Partnership Exchange Issues, Including Mergers and Divisions
Basis and Depreciation Issues
By Gregory J. Rocca and Michael K. Phillips
Copyright 2005 Pacific Realty Exchange, Inc. All rights reserved.
Basis in replacement property is determined under Section 1031(d). Under the
shortcut method, the basis is equal to the fair market value of the replacement
property less the deferred gain on the exchange. See Form 8824. Thus, all
of the deferred gain is preserved in the lower substitute basis of the replacement
property for future recognition if the replacement property is sold in a
taxable transaction. If more than one replacement property is received in
the exchange, the aggregate basis determined under Section 1031(d) is allocated
proportionately to each like-kind property received in accordance with its
fair market value. Rev. Rul. 68-36, 1968-1 C.B. 357.
Special rules under Reg. Section 1.1031(j)-1 govern the computation of
recognized gain and the calculation of basis when a transaction qualifies
as a multiple property exchange. A transaction is treated as a multiple
property exchange when: (i) the taxpayer relinquishes at least one qualifying
property and receives two or more replacement properties of like kind or
like class; (ii) the taxpayer relinquishes two or more qualifying properties
of like kind or like class and receives at least one replacement property
of the same kind or class; or (iii) the taxpayer relinquishes two or more
qualifying properties of different kinds or classes and receives qualifying
replacement properties of like kind or like class to at lease two of the
different types of relinquished property. If a real property exchange involves
the transfer and receipt of any like-kind or like-class personal property,
the multiple property analysis must be used to calculate the gain realized
and recognized from the exchange. This will be the case if cost segregation
has been applied to real estate to separate the personal property components
of the relinquished or replacement property.
The properties must be separated into exchange groups with each exchange
group including at least one relinquished property and one replacement property.
An exchange group consists of all properties relinquished and all properties
acquired in the exchange that are of like kind or like class. Once the amount
of gain realized and recognized in each exchange group and any residual
group is determined, the basis in the replacement property can be calculated.
Basis is calculated within each exchange group under the general principles
of Section 1031(d). The resulting basis of each exchange group is allocated
proportionately to each property received in the group in accordance with
its fair market value under Rev. Rul. 68-36.
On February 27, 2004, proposed and temporary regulations under section
168 were issued to provide guidance for computing depreciation deductions
on MACRS property acquired in transactions subject to Sections 1031 and
1033. T.D. 9115, 69 F.R. 9529. These regulations expand upon IRS Notice
2000-4 by adopting the step-in-the-shoes principle for carryover basis while
providing more detailed guidance on how to compute replacement property
depreciation deductions. The regulations apply only for purposes of computing
depreciation deductions when both the transferred and received property
is subject to MACRS. The regulations do not apply if either the relinquished
or replacement property is subject to a recovery system other than MACRS,
such as pre-1987 ACRS, amortization under Section 197 or where the taxpayer
has elected to exclude the relinquished property from MACRS under Section
168(f)(1).
Under the regulations, depreciation is not allowed if relinquished property
is disposed of in the same year that the property is placed in service.
Depreciation is not allowed for either the replacement or relinquished property
in a like-kind exchange or involuntary conversion if the replacement property
is disposed of during the same year that the relinquished property is placed
in service. Reg. Section 1.168(i)-6T(c)(5). These rules apply when a taxpayer
uses regular MACRS recovery methods and also when a taxpayer elects to apply
optional methods. Depreciation of relinquished property for the year of
the exchange is calculated based on the amount of time that the property
is in service in that year. Reg. Section 1.168(i)-6T(c)(5)(i)
The new regulations focus on the treatment of the "depreciable exchanged
basis" (i.e., carryover basis) that is carried over from a relinquished
property to a replacement property. Exchanged basis is the lesser of (1)
the adjusted basis of the relinquished property, or (2) the basis in the
replacement property. Reg. Section 1.168(i)-6T(b)(7). Excess basis is calculated
after the depreciation deductions for the relinquished property in the year
of disposition are determined. Depreciable exchanged basis equals the exchanged
basis reduced by (i) any use of the relinquished property in the year of
acquisition other than in a taxpayer's trade or business; or (ii) adjustments
to basis resulting from other Code provisions, such as first year bonus
depreciation under Code Section 168(k) or Liberty Zone credits under Section
1400L(b).
