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Calculating Depreciation on a Like-Kind Exchange or an Involuntary
Conversion Temporary regulations have modified the rules for computing depreciation on exchanged or converted property. This article focuses on the use of the optional tables for like-kind exchanges and involuntary conversions.
J.
David Mason, Ph.D., CPA For more information about this article, contact Dr. Mason at jmason@siue.edu.
The Service issued Temp. Regs. Sec. 1.168-6T in February 2004 in the belief that taxpayers were inconsistently taking depreciation on property acquired in like-kind exchanges under Sec. 1031 and involuntary conversions under Sec. 1033.1 The IRS was concerned that, for depreciation purposes, some taxpayers had been regarding the replacement property as a continuation of the relinquished (converted) property, while others had been considering it as new property, resulting in inconsistent treatment. The new regulation generally requires treating the replacement property as a continuation of the relinquished property, to the extent of the carryover (exchanged) basis. In addition, it addressed other important issues, such as the (1) determination of the depreciation allowance under Temp. Regs. Sec. 1.168(i)-6T(c), (2) treatment of passenger automobiles under Temp. Regs. Sec. 1.168(i)-6T(d) and (3) use of the optional depreciation tables2 under Temp. Regs. Sec. 1.168(i)-6T(e). This article focuses on the new rules for using the optional depreciation tables when applying the regulations to like-kind exchanges or involuntary conversions.3 The new rules apply to a like-kind exchange or an involuntary conversion of MACRS property for which the time of disposition and the time of replacement both occur after Feb. 27, 2004. The IRS initially provided guidance to taxpayers in Notice 2000-4,4 which was considered interim guidance until the new regulation could be issued.5 General Effect on Taxpayers Even a cursory reading of the new regulation reveals how it restricts many of the tax planning opportunities apparently available under Notice 2000-4. In addition, it makes recordkeeping more difficult and complex than before, as the new rules require taxpayers to bifurcate the basis of property received into an exchanged (or carryover) basis and an excess (boot) basis. The portion of the basis treated as exchanged basis is considered, in general, to be a continuation of the old asset for depreciation purposes. The portion deemed to be excess basis is treated as if it were a new asset, which results in the excess basis receiving a new life (i.e., a new recovery period) and depreciation method. In short, tax professionals will be hard-pressed to argue that this guidance is taxpayer-friendly. For example, if the replacement property would normally have a longer life for MACRS purposes, the taxpayer has to convert to that life for the portion of the basis that is the exchanged (carryover) basis. The same is true in selecting the depreciation method. If the replacement property would normally have a less accelerated depreciation method, the taxpayer has to use that method for the portion of the basis that is the exchanged basis, even though the regulation treats the replacement property’s exchanged basis as a continuation of the relinquished property for depreciation purposes. Use of Optional Tables The regulation’s guidance on using the optional depreciation tables also reflects a pro-government bias. If taxpayers elect to use them to calculate depreciation, they will be at a comparative disadvantage. Thus, it is generally to the taxpayer’s benefit to opt out of using the optional tables for calculating depreciation on replacement property. Background Historically, tax advisers have often relied on the optional depreciation tables, rather than on the more tedious manual approach, because the tables simplified the calculations and were more time- and cost-efficient. The tables made it unnecessary to determine book value (the remaining undepreciated basis) each year, as this information was incorporated into the rates. Instead, each year, the calculation merely involved multiplying the applicable rate times the original unadjusted basis. For example, for five-year MACRS property (assuming the half-year convention applies) acquired for $10,000 and placed in service in January 2001, the calculation for 2003 depreciation involved identifying the applicable rate from the table6 for year 3 (0.192), and then multiplying the $10,000 undepreciated basis by this rate, thus making year-3 depreciation $1,920. By comparison, calculating the depreciation for 2003 by hand involved multiplying the remaining undepreciated basis by 200% of the straight-line rate, which would require tax advisers to maintain a schedule of the asset’s undepreciated basis. In this example, the tax professional would first determine the remaining undepreciated basis at the beginning of 2003 ($4,800), then compute depreciation as follows: $4,800 200% 1/5 (straight-line rate) = $1,920. In addition, the tax preparer would need to determine when to switch to the straight-line method, because it would yield a higher depreciation amount.7 In the tables,8 the conversion to straight-line is already incorporated into the rate. Exhibit 1 below illustrates the alternative approaches for calculating depreciation for both five-year and seven-year MACRS properties, using an asset with an original unadjusted basis of $10,000 and assuming the half-year convention applies.
