacement MACRS property by previous owners as well as elections made by them have no effect on determining depreciation allowances for the replacement property in the hands of the acquiring taxpayer. For example, an acquiring taxpayer would not be bound to continue depreciating replacement property under the alternative depreciation system if the previous owner had elected to do so under section 168(g)(7). See Treas. Reg. § 1.168(i)-6(c)(2).
Effective date. The final regulations generally apply to like-kind exchanges and involuntary conversions for which the time of disposition and replacement both occurred after Feb. 27, 2004. If the disposition, replacement or both occurred on or before that date, a taxpayer may apply the final regulations or rely on prior IRS guidance.
Election Out Planning
Under Treas. Reg. § 1.168(i)-6(i)(1), a taxpayer may elect to opt out of the final regulations, which otherwise are mandatory for any MACRS property involved in a like-kind exchange or involuntary conversion. By electing not to use the two-basis approach of the regulations, the entire basis in the replacement property is deemed to have been placed in service at the time of replacement, while the adjusted depreciable basis of the relinquished property is treated as disposed. The election is made by a partnership, not the partners separately, and by an S corporation rather than its shareholders separately. A separate election is required for each like-kind exchange or involuntary conversion. Once made, the election may only be revoked with the consent of the IRS, and such consent will be granted only in extraordinary circumstances.
This election may present planning opportunities for clients who engage in like-kind exchanges. CPAs should consider the election for clients who:
Prefer to avoid the cost and complexity of compliance with the bifurcated basis method of the regulations.
Get replacement property with a shorter life or a more accelerated method of depreciation than the property relinquished if greater depreciation deductions are desired.
A BIFURCATED PATH
The final regulations carry forward the foundational approach to depreciating exchanged property promulgated in proposed and temporary regulations. That is, the basis of the replacement property consists of two components: (1) a depreciable exchanged basis reflecting the remaining adjusted basis of the relinquished property and (2) a depreciable excess basis—any excess basis in the replacement property over the exchanged basis reflecting additional consideration that may be paid to acquire the replacement property. See Treas. Reg. § 1.168(i)-6(b)(7) and (8). The rules to apply to the exchanged basis then depend on how recovery periods and depreciation methods of the exchanged properties compare.
Same period and method. If both the recovery period and depreciation method of the replacement property and relinquished property are the same, then the replacement property is depreciated (beginning in the year of replacement and using the applicable convention) applying the same period and method used for the relinquished property. See Treas. Reg. § 1.168(i)-6(c)(3)(ii).
Either period or method is the same. If either the recovery period or the depreciation method for the replacement property is the same as for the relinquished property, then the period or the method that is the same is used to depreciate the replacement property (Treas. Reg. § 1.168(i)-6(c)(3)(iii)).
Either period or method, or both, not the same. If the recovery periods differ or if the methods differ, or both, then Treas. Reg. § 1.168(i)-6(c)(4) provides the following rules:
If the replacement property’s recovery period is longer than that of the relinquished property, depreciation for the exchanged basis beginning in the year of replacement is determined as though the replacement property had originally been placed in service by the acquiring taxpayer in the same taxable year the relinquished property was placed in service, but using the longer recovery period.
If the replacement property’s recovery period is shorter than that of the relinquished property, depreciation of the replacement property is based on the longer period of the relinquished property.
If the depreciation method of the replacement property is less accelerated than that of the relinquished property, depreciation for the exchanged basis is determined as though the replacement property had originally been placed in service by the acquiring taxpayer at the same time the relinquished property was placed in service, but using the less accelerated method.
Example. If the depreciation method of the replacement property in the year of replacement is the 150% declining balance method and the method of the relinquished property is the 200% declining balance method, and if neither method had been switched to the straight-line method in the year of replacement or any prior taxable year, the applicable depreciation rate for the year of replacement and subsequent taxable years is determined by using the rate of the replacement property as if that property were placed in service by the acquiring taxpayer at the time the relinquished property was placed in service by the acquiring taxpayer, until the 150% declining balance method has been switched to the straight-line method (Treas. Reg. § 1.168(i)-6(c)(4)(iii)(B)).
If the replacement property’s method is more accelerated than that of the relinquished property at the time of disposition, depreciation for the replacement property is determined using the same method as the relinquished property, that is, the less accelerated method.
