Depreciation of Like-Kind Exchange Property after Notice 2000-4

Notice 2000-4, on the treatment of depreciation of modified accelerated cost recovery system property received in a tax-deferred exchange, is generally viewed as taxpayer-favorable. However, an analysis of the provisions suggests a need for careful planning when effecting a like-kind exchange, to maximize the benefits and avoid the many tax traps.

J. David Mason, Ph.D. CPA
Visiting Assistant Professor
Clemson University
Clemson, SC

Linda Garrett Levy, Ph.D.
Assistant Professor
University of Colorado at Denver
Denver, CO

Richard L. Levy, J.D., LL.M.
Principal
National Exchange Service Group
Boulder, CO

For more information about this article, contact Dr. Mason at (864) 268-5992 or Mason2@Clemson.edu .

Executive Summary

• Taxpayers should rely on Notice 2000-4 until regulations are issued.

• Generally, the longer a taxpayer has held the relinquished property, the greater the benefits of Notice 2000-4.

• If the replacement property's adjusted basis exceeds that of the relinquished property, two assets are created.

Notice 2000-4¹ explains the treatment of depreciation on modified accelerated cost recovery system (MACRS) property received in a tax-deferred exchange under Sec. 1031 or involuntary conversion under Sec. 1033. The notice, while welcome, requires careful planning when effecting like-kind exchanges, to optimize the benefits and avoid the burdens.²

Background

The like-kind exchange has become a popular tax-deferral strategy for converting assets with built-in gain into other, similar property better suited to a taxpayer's needs. Sec. 1031(a) provides that, generally, no gain or loss is recognized on an exchange of property held for business or investment use solely for replacement property held for business or investment use.

In lieu of recognizing gain on the transaction, Sec. 1031(d) provides that a taxpayer takes a carryover basis in the replacement property (i.e., a taxpayer's basis in the replacement property equals his basis in the relinquished property). The basis of the new property (new basis) is increased to the extent of any boot paid or decreased to the extent of any boot received. The new basis is used in calculating any gain or loss on the property's subsequent sale.

This rule applies regardless of whether the properties involved are subject to depreciation. Because the basis of depreciable property carries over to the replacement property, an issue is whether a taxpayer should be allowed to use the relinquished property's depreciation method and schedule for replacement property, or must begin anew.

Pre-Notice 2000-4 Rules

For transfers prior to the Tax Reform Act of 1986 (TRA '86), Sec. 168 provided that any property placed in service after 1980 had to be treated as new property for depreciation purposes, regardless of how acquired. However, Sec. 168(f)(7) provided that future regulations would govern depreciation in property ex-changes not subject to tax (e.g., like-kind exchanges). Prop. Regs. Sec. 1.168-5(f)(2)(i), issued in 1984, provided that to the extent a taxpayer's basis in the new property was determined by reference to the basis in the transferred property, the taxpayer would continue to depreciate the property received in the exchange as if it were the transferred property; any excess basis would be treated as new property for depreciation purposes.

However, the TRA '86 overhaul of Sec. 168 did not retain Sec. 168(f)(7); thus, Treasury's authority to promulgate the exception terminated and the proposed regulation was withdrawn. For like-kind exchanges after 1986, there was no longer statutory authority allowing a taxpayer to continue to depreciate replacement property as the relinquished property, and excess basis as new property. This suggested that the replacement property had to be treated as new property for depreciation purposes.³

Example 1: X purchased a warehouse in January 1987 for $20,000,000 and depreciated it under the 31.5-year straight-line method. In 2000, X entered into a like-kind exchange of the warehouse for an office building. X's remaining basis in the warehouse became his basis in the office building. However, instead of being allowed to depreciate such basis over the remaining life, 18.5 years (31.5 years – 13 years), X is required to treat the building as a new asset and depreciate it over 39 years.

This approach can have a particularly harsh result, because X would effectively be depreciating a portion of the basis (approximately $11,700,000 of the warehouse's original cost) over 52 years (39 1 13) rather than 31.5, an additional 20.5 years. If instead, X had exchanged residential realty (27.5-year life) for nonresidential realty (39-year life), he would depreciate the remaining basis over an additional 24.5 years, not 20.5.

