Depreciation of Property Acquired Subject to Secs. 1031 and 1033

Taxpayers who acquire modified accelerated cost recovery system (MACRS) property in a Sec. 1031 like-kind exchange or as a result of a Sec. 1033 involuntary conversion have new guidance for depreciating the acquired property under Sec. 168.

Notice 2000-4 states, "the acquired MACRS property should be treated in the same manner as the exchanged or involuntarily converted MACRS property with respect to so much of the taxpayer's basis in the acquired MACRS property as does not exceed the taxpayer's adjusted basis in the exchanged or involuntarily converted MACRS property. Thus, the acquired MACRS property is depreciated over the remaining recovery period of, and using the same depreciation method and convention as that of, the exchanged or involuntarily converted MACRS property. Any excess of the basis in the acquired MACRS property over the adjusted basis in the exchanged or involuntarily converted MACRS property is treated as newly purchased MACRS property."

Example: T purchased a rental office building for $630,000 on Jan. 1, 1990. The building was depreciated using the straight-line method over a 31.5-year recovery period. (Disregard the mid-month convention for this example.) On Jan. 1, 2000, when the building had $200,000 of accumulated depreciation and a remaining recovery period of 21.5 years, the taxpayer exchanged the building and $195,000 cash for a new rental office building in a transaction subject to Sec. 1031. T's basis in the new building is $625,000 ($630,000 cost of the surrendered building, minus $200,000 accumulated depreciation, plus $195,000 cash paid).

Based on Notice 2000-4, T should essentially treat the newly acquired building as two assets in calculating depreciation. One asset is the old building, with an adjusted basis of $430,000, which should be depreciated using the straight-line method over the remaining 21.5-year recovery period. The other asset is a newly purchased building, with a basis of $195,000 (cash paid), which should be depreciated using the straight-line method over a 39-year recovery period. Depreciation in 2000 will be $25,000 ($430,000 basis depreciated over 21.5 years plus $195,000 basis depreciated over 39 years). If T treated the building as newly purchased MACRS property and depreciated the net basis of $625,000 over 39 years, his 2000 depreciation would be only $16,026.

T will claim the same total depreciation, regardless of method, if he holds the newly acquired building for 39 years. However, depreciating the property according to Notice 2000-4 accelerates depreciation over that allowed for newly purchased MACRS property. In addition to accelerating the deductions, Notice 2000-4 provides other tax-saving opportunities. First, the additional depreciation claimed as an ordinary deduction is converted to capital gain (unrecaptured Sec. 1250 gain) if T disposes of the property in a taxable transaction before the end of the 39-year period. Second, if T dies within the 39-year period, any basis step-up will be increased.

Accounting Method

If acquired property subject to Sec. 1031 or 1033 was placed in service before Jan. 3, 2000 and a taxpayer treated it as newly purchased MACRS property (rather than according to Notice 2000-4), the taxpayer may continue this treatment. However, a taxpayer presently depreciating such property as newly purchased MACRS property may change to the depreciation method described in Notice 2000-4, provided the change is made for the first or second tax year ending after Jan. 3, 2000. Thus, a calendar-year taxpayer may change methods in either 2000 or 2001.

A change from treating property as newly purchased property to that described in Notice 2000-4 is an accounting method change to which Secs. 446 and 481 apply. A taxpayer changing the method of accounting for property acquired subject to Sec. 1031 or 1033 must follow Rev. Proc. 99-49's automatic change in accounting method provisions, provided the taxpayer makes the change in method for the first or second tax year ending after Jan. 3, 2000 and takes into account any required Sec. 481(a) adjustment in accordance with Rev. Proc. 99-49.

For property placed in service after Jan. 2, 2000, a taxpayer should use the method described in Notice 2000-4 until regulations under Sec. 168 are issued to address these transactions.

From Kathleen K. Martin, Madison, WI

Tax Treatment of ISO 9000 Costs

A recent IRS ruling clarifies the tax treatment for costs of obtaining, maintaining and renewing International Organization for Standardization (ISO) 9000 certification. Rev. Rul. 2000-4 generally permits the current deduction of ISO 9000-related costs with limited exceptions when specific assets are created. This ruling should be particularly helpful to taxpayers and their tax advisers in an environment in which customer expectations in the global marketplace are making ISO 9000 certification increasingly important for U.S. taxpayers doing business internationally. Further, the ruling presents a helpful guide in analyzing other issues that could arguably be expensed or capitalized.

The ISO developed the ISO 9000 series of standards to ensure that organizations implement and continue to adhere to specific requirements concerning their quality management and quality assurance systems. ISO 9000 certification provides customers with an objective standard in evaluating suppliers of goods and services.

Organizations typically incur internal and external costs to currently assess the quality process in place, create a quality manual, educate employees, implement a new quality system and obtain formal certification from an independent auditor. Subsequent to initial certification, ISO 9000 costs include periodic audits to maintain a certified status and to renew certification on expiration.

Prior to Rev. Rul. 2000-4, there was no specific authority on the tax treatment of ISO 9000-related costs. However, in the current post-INDOPCO environment, the possibility of capitalization of these costs on audit would not seem unlikely. Rev. Rul. 2000-4 provides specific guidance in this instance by analyzing and applying the relevant authority to ISO 9000-related costs.

Citing INDOPCO, Inc., 503 US 79 (1992), Rev. Rul. 2000-4 explains that Secs. 162, 263 and 263A are intended to match expenses with revenues generated by those expenses. It is not enough to say that an expenditure has a future benefit and, thus, must be capitalized. Again citing INDOPCO, the ruling explains that the mere presence of an incidental future benefit may not warrant capitalization; not only the duration, but the extent, of the benefit must be considered. Holding that the ISO 9000-related costs are more like "training" and "advertising" than obtaining licenses, stock trading privileges, state bar certifications and similar market-entry requirements, the ruling concludes that any future benefit is merely incidental rather than significant, and, therefore, the costs need not be capitalized. The only exception relates to the portion of ISO 9000-related costs that result in creating or acquiring a physical asset (such as a quality manual), which must be capitalized appropriately.

Sec. 263A extends Sec. 263's reach by requiring capitalization of certain otherwise currently deductible direct and indirect costs, because they are allocable to real or tangible personal property. Citing Sec. 263A (which generally exempts quality-control expenditures from uniform capitalization), the ruling further holds that ISO 9000-related costs are also exempt.

Taxpayers currently capitalizing ISO 9000-related costs, who want to change to the method described in Rev. Rul. 2000-4, must generally follow the automatic change procedures outlined in Rev. Proc. 99-49. Special rules apply to taxpayers under examination before an Appeals office or a Federal court; however, Section 4.02 of Rev. Proc. 99-49 does not apply.

From Scot P. Roche, Rockford, IL