Effect of New Regulations on Optional Table Use Importantly, in the year of the exchange or conversion, the new regulation requires a separate depreciation calculation for: 1. Relinquished MACRS property in the disposition year. 2. Exchanged basis (relinquished property’s carryover basis) of replacement MACRS property in the acquisition year (if acquired in the exchange or conversion year). 3. Excess basis of the replacement MACRS property in the acquisition year (if acquired in the exchange or conversion year). In the exchange or conversion year, the relinquished property is limited to a partial year of depreciation based on the applicable convention (e.g., half-year convention), and the replacement property’s exchanged basis is also limited to a partial entitlement for the year in which it is acquired.9 Essentially, the new regulation intends to split the annual depreciation on the carryover basis between the portion allocable to the relinquished property and that allocable to the replacement property. There are several reasons for this, including the possibility (as mentioned above) that the replacement property may be subject to a longer recovery period, as well as a less accelerated depreciation method. In addition, if the replacement property is not placed in service in the same tax year as the relinquished property’s disposition year, bifurcation of depreciation allows for the deduction of the depreciation attributable to the replacement property’s carryover basis in the acquisition year. Because of the above complications in determining the depreciation of the relinquished and the replacement properties, tax professionals cannot simply use the rates given in the optional depreciation tables. Rather, the rates must either be modified or an election made to opt out. Alternatives Available To assist tax professionals in making the necessary adjustments when using the optional tables, the new regulation explains how to calculate a “transaction coefficient,” to be used to modify the rates in the optional tables for a like-kind exchange or an involuntary conversion. As mentioned above, an alternative to calculating the transaction coefficient is to opt out of using the optional tables altogether. This election is available whether or not the optional tables had been used for calculating the depreciation on the exchanged (relinquished) property. Thus, prior use of the optional tables is not binding. Alternative 1—modifying the optional table rate: The transaction coefficient has the effect of increasing the depreciation allowance to be recovered over the remaining recovery period of the asset. It is multiplied by the applicable depreciation rate from the optional table. In the replacement year, the product of the previous calculation must be adjusted for the applicable convention.10
For the exchange year, the new regulation requires splitting the depreciation between the relinquished property and the replacement property. To accomplish this, depreciation must be separately computed for each. Both properties are subject to the half-year convention; thus, each will be allowed a half-year’s depreciation in the exchange year. For the relinquished property, using the optional tables would result in a $960 allowable depreciation deduction ($10,000 0.192 0.5). For the replacement property, the exchanged basis (the remaining undepreciated basis) is $3,840 ($10,000 – $2,000 (2001 depreciation) – $3,200 (2002 depreciation) – $960 (2003 depreciation)). However, because the replacement property is seven-year property, the regulation will not allow depreciation of the remaining half-year of depreciation ($960). The regulation requires using the longer recovery period for the replacement property. In Example (1) of Temp. Regs. Sec. 1.168(i)-6T(e)(4), the ex-change occurs in year 3 (2003) of the original property’s five-year MACRS recovery period. According to the new regulation, to calculate the depreciation for the replacement property, the rate for year 3 from the optional table for seven-year property is used, because the property is treated “as if” it has already been depreciated for the years the relinquished property was depreciated (i.e., 2001 and 2002). This rate is then multiplied by the transaction coefficient to arrive at the modified rate to be used to calculate depreciation. The transaction coefficient formula is 1/(1 – x): x equals the sum of the annual depreciation rates identified with the replacement property (seven years in this example), beginning with the year the relinquished property was placed in service, and ending with the year preceding the exchange year. In the above example, the transaction coefficient is 1.6335 (1/(1 – 0.3878)), with x equaling the sum of the rates for years 1 and 2, or 0.3878 (0.1429 + 0.2449). The depreciation allowance for the replacement property for the exchange year is $549: 0.1749 (year-3 rate from the seven-year table) 1.6335 (transaction coefficient) half-year convention exchanged basis ($3,840). For each year after the exchange year, the taxpayer would multiply the applicable rate from the seven-year optional table by the transaction coefficient (1.6335) and the exchanged basis ($3,840). Exhibit 2 below, Optional tables approach, illustrates these calculations.
