View PDF of Article in Tax News & Comment — October 2012
GAIN, LOSS, AND DEPRECIATION ISSUES IN LIKE KIND EXCHANGES
[Note: Excerpted from Like Kind Exchanges of Real Estate Under IRC. §1031 (David L. Silverman, 3rd Ed.,1/11).View treatise at nytaxattorney.com]
View Entire Like Kind Exchange Treatise here: Like Kind Exchange Treatise
I. Calculating Gain or Loss
Realized gain in a property transaction equals the amount realized less the adjusted basis of transferred property. Similarly, in a like kind exchange, realized gain equals the sum of money and the fair market value of property received less the adjusted basis of property transferred. What makes the like kind exchange attractive from a tax standpoint is not that realized gain is vanquished; it is not. Eventually, gain realized in a like kind exchange may be taxed when the property received in the like kind exchange is sold. Two exceptions to this exist: Further tax deferral could be achieved if the taxpayer engaged in another like kind exchange with the same property, or if the taxpayer died owning the property, in which case the property would receive a step up in basis.When Section 1031 was drafted, Congress could have required that only like kind property be received in an exchange, and that the receipt of cash would result in Section 1031 being inapplicable. This was not the route Congress chose. Instead, Congress decided that the receipt of other non-like kind property in an otherwise qualifying exchange would not take the transaction out of Section 1031, but would simply taint the exchange to some extent.
Congress decided that it would be appropriate to compel the taxpayer to recognize that portion of the realized gain to the extent of non-like kind property received in the exchange. Non-like kind property received in a like kind exchange is termed “boot”. Boot may consist of cash, other property. Under Crane v. Com’r, boot may even consist of the assumption by the other party of a mortgage encumbering the property relinquished by the taxpayer in the exchange. Realized gain in a like kind exchange then, is recognized to the extent of the sum of money and the fair market value of nonqualifying property received in the exchange. Thus, if property with a fair market value of 10x dollars and basis of zero is exchanged for like kind property with a fair market value of 5x dollars and 5x dollars in cash, realized gain would be 10x dollars, since AR—AB = 10x. That realized gain would be recognized to the extent of the 5x dollars in cash received. For purposes of calculating the taxpayer’s basis in the replacement property, the taxpayer’s initial basis would be increased by 5x dollars to reflect gain recognized in the exchange. However, basis would also be decreased by 5x dollars to reflect cash received in the exchange. Therefore, basis in the replacement property would remain at zero.
Treatment of Liabilities
As noted, if liabilities associated with the relinquished property are assumed by the other party to the exchange, the taxpayer is deemed to receive cash. Section 1031(d); Regs. § 1.1031(b)-1(c); Coleman v. Com’r, 180 F2d 758 (8th Cir. 1050). Whether another party to the exchange has assumed a liability of the taxpayer is determined under Section 357(d). Although realized gain is recognized to the extent nonqualifying property is received in an exchange, Section 1031(c) provides that realized loss with respect to relinquished exchange property is never recognized, even if nonqualifying property is received in an exchange. Thus, if the taxpayer exchanges property with a basis of 10x dollars and a fair market value of 5x dollars for other property with a fair market value of 5x dollars, the taxpayer will not be permitted to recognize the loss. Rather, the loss would be deferred and would eventually be recognized when the taxpayer sold the property received in the exchange.However, this does not mean that loss will never be recognized in a like kind exchange. Under Section 1001(c), both gains and losses are recognized with respect to nonqualifying property transferred in a like kind exchange. Section 1031 takes a restrictive view of nonqualifying property received in an exchange, since it undermines the purpose of the statute. However, Section 1031 imposes does not operate to disallow loss on the transfer of nonqualifying property in an exchange.
Taxpayer exchanges property in Florida which has declined in value, for an oil and gas lease in Montana, and cash. Realized loss with respect to the Florida property is not recognized because loss is not recognized with respect to the transfer of qualifying property, even if boot is received. However, if as part of the consideration for the Montana property the taxpayer also transferred U.S. Steel stock which had declined in value, realized loss on the Ford stock would be recognized (whether or not the taxpayer received cash boot) because both gains and losses are recognized with respect to the transfer of nonqualifying property in a like kind exchange. When cash boot is received in a deferred exchange covering two taxable years, taxable income is presumably not recognized until the second year, when boot is received. See Revenue Ruling 2003-56.
