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Depreciating property following a like-kind exchange. (Case Study).

Facts: In February 1990, Jim and Ann Hall acquired real property for $500,000 ($100,000 allocated to the land and $400,000 to a commercial building that they lease). Consistent with the rules that applied to nonresidential real property acquired after Dec. 31, 1986 and before May 13, 1993, the Halls have been depreciating the building's $400,000 cost over 31.5 years. Thus, at the end of the 2000 tax year, the Halls had a $261,896 adjusted basis in the building ($400,000 cost - $138,104 depreciation). * In February 2001, the Halls exchanged the land (now worth $150,000), building (worth $550,000) and a $300,000 note, for a larger building and land worth $1 million ($200,000 for the land and $800,000 for the building). The Halls have a realized gain of $338,104 ($1 million value of property received -- $261,896 building basis -- $100,000 land -- $300,000 boot (cash) given). However, none of this gain is realized because the Halls received only like-kind property (and no boot) in the transaction. Issue: How do the Halls depreciate the like-kind property received in the exchange after Notice 2000-4?

Analysis

According to Notice 2000-4, the IRS plans to issue regulations that basically provide carryover basis and depreciation for property received in a like-kind exchange, to the extent of the basis of the property given up. If the basis of the newly acquired property is greater than the old property's, the difference becomes new modified accelerated cost recovery system (MACRS) property, resulting in increased depreciation even though a taxpayer recognizes no gain. Until the Service issues regulations, taxpayers must follow, for property acquired after Jan. 2, 2000, the guidance provided in Notice 2000-4.

Based on the guidance in Regs. Secs. 1.1250-3(d)(6)(ii) and 1.1031(j)-1(d), the Halls realized and recognized gain. The bases of the properties they receive are as follows:

Prior to Notice 2000-4, the Halls might have treated the $501,896 as new real property and depreciated this entire amount over 39 years, beginning in February 2001 (Method A), or they might have treated the property's basis as having two parts--an old portion (equal to a cost of $400,000 and accumulated depreciation of $138,104) and a new portion (equal to the $240,000 allocable portion of the cash paid). The old portion would continue to be depreciated as it was prior to the like-kind exchange, and the new portion would be treated as new 39-year property placed in service in February 2001 (Method B).

Although the two methods will eventually result in the same total depreciation claimed, due to the time value of money (i.e., a deduction today is worth more than a deduction tomorrow, assuming a constant tax rate), Method B is superior. Of course, in the Halls' situation, that is fortuitous; because the like-kind exchange occurred after Jan. 2, 2000, they must use Method B.

To illustrate the advantage of Method B over Method A, Exhibit 1 presents the Halls' depreciation deductions over the next five years under the two methods.

Planning tip. Although the regulations that the Service plans to issue may say otherwise, currently there is nothing that prevents a taxpayer from acquiring an asset with a short depreciable life and later (before the original asset is fully depreciated) swapping it for a longer depreciable-life asset, as long as both properties are like-kind and held either for investment purposes or for use in a trade or business. The effect of such a transaction would be to speed up the depreciation of the asset acquired in the exchange.

Variation. The facts are the same, except that the Halls' old property is an apartment building (rather than a manufacturing facility). In this situation, the carryover portion of the basis in the new building would be depreciated over what was left of the apartment building's original 27.5-year depreciable life. Thus, the advantage of Method B over Method A in the exhibit would be even greater.

Case Study Update

In the August 2001 Case Study, "Computing Stock and Debt Basis when Stock Is Sold during he Year," p. 560, it was indicated that William had a long-term capital gain of $22,000 from a note repayment. Rather, the gain was short-term capital gain (as the note had a short-term holding period).
 Land Building

Value of property
 received $200,000 $800,000
Less: Adjusted basis
 of properly given (100,000) (261,896)
Cash boot given
 (allocated based on
 relative fair market value
 (FMV) of properly received) (60,000) (240,000)
Gain realized $ 40,000 $298,104
Gain recognized (lesser of gain
 realized or boot received) $ 0 $ 0
Adjusted basis of
 properly given up $100,000 $261,896
Plus: FMV of boot given
 (allocated based on
 relative FMV of properly
 received) 60,000 240,000
Gain recognized
 in the transaction 0 0
Less: FMV of boot
 received (0) (0)
Basis of property
 received $160,000 $501,896
Exhibit 1: Methods A and B Comparison

 2001 2002 2003 2004 2005

Method A $11,278 $12,869 $12,869 $12,869 $12,869
Method B $18,089 $18,854 $18,850 $18,854 $18,850
Advantage of
 B over A $ 6,811 $ 5,985 $ 5,981 $ 5,985 $ 5,981


Editor: Albert B. Ellentuck, Esq. Of Counsel King and Nordlinger, L.L.P. Arlington, VA
COPYRIGHT 2001 American Institute of CPA's
No portion of this article can be reproduced without the express written permission from the copyright holder.
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Author:Ellentuck, Albert B.
Publication:The Tax Adviser
Geographic Code:1USA
Date:Nov 1, 2001
Words:897
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