Thus, the type of property relinquished and its holding period before the exchange effect the tax results. In Notice 2000-4, the IRS adopted a taxpayer-favorable position to help mitigate this outcome for property acquired after 1986.

Notice 2000-4

Transfers of MACRS Property after Jan. 2, 2000

Notice 2000-4 states that, for acquired MACRS property placed in service after Jan. 2, 2000, in a like-kind exchange of MACRS property under Sec. 1031 or as a result of an involuntary conversion of MACRS property under Sec. 1033, a taxpayer must follow the principles set out in the notice. Further, Treasury will issue Sec. 168 regulations to address these issues; taxpayers are directed to rely on the notice until regulations are issued.

According to the notice, acquired MACRS property should be treated in the same way as the exchanged or involuntarily converted MACRS property, to the extent the taxpayer's basis in the acquired MACRS property does not exceed his 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 additional basis (i.e., cash paid) 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 2: Y purchased an apartment building in 1988 for $20,000,000 (MACRS residential realty) and depreciated it over 27.5 years. The building's adjusted basis and fair market value (FMV) at the end of 2000 were $12,000,000 and $25,000,000, respectively. At that time, Y exchanged the apartment building and $5,000,000 for an office building (MACRS nonresidential realty) with a $30,000,000 FMV. Y's basis in the office building is $17,000,000 ($12,000,000 + $5,000,000). Of this amount, $12,000,000 is old basis to be depreciated over 14.5 years, the apartment building's remaining life. The other $5,000,000 of basis is new basis to be depreciated over 39 years.

Thus, Y is required to continue to use the more favorable rates for MACRS residential realty, regardless of the fact that he now owns nonresidential realty. Y gets a benefit of continuing to use the older, more favorable depreciation schedule. Only the new basis is subject to nonresidential treatment.

Exchange of MACRS and Non-MACRS Realty

In a like-kind exchange, a taxpayer often relinquishes and/or receives both MACRS and non-MACRS realty (e.g., a depreciable building (Sec. 1250 (MACRS) property) and land (non-Sec. 1250 (non-MACRS) property). For Notice 2000-4 purposes, in an exchange involving both MACRS and non-MACRS properties, it is important to identify the separate bases of the MACRS and non-MACRS properties and to allocate any boot paid appropriately. To the extent a taxpayer's basis in the acquired property exceeds that of the transferred property, the excess (new basis) will be treated as newly purchased MACRS property. Although the notice does not discuss allocation of boot when both MACRS and non-MACRS property are involved, excess basis should be allocated pro rata based on the FMVs of the MACRS and non-MACRS realty received.

Example 3: In July 2000, Z exchanged his apartment complex for an office building. The following information is available:

Relinquished property

	Building (MACRS)	Land (non-MACRS)
FMV	$500,000	$200,000
Adjusted basis	$300,000	$50,000

Z received the office building in exchange for the apartment complex and $100,000. The office building information is as follows:

Replacement property

	Building	Land
FMV	$550,000	$250,000

Notice 2000-4 allows Z to continue to depreciate the old basis ($300,000) over the apartment complex's remaining recovery period. However, the MACRS portion of the excess basis, $68,750 ($100,000 x ($550,000/$800,000)), must be treated as newly purchased MACRS property with a 39-year life. The remaining excess basis, $31,250 ($100,000 + $68,750), is added to the land's basis.

Multiple-Property Exchanges

It is not uncommon for exchanges of improved realty to include personal property. Although the basis allocation rules for such exchanges are much more complex, Notice 2000-4 applies as illustrated in Example 3 above. The portion of the basis of the MACRS property determined with reference to the relinquished property is old basis subject to the carryover rules; any excess basis is treated as newly acquired MACRS property.⁴

Retroactive Application

Notice 2000-4 can also apply to pre-Jan. 3, 2000 transfers. For a limited time—no later than the second tax year ending after Jan. 3, 2000—the IRS will allow taxpayers to change methods for property acquired before Jan. 3, 2000. Thus, taxpayers can continue to treat the replacement property as newly acquired MACRS property, or may treat it as a continuation of the original property to the extent of the old property's carryover basis.

The change in depreciation methods is an accounting method change eligible for the automatic change provisions of Rev. Proc. 99-49.⁵ To the extent the change in depreciation method results in excess or inadequate depreciation (i.e., the difference in depreciation under the two approaches from the exchange year to the year the change is taken into account), it will be treated as a four-year Sec. 481 adjustment in computing taxable income. However, if the adjustment is less than $25,000, a taxpayer may elect to include it in income in the first change year.