Convention. Rules pertaining to the appropriate convention for the exchanged basis appear in Treas. Reg. § 1.168(i)-6(c)(4)(v). If either the relinquished or replacement property is property for which the applicable convention (determined under section 168(d)) is the midmonth convention, the exchanged basis must be depreciated using the midmonth convention. If neither property is property for which the applicable convention is the midmonth convention, then the convention that applied to the relinquished property should be used. There are also special rules for applying the 40% test of section 168(d) in Treas. Reg. § 1.168(i)-6(f).
Example. Bill, a calendar-year taxpayer, placed in service an improved road in January 1998. It is depreciated using the half-year convention. In January 2004, Bill exchanges the road for an apartment building in a like-kind exchange. Bill applies the final regulations to the exchange. Since the recovery period for the building, 27.5 years, is longer than the road’s recovery period, 15 years, the building is depreciated as if it had originally been placed in service in July 1998 and disposed of in July 2004 using a 27.5-year recovery period. Also, since the depreciation method for the building, the straight-line method, is less accelerated than that of the road, the 150% declining balance method, the depreciation allowance for the building is computed using the straight-line method. Therefore, when the building is acquired and placed in service in 2004, its basis is depreciated over the remaining 21.5-year recovery period using the straight-line method and the midmonth convention beginning in July 2004. (See also Treas. Reg. § 1.168(i)- 6(c)(6), example 2.)
Note that no depreciation is allowable for MACRS property disposed of by a taxpayer in a like-kind exchange or involuntary conversion in the same taxable year that such property was placed in service by the taxpayer. If replacement property is disposed of by a taxpayer during the same taxable year that the relinquished property is placed in service by the taxpayer, no depreciation deduction is allowable for either property (Treas. Reg. § 1.168(i)-6(d)(1)(i)). Otherwise, Treas. Reg. § 1.168(i)-6(c)(5) has rules for determining the depreciation allowances for the year of disposition and replacement.
Deferred exchanges. If replacement property is not acquired until after the disposition of the relinquished property, you cannot take depreciation during the period between the disposition of the relinquished property and the acquisition of the replacement property. The recovery period for the replacement property is suspended during this period. See Treas. Reg. § 1.168(i)-6(c)(5)(iv).
EXCESS BASIS
The preceding rules deal with depreciating the exchanged basis of the replacement property. If there is any excess basis in the replacement property that could result from paying cash in addition to the relinquished property, it is treated as property that is placed in service by the acquiring taxpayer in the year of replacement. Therefore, depreciation deductions for the excess basis are determined by using the applicable recovery period, depreciation method and convention prescribed under section 168 for the property at the time of replacement.
Example. In 1990, George placed a shopping center in service. In January of 2005, he exchanges the shopping center plus $2 million cash for an office building in a like-kind exchange. At this time, the shopping center’s adjusted depreciable basis is $1.5 million. After the exchange, the basis of the office building is $3.5 million. The depreciable exchanged basis of $1.5 million is depreciated according to the regulations discussed above. The depreciable excess basis of $2 million is treated as being placed in service by George in 2005 and is therefore depreciated using the applicable method, recovery period and convention prescribed for the office building under section 168 at the time of replacement (see Treas. Reg. § 1.168(i)-6(d)(1)(ii)).
NONDEPRECIABLE PROPERTY
What if land or other nondepreciable property is acquired in a like-kind exchange for, or as a result of an involuntary conversion of, depreciable property? The land or other nondepreciable property cannot be depreciated. See Treas. Reg. § 1.168(i)-6(d)(2). If both MACRS and nondepreciable property are acquired in a like-kind exchange for, or as part of an involuntary conversion of, MACRS property, the basis allocated to the nondepreciable property (determined under section 1031(d) or section 1033(b) and related regulations) is not depreciated, and the basis allocated to the replacement MACRS property is depreciated according to the final regulations.
What if MACRS property or both MACRS and nondepreciable property are acquired in a like-kind exchange for, or as part of an involuntary conversion of, land or other nondepreciable property? The basis in the replacement MACRS property that is attributable to the relinquished nondepreciable property is treated as though the replacement MACRS property were placed in service by the acquiring taxpayer in the year of replacement. Accordingly, the depreciation for the replacement property is determined using the applicable recovery period, method and convention at the time of replacement.
OPTIONAL TABLES
If a taxpayer used an optional depreciation table for the relinquished property, the taxpayer is not required to use an optional table for the exchanged basis of the replacement property. If an optional table was not used for the relinquished property, the taxpayer may nevertheless use the appropriate table for the exchanged basis of the replacement property. Treas. Reg. § 1.168(i)-6(e) provides guidance on choosing the applicable optional table as well as how to modify the calculation for computing depreciation for the replacement property.