“Trading Up” and “Trading Down”
Where a taxpayer “trades up” by acquiring property more valuable than the property relinquished and no boot is received, Section 1031 operates to defer recognition of all realized gain, (except in unusual circumstances involving depreciation recapture under Section 1245). However, if the taxpayer “trades down” and acquires property less valuable than that relinquished (thereby receiving cash or other nonqualifying property in the exchange) like kind exchange status will not (for this reason) be imperiled, but the taxpayer will be forced to recognize some of the realized gain. Boot may consist of property excluded by definition in Section 1031 from like kind exchange treatment. For example, Section 1031 (a)(2)(D) states that Section 1031 “shall not apply” to the exchange of partnership interests, even though the exchange of partnership interests might otherwise be considered the exchange of like kind property. Boot may also consist simply of property which fails to constitute property that is of like kind to the property relinquished in the exchanged (e.g., the receipt of a truck in exchange for a horse). The IRS has taken the position that boot may result even if no nonqualifying property is received in the exchange; for example in an exchange of real estate whose values are not approximately equal. See PLR 9535028. This result could also conceivably occur in a situation involving the exchange of property among beneficiaries during the administration of an estate.
Some Closing Expenses Offset Boot
The receipt of cash or other nonqualifying property would normally produce taxable boot to the extent of realized gain. However, Rev. Rul. 72-456 provided that brokerage commissions and many other transaction costs may be expensed, reducing gain realized and, in effect, also reducing recognized gain. Blatt v. Com’r, 67 T.C.M. 2125; T.C. Memo (1994-48) concurred, and held that expenses incurred in connection with the exchange and not deducted elsewhere on the taxpayer’s return may offset boot. In such cases, the taxpayer may in effect “trade down.” On the other hand, some closing costs or transactional expenses that may be paid with exchange proceeds are not excluded from amount realized or added to the basis of replacement property. Rather, they are operating costs due to the ownership of real property. However, even though they may not affect calculations with respect to the like kind exchange (and may therefore not appear on Form 8824), they may be deductible elsewhere on the return.
II. Depreciation Issues
Section 1245 or Section 1250 depreciation recapture can affect depreciable property held for more than one year and disposed of at a gain by reclassifying that gain as ordinary income. Section 1245 property is any depreciable property consisting of either tangible personal property or intangible amortizable personal property described within Section 1245(a)(3)(B) through (F). Section 1245 property employs “accelerated” or “front-end loaded” methods of depreciation, such as 200 percent or 150 percent declining balance. Whether property constitutes Section 1245 property for depreciation purposes is a federal tax determination. Local law classification of property as real property or personal property – though important for purposes of Section 1031 – has little relevance for purposes of determining whether property is Section 1245 property or Section 1250 property. Section 1250 property, defined by exclusion, consists of depreciable real property, other than Section 1245 property. Commercial and residential real property both constitute Section 1250 property. Commercial property is depreciable over 39 years using the straight-line method, while residential real estate is depreciable on the straight-line method as well, but over 27.5 years.
Cost Analysis Studies
Hospital Corporation of America, 109 T.C. 21 (1997) held that tangible personal property includes many items permanently affixed to a building. The decision, to which the IRS subsequently acquiesced, made viable the use of cost analysis studies to allocate building costs to structural components and other tangible property. The result of reclassification of Section 1250 property is the birth, for depreciation purposes, of Section 1245 property. By reclassifying Section 1250 real property as Section 1245 personal property, shorter cost recovery periods can be used. A successful cost segregation study would convert Section 1250 property to Section 1245 property with depreciation periods of five or seven years, using the double-declining balance method in Section 168(c) and (e)(1). The IRS Cost Segregation Audit Techniques Guide states that a cost segregation study should be prepared by a person with knowledge of both the construction process and the tax law involving property classifications for depreciation purposes. In general, a study by a construction engineer is more reliable than one conducted by a person with no engineering or construction background. Cost segregation professionals must verify the accuracy of blueprints and specifications, and take measurements to calculate the cost of assets and then to segregate them. The average cost segregation study may identify 25 percent to 30 percent of a property’s basis that is eligible for faster depreciation.
