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Study Notes on Exchanges
VII. Section 1031 Exchange (Basis)
The basis of the property transferred, decreased by the amount of money received (note: mortgage boot received is treated as cash received), and increased by any gain or decreased by any loss (on non-like-kind property) recognized in the exchange (§1031(d))
Substitute or carryover basis.
- =Property received is equal to the property transferred.
- + Capital expense incurred will increase the basis.
- + Transactional expense.
- + Recognize gain.
- – Net boot received.
- – Recognize loss.
- – Boot received.
The Non-like-kind property will be allocated first to the extent of its fair market values, then, Like-kind property will be allocated for the remaining basis.
1981 through 1986.
- Repeal ACRS applied to depreciable real properties.
- Replace residential and commercial property with 27.5 and 39 years of useful life for straight-line depreciation.
Depreciated under the “old-old” rules in effect before ERTA if the useful life of the acquired property (as calculated under the “old-old” depreciation system) exceeds the MACRS recovery period; new basis is recovered under the straight-line method of the TRA ‘86 (i.e., MACRS); or
Depreciated under MACRS if the useful life of the acquired property (as calculated under the “old-old” depreciation system) does not exceed the MACRS recovery period ; new basis is again recovered under the straight-line method of the TRA ‘86 (i.e., MACRS).
Recovered under the straight-line method of the TRA ‘86 (i.e., MACRS).
Test your Knowledge
VIII. Section 1031 Exchange (Depreciation, MACRS, and Recapture)
Deduction for the exhaustion, wear and tear, and obsolescence of property used in the taxpayer’s trade or business or of property held by the taxpayer for the production of income.
Depreciation.
Fifteen years but the taxpayer can elect 35 or 40 years extended recovery period.
- Accelerated Cost Recovery System (ACRS).
- Real property other than low-income housing is depreciated using the 175% declining balance method.
- The taxpayer has an option to use the straight-line method over 15, 35, and 45 years.
Tax Reform Act (TRA) of 1986.
27.5 years and 31.5 years straight-line method.
(OBA 93 increased commercial property to 39 years)
The year 2000 (Notice 2000-04).
For the MACRS property was placed in service after January 2, 2000, on how to be depreciated if acquired in a like-kind exchange or by involuntary conversion.
Either continue using the taxpayer’s present methods or switch to the method outlined in Notice 2000-4.
- Have acquired the property in a like-kind exchange under §1031 or by involuntary conversion under §1033;
- Be presently treating the acquired property as newly purchased MACRS property;
- Make the change for the first or second tax year ending after January 3, 2000; and
- Change their accounting methods, using the automatic change in accounting method rules outlined in R. P. 99-49.
Subject to MACRS, the basis of the replacement property is depreciated over the remaining recovery period of the relinquished MACRS property. This is referred to as the general rule.
Land/improvement ratio.
The ratio may be proper if it is based on the value of property tax.
Allow a party to improve his or her land/improvement ratio for purposes of depreciation by allocating a greater portion of his or her basis to the depreciable assets acquired.
- Acquire a depreciable asset with a shorter recovery life than the asset that was given up.
- Trading property with a small encumbrance for one of equal equity but with a large encumbrance. The net increase in debt will increase basis upon which future depreciation and cost recovery can be based.
Converting capital gain into an ordinary income of all or a part of depreciation allowed or allowable in the past.
Section 1245 and Section 1250.
To the extent of all depreciation allowed or allowable after 1961.
- To the extent of depreciation deductions exceeding allowable deductions under the straight-line method.
- 1250 also applies to any depreciation taken if the property is disposed of less than 12 months from the date of acquisition.
Section 1245 applies to personal property and Section 1250 applies to real property.
Greater of (1) the gain recognized on the §1031 exchange, OR (2) the excess of §1250 gain which would have been recognized, except for §1031, over the fair market value of the §1250 property acquired.
- The amount of realized gain recognized as ordinary income could not exceed the sum of gain recognized under §1031, plus the fair market value of property acquired that was not §1245 property.
- Any amounts that escaped recapture were transferred to the new property.
(Note: since personal property is no longer qualify in Section 1031 exchange, the application of the bullet points is no longer in effect. Therefore, an exchange of personal properties is considered non-like kind or a sale).
(Note: Certain properties using ACRS prior to ERTA may fall under Section 1245 properties because ERTA classified these properties as Section 1245. Therefore, the application may still apply for certain properties.)
Property under Section 1245.
- Commercial ACRS into commercial MACRS.
- Commercial ACRS into residential MACRS.
- Commercial ACRS into raw land.
- Residential ACRS into raw land.
(Note: These properties (Commercial or residential real properties) may not result in recapture after the passage of TRA 1986, because these properties will depreciate on a straight-line basis under MACRS.)
- First to boot received at fair market values.
- Second to Section 1250 properties.
- lastly to non- Section 1250 qualifying properties.
(Note: If more than one 1250 qualifying properties are received, the basis will be allocated proportionally based on their relative fair market values.)
First, the aggregate basis will be allocated to Section 1245 property to the extent of its fair market value and then to the non-Section 1245 qualifying property.
Tax Reform Act (TRA) of 1986 and effective January 1, 1986.