Practical application of the new MACRS depreciation regs.
Sec. 167 permits as a depreciation deduction a reasonable allowance for exhaustion or wear and tear of property held for use in a trade or business or for the production of income. Sec. 168 generally governs the depreciation of tangible property placed in service after 1986 (MACRS property). Sec. 1031 (a)(1) provides that, generally, no gain or loss is recognized on an exchange of like-kind property. Under Sec. 1033(a)(1), generally, no gain or loss is recognized if property is compulsorily or involuntarily converted into similar or related use property. Property acquired in a transaction to which Sec. 1031 or 1033 applies generally takes the same basis as the property surrendered in the exchange, less any cash received, plus any gain recognized. However, prior to 2000, there was no guidance under Sec. 168 for determining the appropriate depreciation adjustment for MACRS property acquired in these transactions.
In January 2000, the IRS issued Notice 2000-4, to provide guidance for depreciating MACRS property acquired in a Sec. 1031 like-kind exchange or as a result of a Sec. 1033 involuntary conversion. According to the notice, the IRS intended to issue regulations under Sec. 168 to address these transactions, and taxpayers were instructed to follow the principles of Notice 2000-4 until the IRS issued the regulations.
Under the notice, the carryover basis of acquired MACRS property is depreciated over the remaining recovery period of the exchanged or involuntarily converted MACRS property, using the same depreciation method, recovery period and convention. Thus, "step into the shoes" principles were required for the carryover basis. Any excess basis acquired in the exchange or involuntary conversion is treated as newly purchased MACRS property. Notice 2000-4's provisions were mandatory for MACRS property placed in service after Jan. 2, 2000, if acquired in exchange for MACRS property in a Sec. 1031 like-kind exchange or Sec. 1033 involuntary conversion.
Temp. Kegs. Sec. 1.168(i)-6T provides a depreciation regime that requires determining the depreciation method and recovery period that would have been applicable had the replacement property been placed in service during the same tax year as the relinquished property. For these purposes, any election to apply the 150%-declining-balance method or the straight-line method to a class of property, made in the year the relinquished property was placed into service, is taken into account.
Acquired replacement MACRS property that has the same or shorter recovery period, and the same or more accelerated depreciation method, as the relinquished MACRS property, is subject to a general step-into-the shoes rule (i.e., similar to the principles of Notice 2000-4). Under the general rule, the replacement property's exchanged basis is depreciated over the remaining recovery period (taking into account the applicable convention), using the same depreciation method of the relinquished MACRS property.
However, according to Temp. Kegs. Sec. 1.168(i)-6T(c)(4)(i), if the replacement MACRS property has a longer recovery period than the relinquished MACRS property, the carryover basis is depreciated beginning in the replacement year, over the remaining recovery period applicable had the replacement property been placed in service on the relinquished property's placed-in-service date. Similarly, under Temp. Regs. Sec. 1.168(i)-6T(c)(4)(iii), if the replacement MACRS property has a less accelerated depreciation method than the relinquished property, the acquired replacement property is depreciated using the less accelerated method that would have applied had it been placed in service on the date the relinquished MACRS property was originally placed in service.
Example: Q originally acquired a building for use as a restaurant in January 1996. The property wax subject to depreciation using the straight-line method, with a 39-year recovery period and the mid-month convention. In January 2004, when the property had been depreciated for eight full years, Q exchanged the restaurant for a radio tower, in a Sec. 1031 exchange.
Had Q placed the radio tower in service in January 1996, it would have been subject to depreciation under the 150%-declining-balance method over a 15-year recovery period and a half-year convention. The radio tower (the replacement property) would have been subject to a shorter recovery period and a more accelerated depreciation method than the restaurant (the relinquished property). Accordingly, under Temp. Regs. Sec. 1.168(i)-6T(c)(4)(ii) and (iii), the radio tower's depreciable exchanged basis is to be depreciated over a remaining life of 31 years (the restaurant's longer 39-year recovery period, less the eight recovery years already transpired) using the straight-line method (the less accelerated method) and the mid-month convention.