Taxpayer plans to exchange land and a building in that he has owned for seven years. The property has a fair market value of $3 million and an adjusted basis of $1 million. As Section 1250 property, it has been depreciated using the straight-line method over 39 years. Replacement property, consisting of land and an office building is acquired for $3 million, 80 percent of the value of which is allocated to the building. The basis of the replacement building is therefore $800,000. The basis of the land is $200,000. A cost segregation study determines that 25 percent of the value of the office building is personal property qualifying for a 7-year recovery period using the 200 percent declining balance method of depreciation. The cost segregation study has increased the total first year depreciation deductions from $20,513 (i.e., $800,000/39) to $71,385 [($600,000/39) + (2/7) x $200,000)].
The basis of replacement property reflects the basis of relinquished property. If relinquished property has been heavily depreciated and little basis remains (or had a low basis to begin with) an otherwise successful cost segregation study of the replacement property would yield little tax benefit. However, if new funds have been invested or borrowed to exchange into more valuable property, the basis of the replacement property will reflect that investment, and a cost segregation study might yield tangible tax benefits. Some Section 1245 property, such as a barn, constitutes a “single purpose agricultural structure” under Section 1245(a)(3)(D). Section 1031 largely defers to local law in determining whether property is real or personal and it is remote that a barn would not be classified as real property for local law purposes. Therefore, some property may be classified as Section 1245 property for purposes of depreciation, since that is a federal tax determination, while at the same time be classified as real property for purposes of Section 1031, since that is a local law determination.
If Section 1250 property has been reclassified as Section 1245 property for purposes of depreciation but still is real property under local law, the taxpayer could enjoy the best of both worlds: faster depreciation and qualification as real property for future exchanges. However, assume reclassification results in Section 1245 property that constitutes personal property under local law. If that property is later exchanged for either (i) real property or (ii) personal property that is not of like class, boot gain will result. Therefore, if replacement property does not have the same “mix” of real and personal property for purposes of Section 1031 – or even the same “mix” of “like class”” personal property, the resulting inability to completely satisfy the ““like kind” exchange requirement will result in boot, and perhaps also depreciation recapture. If Section 1245 property is classified as real property under local law, and is exchanged for property that is real property under local law, no boot will result. However, since Section 1245 trumps Section 1031, the taxpayer is not out of the woods, because the operative provisions of Section 1245, relating to depreciation recapture, might still apply. Depreciation recapture can occur in a boot-free like kind exchange if more Section 1245 property is relinquished in the exchange than is received.
If some or all of the relinquished property does not constitute real property under local law, it will not be of like kind to replacement property consisting entirely of real property. Boot gain could also result if the Section 1245 property relinquished is not of “like class” to the Section 1245 property received in the exchange. As in the case where no boot is present, depreciation recapture may also result if more Section 1245 property is relinquished than is received in the exchange. As noted, whether or not boot gain is present, Section 1245 ordinary income depreciation recapture may occur in an exchange if more Section 1245 property is relinquished than is received. Section 1245(b)(4) provides that if property is disposed of in a §1031 exchange, depreciation recapture cannot exceed the amount of gain recognized without regard to Section 1245 plus the fair market value of non-Section 1245 property acquired in the exchange. Therefore, Section 1245 recapture cannot exceed the sum of (i) boot gain and (ii) the extent to which Section 1245 property relinquished in the exchange exceeds Section 1245 property received in the exchange. IRC § 1245(b)(4)(B). Ordinary income recapture cannot exceed gain realized in the exchange. Section 1245(a)(1)(B).
The Regulations under Section 1245 require only that the replacement property be Section 1245 property to avoid recapture. Thus, no depreciation recapture will result if Section 1245 property with a class life of 7 years is replaced with Section 1245 property with a class life of 10 years. However, the boot analysis under Section 1031 is different: Boot will result if the Section 1245 property exchanged and received are not of like kind or like class. In this respect, the boot rules of Section 1031 are more restrictive than the recapture rules of Section 1245.