Depreciation conventions affect the annual depreciation allowance for property
by defining what amount of recovery is available in the years when a taxpayer
places a property in service and takes the property out of service. The
half-year convention assumes for depreciation calculation purposes that
property is placed in service and removed from service at the midpoint of
the year. This convention provides a 50% depreciation regular allowance
in those years (not considering any bonus allowances). Improved residential
and non-residential real estate (as well as railroad grading and tunnel
boring equipment) is subject to a mid-month convention. The mid-month convention
permits a more precise allocation of the annual allowance in the initial
and final years of depreciation. Where more that 40% of depreciable property
(other than most real estate) is placed in service at the end of a year,
Section 168 requires use of a mid-quarter convention. The mid-quarter convention
is designed to prevent excess deductions through year-end acquisitions and
allows a 12.5% (of annual) depreciation allowance in the first year a property
has been placed in service.
It is permissible to exchange improved residential real property (subject
to the mid-month convention) for land improvements (subject to the mid-year
convention). It is also possible to exchange property subject to the mid-quarter
convention for property subject to the mid-year convention. Every like-kind
exchange or involuntary disposition must take into account the conventions
applicable to the initial year of the replacement property and the final
year of the relinquished property. Thus, the regulations address transitions
from relinquished property subject to one convention to replacement property
subject to another convention. See Reg. Section 1.168(i)-6T(c)(4)(v)(A).
Under these rules, if property depreciated using the mid-month convention
is acquired as replacement property for relinquished property depreciated
using the half-year convention, the exchanged basis in replacement property
is deemed to be placed in service in the month that is the mid-point of
its placed in service year (July for calendar year taxpayers), but must
be depreciated using the mid-¬month convention. This can occur where
fixtures classified as real property under state law but as property eligible
for 5 or 7 year recovery under Section 168 or land improvements or other
real estate eligible for 15 year recovery, which are subject to the half-year
convention, are exchanged for residential or non-residential real property.
If property depreciated using the mid-month convention is acquired as replacement
property for relinquished property depreciated using the mid-quarter convention,
the replacement property's exchanged basis is deemed to be placed in service
in the month that is the mid-point of the relinquished property's placed
in service quarter and must be depreciated using the mid-month convention.
Regardless of whether replacement property would otherwise be subject to
the half-year convention, if it is received as replacement property for
an asset subject to the mid-quarter convention, the mid-quarter convention
applies to the exchanged basis component of the replacement property.
If both the applicable recovery period and depreciation method for the
replacement property are the same as the recovery period and method for
the relinquished property, the depreciation deduction attributable to depreciable
exchanged basis is calculated using the same recovery period and method
as the relinquished property. Reg. Section 1.168(i)-6T(c)(3)(ii). If either
the recovery period or the depreciation method for the replacement property
is the same as the recovery period or method for the relinquished property,
the depreciation deduction for the depreciable exchanged basis is calculated
using the recovery period or the method that is the same as that of the
relinquished property.
If either the recovery period or depreciation method for the replacement
property is not the same as the recovery period or method for the relinquished
property, the following rules apply: (1) if the recovery period for the
replacement property is longer than the period for the relinquished property,
the depreciation deduction applicable to the depreciable exchanged basis
is calculated as though the replacement property had originally been placed
in service in the same taxable year the relinquished property was placed
in service, but using the longer recovery period of the replacement property;
(2) if the recovery period for the replacement property is shorter than
the period for the relinquished property, the depreciation deduction is
calculated using the same (i.e., longer) recovery period as that of the
relinquished property; (3) if the depreciation method for the replacement
property is less accelerated than the method for the relinquished property,
the depreciation deduction is calculated as though the replacement property
had originally been place in service at the same time as the relinquished
property, but using the less accelerated method; and (4) if the depreciation
method for the replacement property is more accelerated than the method
for the relinquished property, the depreciation deduction is calculated
using the same (i.e., less accelerated) depreciation method as the relinquished
property. If the replacement property has the same or shorter recovery period,
or the same or more accelerated depreciation method, the depreciable exchanged
basis component of replacement property is depreciated over the remaining
recovery period of, and using the same depreciation method and convention
as, the relinquished property.
In simultaneous exchanges involving property with depreciable exchanged
basis, the taxpayer will need to compute deductions attributable to both
the relinquished and replacement properties in the year of the exchange.