Alternative 2—electing out: Exhibit 2, Manual approach, illustrates the calculation without the optional tables. A comparison of the two approaches reveals that the transaction coefficient approach results in less depreciation per year until the final year. In the final year, it yields higher depreciation. As shown in the exhibits, year 8 depreciation is higher, because the transaction coefficient approach does not result in the asset being fully depreciated by the end of year 8 (the final year), without an adjustment. To correct this, Temp. Regs. Sec. 1.168(i)-6(T)(e)(2)(iii)12 permits a deduction of any remaining undepreciated cost in the asset’s final year. Difference between alternatives: Exhibit 2 shows that the difference in the annual depreciation between either modifying the optional table rate or electing out is greatest in the initial year, because an additional $137 depreciation occurs by opting out of the transaction coefficient approach (the manual calculation yields $686, as opposed to only $549 for the transaction coefficient approach). This is a 25% increase in allowable depreciation. Thus, for example, a like-kind exchange that generates $1 million depreciation for the replacement property using the transaction coefficient approach further illustrates the magnitude difference. By electing out, the annual depreciation can be increased by $250,000.13 For an exchange of five-year for seven-year MACRS property, each subsequent year after the exchange year will generate an additional 15% depreciation deduction from opting out of the transaction coefficient approach. If the objective is to maximize and accelerate the annual depreciation deduction, an opt-out election should be made. Alternatively, if the objective is to defer, rather than accelerate, allowable depreciation deductions, the transaction coefficient approach would appear to be preferable. There are two basic causes for the difference between the two methods. The first is found in Temp. Regs. Sec. 1.168(i)-6T(c)(5)(ii)(A), which does not permit the transaction coefficient approach to increase the exchanged basis for the partial year of depreciation taken on the relinquished asset in the disposition year in calculating depreciation for the remaining partial year of the exchange. However, Temp. Regs. Sec. 1.168(i)-6T(c)(5)(ii)(A)(2) states that this adjustment must be made for purposes of calculating depreciation, when not using the transaction coefficient approach on the exchanged basis in the exchange year. This adjustment is needed to permit a full-year’s depreciation for the ex-change year. For that year, the depreciation is to be split between the replacement and the relinquished properties. The effect of not making this adjustment is illustrated by returning to the example, but modifying the replacement property to be five-year, rather than seven-year, MACRS property. The regulation clarifies that the relinquished property and the replacement property should both be allowed a full half-year of depreciation (i.e., $1,920 split equally ($960 for each property)) between them.14 This will not occur when calculating depreciation for the replacement property on the exchanged basis, as such basis that has been reduced by the $960 of depreciation already allowed for the relinquished property. Thus, if the depreciation for the replacement property is calculated on the exchanged basis, which has already been reduced by $960, it will only be $768 (($3,840/5 years) 200% half-year convention), not $960 ((($3,840 + $960)/5 years) 200% half-year convention)) that the taxpayer should be entitled to deduct. For the year, the depreciation would be $1,728, rather than $1,920. The second reason for the difference between the two approaches is a limit inherent in the transaction coefficient itself. This approach does not provide an adjustment when the regulation requires the replacement property to use a different life and/or method from that of the relinquished property.15 In the above example, the replacement property was seven-year MACRS, and the relinquished property was five-year MACRS property. In the exchange year, a half-year of depreciation is calculated for the replacement property using the new seven-year life, and a half-year of depreciation is calculated for the relinquished property assuming a five-year life. The transaction coefficient approach is not designed to make this adjustment and, for years subsequent to the exchange, it adjusts “as if” a full year of seven-year MACRS activity had occurred in the initial year. In fact, a half-year of seven-year MACRS activity occurred in the exchange year. This results in depreciation in subsequent years being understated under the transaction coefficient approach. Conclusion The new regulation provides useful guidance on the depreciation of MACRS properties involved in a like-kind exchange or an involuntary conversion. However, the guidance on applying the transaction coefficient to such transactions suggests that, in most cases, it will be to the taxpayer’s advantage to elect out of using the optional tables. The benefit can be an increase of up to 25% in the allowable depreciation deduction in the exchange year. Regardless of the method chosen, it is important to verify that the amounts calculated have been computed for the relinquished and the replacement properties according to the preferred approach (even if the depreciation calculations are computer-generated). It is possible that the technology is performing the calculation in a manner similar to the transaction coefficient approach under Temp. Regs. Sec. 1.168(i)-6T(e), rather than the manual approach under Temp. Regs. Sec. 1.168(i)-6T(c)(5)(ii)(A). |
