Henricks, Martin, Thomas & Zollars, Ltd.
Certified Public Accountants

by Edward K. Zollars, CPA

The IRS on January 4 issued a notice about how they propose that property received in a Section 1031 exchange should be treated for depreciation purposes. What the IRS said in the notice (which is reproduced below) is that taxpayers will no longer, as of January 3, 2000, be able to treat the property received as new property for depreciation purposes. Rather we must continue to depreciate the portion of the basis that carries over in the transaction under the same methods we had used before.

As the notice indicates, there was no guidance before now on how we should depreciate such property. Previously we had often treated property as “new” property for depreciation purposes to pick up a shorter life and/or realize other tax benefits of larger depreciation deductions.

The notice is rather short on explanations, though we would expect additional explanations to come from the regulations that will be issued later in the year. However, this change in calculating the depreciation could impact the economics of any 1031 exchanges that you might be involved in. For that reason, it will be important to keep a watch on developments during the year on this issue.

Note that this provision also affects involuntary conversions under Section 1033.

IRS Notice 2000-4; 2000-3 IRB 1 (January 4, 2000)

Part III -- Administrative, Procedural, and Miscellaneous

This notice provides guidance about the depreciation of property subject to section 168 of the Internal Revenue Code (MACRS property) that is acquired in a like-kind exchange under section 1031 or as a result of an involuntary conversion under section 1033. The Internal Revenue Service and the Department of Treasury intend to issue regulations under section 168 that will address these transactions. Taxpayers should follow this notice until these regulations are issued. Public comments to aid in the development of the regulations are requested by March 31, 2000.

BACKGROUND

Section 167 allows as a depreciation deduction a reasonable allowance for the exhaustion, wear and tear of property used a trade or business or held for the production of income. The depreciation allowable for depreciable tangible property placed in service after 1986 generally is determined under section 168 (MACRS).

Section 1031(a)(1) provides that no gain or loss is recognized on the exchange of property held for productive use in a trade or business or for investment if the property is exchanged solely for property of like kind that is to be held either for productive use in a trade or business or for investment.

Section 1033(a)(1) provides that if property (as a result of its destruction in whole or in part, theft, seizure, or requisition or condemnation or threat or imminence thereof) is compulsorily or involuntarily converted into property similar or related in service or use to the property so converted, no gain is recognized.

The basis of property acquired in a transaction to which section 1031 or section 1033 applies generally is the same as the property surrendered in the transaction less any cash received plus any gain recognized. However, there is no guidance as to how to depreciate the basis of the acquired property under section 168.

APPLICATION

For purposes of determining the depreciation allowable for MACRS property acquired in an exchange of MACRS property for like- kind property to which section 1031 applies, or acquired in replacement of involuntarily converted MACRS property to which section 1033 applies, the acquired MACRS property should be treated in the same manner as the exchanged or involuntarily converted MACRS property with respect to so much of the taxpayer's basis in the acquired MACRS property as does not exceed the taxpayer's adjusted basis in the exchanged or involuntarily converted MACRS property. Thus, the acquired MACRS property is depreciated over the remaining recovery period of, and using the same depreciation method and convention as that of, the exchanged or involuntarily converted MACRS property. Any excess of the basis in the acquired MACRS property over the adjusted basis in the exchanged or involuntarily converted MACRS property is treated as newly purchased MACRS property.

For acquired MACRS property placed in service on or after January 3, 2000, in a like-kind exchange of MACRS property under section 1031 or as a result of an involuntary conversion of MACRS property under section 1033, a taxpayer must follow the principles set out in this notice.

For acquired MACRS property placed in service before January 3, 2000, in a like-kind exchange of, or as a result of an involuntary conversion of, MACRS property, the Service is aware that taxpayers are depreciating this acquired property either (i) in the manner set out in this notice consistent with section1.168-5(f) of the proposed Income Tax Regulations, published in the Federal Register on February 16, 1984 (49 Fed. Reg. 5940), under former section 168 (ACRS); or (ii) as newly purchased MACRS property. The Service will allow a taxpayer to continue to use its present method of depreciating the acquired property and will treat these methods as allowable methods of depreciation. However, a taxpayer presently treating the acquired property as newly purchased MACRS property may change to treating the property under the principles in this notice, provided the property has been treated by the taxpayer as acquired in a section 1031 like- kind exchange or section 1033 involuntary conversion and the change is made for the first or second taxable year ending after January 3, 2000.

CHANGE IN METHOD OF ACCOUNTING

A change from treating MACRS property acquired in a section 1031 like-kind exchange or section 1033 involuntary conversion as newly purchased MACRS property to treating the property under the principles of this notice is a change in method of accounting to which the provisions of section 446 and section 481 and the regulations thereunder apply. A taxpayer changing its method of accounting for the acquired MACRS property must follow the automatic change in accounting method provisions of Rev. Proc. 99-49, 1999-52 I.R.B. 725, provided the taxpayer makes the change in method of accounting for the first or second taxable year ending after January 3, 2000, and takes into account any necessary section 481(a) adjustment in accordance with the provisions of Rev. Proc. 99-49. The scope limitations in section 4.02 of Rev. Proc. 99-49 do not apply to the taxpayer. However, if the taxpayer is under examination, before an appeals office, or before a federal court, the taxpayer must provide a copy of the Form 3115, Application for Change in Accounting Method, to the examining agent(s), appeals officer, or counsel for the government, as appropriate, at the same time that the taxpayer files the copy of the Form 3115 with the national office. The Form 3115 must contain the name(s) and telephone number(s) of the examining agent(s), appeals officer, or counsel for the government, as appropriate.

REQUEST FOR COMMENTS

The Service and the Treasury Department intend to issue regulations under section 168 to address the depreciation of MACRS property acquired in a section 1031 like-kind exchange or section 1033 involuntary conversion. Before issuing proposed regulations, the Service and the Treasury Department invite comments from the public to aid in the development of these regulations. Comments should be submitted in writing by March 31, 2000, to:

Alternatively, comments may be submitted electronically via:

http://www.irs.gov/prod/tax_regs/comments.html

(the Service Internet site).

EFFECT ON OTHER DOCUMENTS

Rev. Proc. 99-49 is modified and amplified to include this automatic accounting method change in the Appendix.

DRAFTING INFORMATION

The principal author of this notice is Alan H. Cooper of the Office of Assistant Chief Counsel (Passthroughs and Special Industries). For further information regarding this notice contact Mr. Cooper at (202) 622-3110 (not a toll-free call).

Edward K. Zollars, C.P.A. is a shareholder in the Phoenix CPA firm of Henricks, Martin, Thomas & Zollars, Ltd. He has served on committees and task forces on the national and local level for the American Institute of CPAs and the Arizona Society of CPAs. He has lectured at a number of continuing education presentations, most recently at the AICPA’s National Conference on Federal Taxes and Virginia Tech University’s Annual Accounting & Auditing Conference. Ed has written articles published in the Journal of Accountancy and The Tax Adviser, as well as being cited as a source for articles in Investors Business Daily, Forbes, and Worth. He also is a regular contributor to the Internet newsgroup misc.taxes.moderated. He can be reached at (602) 955-8530 or via email at ed@hmtzcpas.com.