Example 4: In 1997, A exchanged $50,000 and MACRS nonresidential realty purchased in 1992, with a $125,000 adjusted basis and $335,000 FMV, for MACRS property with a $385,000 FMV. For 1997–1999, A treated the acquired property as newly purchased MACRS property and depreciated the $175,000 basis ($125,000 old basis + $50,000 new basis) using a 39-year life. A may elect to change accounting methods and depreciate the $125,000 old basis over the relinquished property's remaining original life. The $50,000 of new basis is not eligible for this change. A, a calendar-year taxpayer, must make the change effective for his 2000 or 2001 tax year.

 

Tax Planning and Traps

Planning

Notice 2000-4 is seen as pro-taxpayer because it essentially allows accelerated depreciation deductions on exchanges entered into after the notice's effective date, through the use of a shorter life. In addition, taxpayers can apply the notice to like-kind exchanges entered into before the effective date. For tax planning purposes, it is generally true that the longer a taxpayer has held the relinquished property, the greater the tax benefit from the notice.

Pre-Jan. 3, 2000 Exchanges

Taxpayers who entered into exchanges of MACRS realty before the notice's effective date and treated the replacement property as new should reevaluate to determine if the tax benefits of treating the replacement property under the old method exceed the costs of changing methods. Change should be elected if the taxpayer:

1. Held the relinquished property long before the exchange.

2. Exchanged residential realty for nonresidential realty.

3. Exchanged 31.5-year nonresidential realty for 39-year nonresidential realty.

Example 5: B purchased an office building (nonresidential realty) in 1992 and depreciated it over 31.5 years. At the end of 1994, the adjusted basis and FMV were $4,000,000 and $6,000,000, respectively. At that time, B entered into a like-kind exchange; he transferred the office building and $1,000,000 for a different office building (nonresidential realty) with a $7,000,000 FMV. B treated the acquired building as new property and depreciated it over 39 years, rather than the relinquished property's remaining 28.5-year life. B should consider electing the Notice 2000-4 carryover rules, which would accelerate depreciation.

Example 6: C purchased an office building (nonresidential realty) in 1996 and depreciated it over 39 years. The adjusted basis and FMV at the end of 1999 were $9,000,000 and $12,000,000, respectively. At that time, C exchanged the office building and $1,000,000 for an apartment building (residential realty) with a $13,000,000 FMV. C originally treated the apartment building as new property and depreciated it over 27.5 years, rather than the office building's remaining 35-year life. C is not advised to elect under the notice.

Tax planning suggestions for pre-Notice 2000-4 exchanges are summarized in Exhibit 1.

.

Post-Jan. 2, 2000 Exchanges

Taxpayers contemplating acquiring MACRS nonresidential realty should consider exchanging residential property (27.5-year life) for nonresidential property (39-year life) under Sec. 1031. This could result in a shorter life for the acquired property than if nonresidential property was exchanged for nonresidential property.

Taxpayers seeking investment property should consider purchasing residential realty rather than nonresidential realty. If a taxpayer later seeks to exchange the residential realty for nonresidential realty, both pieces of property will be depreciated over the shorter residential realty rules (27.5 years). Caution is in order here; if the residential property is acquired with the intent to hold it for exchange purposes (rather than for investment or business purposes), the property will not qualify for like-kind exchange treatment.⁶ The taxpayer carries the burden of establishing intent.⁷

Tax planning considerations for post-Notice 2000-4 exchanges are summarized in Exhibit 2.

Traps

Recordkeeping: If the replacement property's adjusted basis exceeds the relinquished property's, additional recordkeeping obligations arise under Notice 2000-4; taxpayers cannot elect to treat the replacement property as a single newly acquired MACRS property. The notice requires taxpayers to treat such property as two assets: the first takes the carryover adjusted basis (depreciated as a continuation of the old asset) and the second takes the excess adjusted basis (depreciated as a newly acquired asset). Separate basis and depreciation calculations have to be maintained, as well as detailed records on tax attributes that carry over to the acquired properties. When the replacement property is eventually disposed of, the taxpayer must take into account both sets of basis and tax attribute records when calculating gain or loss.

