Depreciation of property received in a like-kind exchange.

Sec. 1031(a) provides that a taxpayer that transfers depreciable property held for use in its business and receives back solely property of like kind to be held for productive use in its business (i.e., a like-kind exchange) does not recognize gain or loss on the exchange. Instead, under Sec. 1031(d), the taxpayer takes a basis in the depreciable property received in the exchange equal to the basis it had in the depreciable property transferred. In a like-kind exchange of depreciable tangible property after 1986, must a taxpayer depreciate the entire basis of the property received in the exchange over a new depreciation period, as if the taxpayer had purchased the property? This has proven to be a "trap for the unwary" in many cases, because the conclusion is that the taxpayer will be required to do so.

The analysis that supports this conclusion begins with Sec. 168 as in effect prior to the fax Reform Act of 1986 (TRA) (former Sec. 168). Generally, under former Sec. 168, the basis of depreciable tangible property placed in service by a taxpayer after 1980 (referred to as "recovery property") was treated as new property and was depreciated over the applicable recovery period incorporated in tables provided in former Sec. 168. Unless an exception applied, this general rule applied whether the taxpayer purchased the property, constructed it or acquired it in a transaction in which no gain or loss was required to be recognized (e.g., a Sec. 731 or 1031 transaction).

Former Sec. 168 contained two exceptions to the general rule that applied to nonrecognition transactions. The first exception, in former Sec. 168(f)(10), provided that, in the case of recovery property transferred in a transaction described in Sec. 332, 351, 361, 371(a), 374(a), 721 or 731, the transferee was treated as the transferor for purposes of computing the depreciation deductions allowable with respect to so much of the basis in the hands of the transferee as did not exceed the adjusted basis in the hands of the transferor (the "step-into-the-shoes" rule). Thus, for example, if a taxpayer received property in a distribution from a partnership under Sec. 731, the taxpayer "stepped into the shoes" of the partnership, to the extent of the partnership's basis in the property at the time of the distribution, and continued depreciating the property as if the property had not been distributed.

The second exception, in former Sec. 168(f)(7),provided that,notwithstanding any other provision of Sec. 168, the depreciation deduction allowed in the tax year in which recovery property was acquired or disposed of in a transaction in which gain or loss was not recognized in whole or in part, was to be determined in accordance with regulations prescribed by the Secretary. Pursuant to this authority,Treasury promulgated Prop. Regs. Sec. 1.168-5(f), which specified exceptions to the general rule for Sec. 1031 transactions, as well as for Sec. 1033 transactions and transfers of property by gift and by reason of death. Specifically, Prop. Regs. Sec. 1.168-5(f) provided that, in a transaction described in Sec. 1031, the allowable depreciation deduction for the exchanged and acquired properties was determined under rules similar to the "step-into-the-shoes" rule. Thus, if a taxpayer received property in a Sec. 1031 like-kind exchange, to the extent of the taxpayer's basis in the property transferred in the exchange, the taxpayer continued depreciating the property received in the exchange as if it had retained the transferred property.

In the TRA, Congress enacted a modified version of Sec. 168, applicable generally to depreciable tangible property placed in service after 1986. A subtle, unexplained change made by the TRA leads to the conclusion that depreciation starts anew for property acquired after 1986 in a Sec. 1031 like-kind exchange Congress retained the general rule that the basis of property placed in service by a taxpayer is depreciated over a new depreciation period, regardless of how the taxpayer acquired the property (i.e. whether the taxpayer purchased the property or acquired it in a nonrecognition transaction). Congress also retained the "step-into-the-shoes" exception provided in former Sec. 168(f)(10) for the transactions specified in that section (i.e., transactions described in Sec. 332, 351, 361, 721 or 731); this exception was moved to Sec. 168(i)(7). Congress did not, however, retain the exception provided in former Sec. 168(f)(7) that gave Treasury the authority to promulgate regulations providing special treatment for other nonrecognition transactions (such as Sec. 1031 like-kind exchanges). Furthermore, Congress did not provide any statutory exception for nonrecognition transactions other than those contained in Sec. 168(i)(7). Accordingly, for property received by a taxpayer in a Sec. 1031 like-kind exchange after 1986, the general rule applies, requiring the taxpayer to depreciate over a new recovery period the entire basis of the property acquired.

Did Congress intend this change in the treatment of Sec. 1031 transactions? Although it is generally understood that Congress did intend this change, there is no mention of it in either the TRA's legislative history or General Explanation. This is rather curious, to say the least, given the significant negative impact the change generally had on like-kind exchanges.

Example: Taxpayer T purchased an office building in 1986 for $19,000,000. Under former Sec. 168, T generally would have depreciated the building over 19 years using the straight-line method. By 1997, T would have taken depreciation deductions of approximately $10,000,000. If the rule under former Sec. 168(f)(7) were still in effect, T would continue to depreciate the remaining $9,000,000 over the next nine years, even if the building were exchanged for another office building in a Sec. 1031 exchange.

Following the TRA, however, depreciation of an office building received in a like-kind exchange would begin anew: T would be required to treat the office building received in the exchange as a new property and depreciate the $9,000,000 basis over a new 39-year period.

From Richard G. Blumenreich, J.D., LL.M., Washington, D.C.