As the example illustrates, in certain circumstances the temporary regulations require depreciation over a longer recovery life or by using a less accelerated method than if the replacement property had been acquired as a separate new asset and depreciated accordingly. Consequently, Temp. Regs. Sec. 1.168(i)-6T(i) provides an election out, by which the replacement MACRS property's entire basis is treated as newly placed in service at the time of replacement. This exception is intended to mitigate any adverse tax effects that the new rules may impose. Under Temp. Regs. Sec. 1.168(i)-6T(j), a separate election is required for each like-kind exchange or involuntary conversion and must be made by the due date (including extensions) of the taxpayer's Federal return for the replacement year.
Similar to Notice 2000-4, Temp. Kegs. Sec. 1.168(i)-6T(b)(10) and (d)(1) provide that any excess basis in the replacement MACRS property is treated as separate property placed in service in the exchange year. As such, the excess basis is depreciable under a recovery period and depreciation method determined without regard to the relinquished property. As a separate, new asset, the taxpayer could make a Sec. 179 election for the excess basis, if otherwise allowed. (Earlier temporary regulations, Temp. Regs. Sec. 1.168(k)1T(f)(5) (published 9/8/03), make clear that both the carryover basis and the excess basis of property acquired in a Sec. 1031 like-kind exchange or Sec. 1033 involuntary conversion are allowed a first-year bonus-depreciation deduction under Sec. 168(k) or 1400L(b), if such replacement property otherwise meets the requirements to be qualified property.)
Unlike Notice 2000-4, the temporary regulations contain a plethora of rules addressing situations that may commonly arise in the context of a like-kind exchange or involuntary conversion transaction, including (1) the treatment of assets relinquished front a depreciation general asset account, (2) deferred exchanges, (3) an acquisition prior to the disposition, (4) exchanges involving nondepreciable property, (5) depreciation limits for passenger automobiles and (6) short tax years. Notable among these rules is the suspension of the recovery period when there is a lag between disposing of the relinquished property and acquiring the replacement property. The temporary regulations specify that these disposition and acquisition dates are determined in accordance with the applicable convention for the properties. In some cases (such as when a disposition and an acquisition are in different tax years (even if only by a few days)), this suspension period could result in a significant gap in the depreciation schedule. (The temporary regulations provide no guidance on whether an intermediary in a like-kind exchange (such as an exchange accommodation titleholder) is entitled to depreciation.)
Conversely, when the replacement property is placed in service prior to a disposition of the relinquished property in an involuntary conversion, Temp. Regs. Sec. 1.1680)6T(d)(4) provides a two-step computation. First, depreciation is taken prior to the disposition, for both the relinquished and replacement MACRS properties, as if there is no See. 1033 transaction. Then, at disposition, there is an adjustment into income for any depreciation taken on the replacement property in excess of that which would have been allowed had the disposition occurred on the replacement property's acquisition date.
Additionally, Temp. Kegs. Sec. 1.168(i)-6T(c)(2) specifies that the previous owners' treatment of the acquired replacement property has no effect in determining the depreciation treatment of the MACRS property in the acquiring taxpayer's bands. Finally, the temporary regulations offer no guidance on how to depreciate a like kind exchange or involuntary conversion involving multiple properties; the preamble indicates merely that taxpayers should apply the temporary regulations' principles to such transactions.
The temporary regulations depart from the strict step-into-the-shoes principles mandated by Notice 2000-4, and impose what could be considerable complexity in computing depreciation following a like-kind exchange or an involuntary conversion. Even a straightforward exchange of two different types of real property may require extensive computations (consider the results in the example above had Q relinquished the 15-year radio tower for a 39-year restaurant). A taxpayer that begins with one asset and engages in a string of like-kind exchanges may find itself tracing several different basis streams, as the carryover basis from the initial asset and the excess basis of the second asset become the carryover basis of a third asset. The temporary regulations, fortunately, provide an election out of these rules. However, some taxpayers may make the election simply to avoid complexity, rather than to gain the most advantageous depreciation regime.
David Madden, J.D., LL.M.
Washington National Tax Service
FROM LYNN AFEMAN, CPA, AND SARAH STAUDENRAUS, CPA, WASHINGTON, DC
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|Title Annotation:||modified accelerated cost recovery system|
|Publication:||The Tax Adviser|
|Date:||Jun 1, 2004|
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