Basis in Replacement Property from Like-Kind Exchanges

In Notice 2000-4, the IRS issued new guidance on depreciation of replacement property acquired through a like-kind exchange under Secs. 1031 and 1033. Before the notice, there was little direction on how to depreciate the basis of acquired property in a tax-deferred exchange under Sec. 168, 1031 or 1033. The principles outlined in this notice are effective for tax years ending after Jan. 3, 2000, and will remain in effect until Treasury issues proposed regulations.

Depreciation Treatment of Acquired Property

The depreciation allowable for tangible property placed in service after 1986 generally is determined under Sec. 168. Because no gain or loss is recognized under Secs. 1031 and 1033 on the exchange of property held for the productive use in a trade or business or for investment, the basis of property acquired is generally the same as the basis of the property surrendered in the transaction, less any cash received, plus any gain recognized on the exchange. Any additional amounts invested in excess of the net proceeds on the exchange increase the depreciable basis of the replacement property. Until Notice 2000-4, property acquired in a tax-deferred exchange could be depreciated as a new asset or as a continuation of the old asset (as provided for in Prop. Regs. Sec. 1.168-5(f)).

Notice 2000-4 states that the acquired property in a tax-deferred exchange should retain the attributes of the old asset exchanged in the transaction. For all intents and purposes, the property should be depreciated as if nothing had happened. The old asset's adjusted basis will continue to be depreciated over the remaining useful life immediately before the exchange. The character of the depreciation expense deducted under Sec. 168 in prior years will be retained as Sec. 1245 depreciation or Sec. 1250 unrecaptured depreciation. In the event of a gain on the sale of the replacement property, a taxpayer will recapture the depreciation taken on the pre-exchange asset to the extent proceeds equal or exceed depreciation taken on that asset (sales within two years of a related-party exchange will void the tax-deferred exchange, as provided for under Sec. 1031(f)(1)). Any amounts invested in excess of the net proceeds received on the like-kind exchange are treated as a new asset whose holding period begins on the date of the exchange and is depreciated according to its depreciation class life.

Example: A commercial building was placed in service in July 1987, with a cost of $2,000,000. Depreciation of $664,530 was taken until Dec. 31, 1999, when it was exchanged for another building with a fair market value (FMV) of $1,500,000 and $1,000,000 in cash.

If, instead of receiving $1 million boot, the taxpayer had paid $1 million in addition to the property exchanged, the new property would be entitled to a basis of $2,211,640, of which $1,211,640 would continue to be depreciated over the remaining life of the old property exchanged and $1,000,000 would be treated as a new asset and depreciated over 39 years.

Transition

For exchanges on or after Jan. 3, 2000, taxpayers should follow the guidelines of Notice 2000-4. If the taxpayer exchanged an asset before this effective date and set up the replacement property as a new asset, the IRS will allow a change of method for the first or second tax year ending after Jan. 3, 2000. After this time, the taxpayer is required to continue using whatever method was employed at the date of the exchange. If the taxpayer makes a change to its method of depreciation for the replacement property, a change in accounting method on Form 3115, Application for Change in Accounting Method, must be filed. This change is eligible for automatic change procedures and does not require prior approval from the Service. Further guidance is available in Rev. Proc. 99-49.

From Mark E. Abrams, CPA, Smith & Howard, PC, Atlanta, GA