The extent of depreciation recapture may depend on the value of Section 1245 property relinquished versus the value of Section 1245 property received in an exchange. If more Section 1245 property is relinquished than is received, ordinary income depreciation recapture may result. Anticipating efforts to undervalue Section 1245 property relinquished, Regs. § 1.1245-1(a)(5) requires the total amount realized on the disposition be allocated between Section 1245 property and non-Section 1245 property in proportion to their respective fair market values. If the buyer and seller have adverse interests, an arm’s length agreement will establish the allocation. In the absence of an agreement, the allocation is based on a facts and circumstances approach.
Unrecaptured Section 1250 Gain
Property subject to unrecaptured Section 1250 gain is taxed at 25 percent when sold. Section 1(h)(7). This rate is 10 percent higher than the usual rate imposed for long term capital gains. The higher rate serves as a proxy for depreciation recapture. Unrecaptured Section 1250 gain applies to all depreciation taken on real property, whether straight line or otherwise, except for Section 1250 “excess” depreciation that is subject to ordinary income recapture. What happens to unrecaptured Section 1250 gain following a like kind exchange? The Code does not address the issue. Presumably, unrecaptured Section 1250 gain would be treated in the same manner as Section 1250 excess depreciation, so that the deferred unrecaptured Section 1250 gain would roll over into the replacement property.
Although Section 1250 recapture with respect to which “additional depreciation” has been taken, can also occur in an exchange, TRA 1986 generally required that all real property be depreciated on a straight line basis. Therefore, Section 1250 recapture should no longer be an issue in most exchanges. Section 1031(d)(4)(D); Regs. § 1.1250-3(d)(5). Basis must be allocated to reclassified replacement property consisting of both Section 1245 and Section 1250 property. The aggregate basis of the reclassified replacement property equals the basis of the relinquished property, with adjustments as provided for in Section 1031(d). Regs. §1.1245-5(a)(2) requires that basis first be allocated to non-Section 1245 property to the extent of its fair market value, with the residue being allocated to Section 1245 property. The effect of this forced allocation will be to produce longer depreciation periods.
Taxpayer sells a building containing Section 1245 property on June 30, 2006, for $1 million. The building had originally cost $700,000. Depreciation deductions of $300,000 had been taken, of which $100,000 was subject to ordinary income depreciation recapture under Section 1245(a)(2). The sale would result in (i) $100,000 of “excess” depreciation under Section 1245 taxed at 35 percent; (ii) $200,000 of unrecaptured Section 1250 gain taxed at 25 percent; and (iii) $300,000 of long term capital gain taxed at 15 percent. A NYC taxpayer would incur a tax of $236,220, resulting in an effective tax rate of 39.37 percent, computed as follows: [($100,000 x .35) + ($200,000 x .25) + ($300,000 x .15) + ($600,000 x .0897) + ($600,000 x .0365) + ($1,000,000 x .004) + ($1,000,000 x .02625)].
If this property were instead exchanged, all of the LTCG and all of the unrecaptured Section 1250 gain would be deferred. The fate of the Section 1245 recapture gain would depend on whether more Section 1245 property was relinquished in the exchange than was received. The only tax that could not be deferred in the exchange would be the combined state and local transfer tax liability of $30,500.
Regulations Governing Depreciation of Property Received in Exchange
Treas. Reg. § 1.168(i)-6 governs the method of depreciating property acquired in a like kind exchange. The taxpayer may elect out of applying Reg. § 1.168(i)-6 by indicating on Form 4562 “Election Made Under Section 1.168(i)-6T(i).” If an election out is made, the taxpayer calculates depreciation based upon the entire basis of the replacement property at the time it is placed in service. If no election is made not to apply Treas. Reg. §1.168(i)-6, the basis of replacement property will consist of (i) “Old Basis” and (ii) “New Basis”. Old Basis is the adjusted basis of relinquished property, while New Basis is any additional basis arising in the exchange. In general, an election out may be desirable when the recovery period or depreciation method of the replacement property is different from that of the relinquished property. If an election out is made, the replacement property is depreciated using the recovery period and depreciation method of the replacement property, even if the recovery period is shorter and the depreciation method faster. No depreciation is allowed during the exchange period. Accordingly, depreciation with respect to “Old Basis” and “New Basis” will both commence when the replacement property is acquired. The depreciation allowed will depend upon whether the replacement property has (i) a longer (or shorter) MACRS recovery period than the relinquished property and (ii) a slower (or faster) depreciation method than the relinquished property had.