MULTIPLE PROPERTIES
The final regulations don’t include rules dealing with the allocation of basis among multiple properties involved in like-kind exchanges or involuntary conversions for purposes of depreciation. The explanation to TD 9314 refers to Treas. Reg. §§ 1.1031(j)-1 and 1.1033(b)-1 for the determination of basis to which these regulations would then apply for determining the depreciation allowable with respect to such basis.
ARDUOUS COMPLIANCE
These regulations are complex and burdensome. For CPAs who have clients dealing with multiple like-kind exchanges or involuntary conversions, the cost and difficulty of properly administering affected assets can be substantial. In fact, the IRS and Treasury acknowledged this complexity in TD 9115, which contained the temporary regulations preceding the final regulations:
“Commentators suggested that implementing the general rule for all depreciable property was burdensome because taxpayers would have onerous computational and administrative difficulties due to the possibility of having to track different depreciation components of one asset. Responding to these comments, the temporary regulations include a provision by which taxpayers may elect not to apply these temporary regulations.” See the sidebar “Election Out Planning,” for more information. 
Section 351 Connection
When anyone transfers assets to a corporation in exchange solely for stock of that corporation, and that person has control of the corporation immediately after the exchange, no gain or loss is recognized by the transferor under section 351. Moreover, the corporation does not recognize any gain or loss under section 1032. Under section 362, the corporation’s basis in the property it receives is the same as the basis the transferor had in it, increased by the amount of gain recognized to the transferor, if any, that could result from the transferor’s receipt of “boot.” Under certain circumstances, the corporation may have to reduce its basis in assets with built-in losses.
Section 351 raises questions involving the exchange of depreciable property. For example, when depreciable property is transferred to a corporation in a section 351 exchange, and the shareholder/transferor has not fully depreciated the property, the corporation must use the same depreciation method and recovery period that the transferor used. This rule, from section 168(i)(7), is applicable to the extent that the corporation’s basis is the same as the transferor’s basis in the property. If the transferee/corporation’s basis in the property exceeds the transferor’s basis, suggested guidance, Prop. Treas. Reg. § 1.168-5(b)(7), indicates that the corporation should treat the excess basis as newly purchased depreciable MACRS property and use the recovery period and depreciation method applicable to the class of property transferred. When the corporation’s basis in the property is less than the transferor’s basis, the guidance is less clear on how the corporation is to depreciate the transferred property. Prop. Treas. Reg. § 1.168-5(b)(6) says that in this situation, the corporation should follow Prop. Treas. Reg. § 1.168-2(d)(3) for rules relating to “redeterminations” of basis. These proposed regulations have not been amended to reflect many changes in the law enacted since their release in 1984.
The similarities between like-kind and section 351 exchanges suggest that guidance for depreciating property in the former may also be applied to the latter. Likewise, it may be helpful to compare the final regulations’ bifurcated approach to handling depreciation of exchanged property to how the proposed regulations deal with excess basis.
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EXECUTIVE SUMMARY
Final regulations of Treas. Reg. § 1.168(i)-6 provide rules and examples to help harmonize depreciation treatment under the modified accelerated cost recovery system (MACRS) of the exchanged basis of relinquished and replacement property in likekind exchanges and involuntary conversions under IRC §§ 1031 and 1033. This guidance can prove of particular importance to tax advisers and their clients involved in such transactions, for which depreciation treatment has often been inconsistent.
If the depreciation period and/or method previously used for the relinquished and replacement property are the same, the replacement property is depreciated using the same period and/or method. If the replacement property’s recovery period is shorter than that of the relinquished property, the longer period of the relinquished property applies to the replacement property. If the replacement property’s recovery period is longer than that of the relinquished property, that longer period still applies after the exchange, but beginning from the year the relinquished property was placed in service. Similar rules govern depreciation method.
Excess basis in the replacement property received in the exchange or involuntary conversion is depreciated under the applicable period, method and convention at the time of replacement.
The regulations also prescribe rules for reconciling exchanges involving both depreciable property and land or other nondepreciable property.
Michael G. Stevens, CPA, LL.M., is an assistant professor of accounting at Queens College of the City University of New York. His e-mail address is michael.stevens@qc.cuny.edu.
