New Guidance on Depreciation of Replacement Property Acquired In Like-Kind Exchanges (Reg. 1.168(i)-6)
Depreciation Guidance (pdf), for a more detailed explanation and example calculations.
Calculation Worksheet (pdf), to calculate basis in Replacement Property.
The IRS has issued final regs on how to depreciate MACRS property acquired in a Code Section 1031 exchange when both the acquired and the relinquished property are subject to MACRS in the hands of the taxpayer. The final regs adopt the previously issued temporary regs with only minor changes. The regulations apply to exchanges completed after February 27, 2004. Notice 2000-4, which provided interim guidance until the temporary regulations were issued is obsolete after February 27, 2004.
Taxpayers can elect-out of applying the new regulations if it is felt that the rules are too burdensome to use. In this case, the taxpayer must treat the entire basis of the replacement property as being replaced in service at the time of replacement. This is the way it was done before the IRS issued Notice 2000-4. According to the regulations, taxpayers who choose to elect-out of the provisions of the regulations can do so by typing at the top of Form 4562 "ELECTION MADE UNDER SECTION 1.168(i)-6T(i)."
Notice 2000-4 and the New Regulations
What Notice 2000-4 and the new Regulations tell us is that the tax-basis of replacement property acquired in a 1031 exchange or a §1033 condemnation sale is comprised of -
- Old Basis – The tax basis of the relinquished property just as if there had been no disposition at all (referred to as the "exchanged basis"), and
- New Basis – Additional basis obtained in the exchange (referred to as the "excess basis").
The concept of "Old Basis" and "New Basis" is retained in the new regulations and details of the application of the rules can be summarized as follows -
- Replacement property cannot be depreciated during the time-gap between the time the relinquished property is sold and the replacement property is acquired and put into service. So, the new depreciation schedule for the replacement property will have a depreciation start-date for "old basis" that is consistent with the start date of the depreciation of the "new basis."
- "Old Basis" will continue to be depreciated in the same manner as the relinquished property was being depreciated only if the replacement property has the same or shorter recovery life or depreciation method as the relinquished property had. Otherwise, the depreciation of the "old basis" will have to be modified as described in the following examples.
1. The replacement property has a longer MACRS recovery period than the relinquished property had. The "old basis" of the replacement property will be depreciated over what would have been left of the recovery period of the replacement property had the replacement property been placed in service in the same tax year that the relinquished property was placed in service.
Illustration – A taxpayer trades a 20-year farm property that he acquired ten-years ago for a 39-year commercial property. The commercial property has a 39-year MACRS recovery period and is treated as if it had been acquired ten-years ago. The remaining MACRS recovery period for the commercial property is 29-years (39-years minus 10-years). The taxpayer depreciates the commercial property over 29-years commencing with the date is it placed in service. This is not as good as being able to depreciate the commercial property over 20-years, but is still a break for the taxpayer.
2. The replacement property has a shorter MACRS recovery period than the relinquished property had. The "old basis" of the replacement property will be depreciated over the remaining recovery period of the relinquished property with no change.
3. The replacement property has a slower depreciation method than the relinquished property had. The "old basis" will be depreciated over the slower method of the replacement property.
4. The replacement property has a faster depreciation method than the relinquished property had. The "old basis" of the replacement property will be depreciated using the slower depreciation method with no change.
Transactions Involving Land
Land is never depreciable. Also, land is not MACRS property. If depreciable property and land are exchanged for land (with no buildings or improvements), the entire basis of the relinquished property becomes the tax basis of the land acquired as replacement property. If land and improvements are exchanged for land and improvements, the allocation of basis to the replacement land must be reasonable. For instance, if the relinquished property is a commercial building with about 10% of its value in land, and the replacement property is a farm land with a building on it worth about 10% of the purchase price of the replacement property, then the "exchanged basis" will have to be reallocated between buildings and land.