Depreciation recapture: An otherwise tax-deferred like-kind exchange of either Sec. 1245 or 1250 property can result in gain recognition due to depreciation recapture. Secs. 1245 and 1250 override the Sec. 1031 nonrecognition provisions. This is a potential trap for exchanges of realty; the definition of like-kind refers to the character of the property, rather than to its nature or quality. Accordingly, any business or investment real property is treated as like-kind to any other real property held by a taxpayer for business or investment purposes, regardless of the realty's nature. It is irrelevant to Sec. 1031 exchange treatment whether the realty involved in the exchange is Sec. 1245 or 1250, improved or unimproved, ACRS, MACRS or nondepreciable. However, the realty's nature is critical to both the application of Notice 2000-4 and to the recapture provisions, because the depreciation recapture provisions apply whenever properties of dissimilar natures are exchanged.

Example 7: D acquired a single-purpose horticulture structure (MACRS) in 1990. In 2000, when the property was worth $200,000, fully depreciated and had $250,000 recapture potential, it was exchanged for unimproved realty with a $200,000 FMV (non-MACRS, non-Sec. 1245 property). D planned to build a single-purpose horticulture structure on the land. Although the exchange qualified for like-kind treatment, it ran afoul of the Sec. 1245(b)(4) recapture rules, because Sec. 1245 property was exchanged for non-Sec. 1245 property. Recapture of all previously taken depreciation, up to the FMV of the non-Sec. 1245 property received (limited to the FMV of the property relinquished), is required.

This exchange will trigger $200,000 depreciation recapture, resulting in $200,000 ordinary income. The remaining $50,000 of recapture potential will attach to the unimproved land and trigger additional deprecation recapture on the land's later sale. In addition, the structure to be built will be treated as new property for depreciation purposes.

Tax planning: Instead of exchanging the Sec. 1245 structure for the unimproved land, D should have entered into a new construction Sec. 1031 exchange, under which the horticulture structure would be constructed, then exchanged for the old property. D could have accomplished his objectives (i.e., acquiring a new structure) and avoided the recapture provisions on the exchange of Sec. 1245 property for Sec. 1245 property. Further, to the extent basis in the new structure is a carryover basis, the transaction would qualify for Notice 2000-4 treatment. Only the excess basis would be newly acquired property for MACRS purposes; see Exhibit 3.

Another trap is inadvertently exchanging ACRS realty for MACRS realty. If this occurs, the benefits of Notice 2000-4 depreciation carryover are lost. The notice does not address this issue, because it addresses only the exchange of MACRS property for MACRS property; thus, it cannot be used for guidance in any exchange involving one or more non-MACRS properties. The IRS will continue to treat the replacement property in such situations as newly acquired (i.e., placed in service currently, subject to the MACRS rules and conventions of the exchange year). In addition, depreciation recapture may result.

Example 8: Several years ago, E acquired an office building and depreciated it under the then-applicable ACRS rules for real estate. In 2000, E exchanged the building for another office building (MACRS) of equal value. The total depreciation to the date of exchange was $500,000; the FMV was $750,000. The exchange qualified for Sec. 1031 treatment, but not for the carryover depreciation rules, because Notice 2000-4 applies only to exchanges of MACRS property. Further, if the original office building was placed in service 1980–1987 and an accelerated depreciation method used, it is deemed Sec. 1245 property, not Sec. 1250 property. Because the FMV of the non-Sec. 1245 property received is greater than the total depreciation taken, the full amount of depreciation taken ($500,000) will be recaptured and taxed as ordinary income.

Tax planning: Rather than exchanging the old building and paying tax on recapture, E should consider remodeling the building and holding it until death; his heirs will receive a step-up in basis and no depreciation recapture potential.

The depreciation traps to avoid in like-kind exchanges are summarized in Exhibit 4.

Conclusion

Notice 2000-4 may generally be viewed as good news for taxpayers. However, this deceptively simple pronouncement can prove to be a burden for inadequately planned and executed like-kind exchanges. As with virtually every other aspect of a Sec. 1031 exchange, many practical considerations must be addressed to take advantage of the planning opportunities and avoid the many tax traps. The goal is to achieve a tax-deferred transaction that will qualify for taxpayer-favorable treatment.