On this More More Monday we are discussing a tax trap that has surprised many Taxpayers completing a 1031 exchange. We all know one the biggest reasons one completes an exchange is to defer the capital gains. We have also discussed in previous Exchanging Times posts that a 1031 exchange will also defer the depreciation so no recapture is due. Unfortunately, that is true only if the replacement property is depreciable property.
The basis of a replacement property acquired in a 1031 exchange is lowered by the deferred gain. Essentially, the basis is carried to the new property and increased by any additional property value acquired.
T.D. 9115 (2/27/04) is a clarification of Notice 2000-4 and states the basis of the replacement property is generally the same as that of the relinquished property less any cash received plus any gain recognized. Notice 2000-4 clarified how Modified Accelerated Cost Recovery System (MACRS) replacement property should be depreciated. The MACRS replacement property should be treated in the same manner as the MACRS relinquished property with respect to so much of the Exchanger’s basis in the replacement property as does not exceed the Exchanger’s adjusted basis in the relinquished property. The replacement property is depreciated over the remaining recovery period of, and using the same depreciation method and convention as that of the relinquished property. Any excess basis in the replacement property is treated as newly acquired MACRS property. There will generally be at least two different depreciation schedules in place on one asset. Notice 2000-4 applies to properties placed into service on or after January 3, 2000. T.D. 9115 now gives Exchangers the option to elect out of this depreciation treatment.
The problem comes in when non-depreciable property, such as land, is acquired. In that situation, the Exchanger will be unable to defer the depreciation and will be required to recapture the depreciation. Nonetheless, a 1031 exchange can still be a powerful tax strategy even when depreciation must be recaptured. Consult your tax advisor to help you determine if an exchange will work in your situation.
For more information, please contact the 1031 CORP. Exchange Team.