Calculation of the replacement property deduction is based on an allocation
of the deduction to the year of the replacement property acquisition based
on the length of that year and the number of months in the year in which
the replacement property is in service. This eliminates depreciation deductions
relating to periods when no property is owned in a deferred exchange. Under
these rules, a single year's depreciation associated with depreciable exchanged
basis is divided between the periods that the basis was connected to the
relinquished property and then to the replacement property. See Reg. Section
1.168(i)-6T(c)(5)(ii).
In a like-kind exchange, land or other non-depreciable property may be
received in exchange for depreciable property since unimproved real property
is like kind to improved real property under Section 1031. The regulations
explicitly provide that land and other non-depreciable property received
in an exchange or conversion transaction is not eligible for depreciation.
If both MACRS property and non-depreciable property are acquired in an exchange,
the exchanged basis must first be allocated between the depreciable and
non-depreciable property based on the regulations under Section 1031(d)
and using a relative fair market value method. Rev. Rul. 68-36. If MACRS
depreciable property is acquired as replacement property for land or other
non-depreciable property, the newly created MACRS basis in the replacement
property attributable to the relinquished non-depreciable property is treated
as placed in service in the year of replacement. See Reg. Section 1.168(i)-6T(d)(2)(ii).
Such basis is depreciated using the applicable recovery period, method and
convention prescribed in Section 168 for that type of property under a "fresh
start" method.
Excess basis (i.e., "new" or "additional" basis) is
the excess of the basis in the replacement property (as determined under
Section 1031(d)) over exchanged basis. Depreciable excess basis is excess
basis reduced by (i) the percentage of that basis attributable to the taxpayer's
use of the replacement property in the year of acquisition other than in
a taxpayer's trade or business; and (ii) adjustments to basis resulting
from other Code provisions, such as Section 179 expensing, bonus depreciation
under Code Section 168(k) or Liberty Zone credits under Section 1400L(b).
Reg. Section 1.168(i)-6T(b)(10). Generally the new regulations treat the
excess basis in replacement MACRS property as newly acquired property that
is placed in service in the year of replacement. The depreciation allowance
for depreciable excess basis is determined by using the applicable recovery
period, depreciation method, and convention prescribed under Section 168
for the specific type of property at the time of replacement. Only excess
basis in replacement property is eligible for the Section 179 election to
expense the cost of newly placed in service property.
The regulations provide that a taxpayer my elect not to apply these regulations.
See Reg. Section 1.168(i)-6T(i). If this election is made the entire basis
of the replacement property (i.e., both the exchanged and excess basis)
is treated as being placed in service at the time of replacement. The relinquished
property is treated as disposed of at the time of disposition. The election
is made separately by each person acquiring replacement property and a separate
election is required for each like-kind exchange or involuntary conversion.
The election must be made by writing at the top of Form 4562, "Election
Made Under Section 1.168(i)-6T(i)," or in the manner provided for on
Form 4562 or its instructions. In an exchange of multiple assets, taxpayers
may be able to make the election on an asset-by-asset basis and exclude
certain assets from the application of the regulations.
The new regulations provide that "depreciation is not allowable during
the period between disposition of the relinquished MACRS property and the
acquisition of the replacement MACRS property." See Reg. Section 168(i)-6T(c)(5)(iii)(A).
When a deferred exchange is completed in the year following the year of
the relinquished property transfer, depreciation for the year of the relinquished
property disposition is not added back to depreciable exchanged basis when
calculating depreciation for the year of the replacement property acquisition.
The year of disposition has closed, and the deduction in the subsequent
year for the replacement property acquisition should be based on the adjusted
depreciable basis as of the start of that year.
The regulations provide that in a like-kind exchange, the carryover basis
and excess basis, if any, of acquired MACRS property are eligible for the
addition first year deprecation deductions if the acquired property is "qualified
property” under Section 168(k)(2) (property for which the 30% deduction
is allowable) or under Section 168(k)(4) (property for which the 50% deduction
is allowable). The depreciable property must be of a specified type, such
as MACRS property that has a recovery period of 20 years or less, certain
computer software, certain water utility property, and qualified leasehold
improvement property depreciated under Section 168. Qualified leasehold
improvement property does not include improvements attributable to the enlargement
or internal structural framework of a building, any elevator or escalator,
and any structural component benefiting a common area. The original use
of the depreciable property must commence with the taxpayer after September
10, 2001 for 30% qualifying property or after May 5, 2003 for 50% qualifying
property. Qualified property must be placed in service before January 1,
2005. |