Greenberg Traurig Alert

IRS Allows Taxpayers to Claim Increased Depreciation Deductions for Closed Section 1031 Exchanges

February 2000
By Jay I. Gordon and David W. Bunning, Greenberg Traurig, New York Office

  View or download the PDF version of this Alert here.

As one of its first actions in the year 2000, the Internal Revenue Service issued Notice 2000-4 advising taxpayers that new, generally more favorable rules will apply in the future with respect to the depreciation deductions that can be claimed for property acquired in a tax-free exchange under Section 1031 of the Internal Revenue Code. Moreover, in an act of administrative benevolence, the IRS also announced that the more favorable rules can apply to section 1031 exchanges concluded in past years if the taxpayer affirmatively so elects and files the appropriate forms. An exciting aspect of this development requiring taxpayer action is that the IRS will allow taxpayers who have completed section 1031 exchanges in the past to deduct, over four years, the aggregate excess amount of depreciation that would have been deductible in the past had this Notice been applicable at that time. The result for concluded exchanges is not only potentially accelerated depreciation deductions in future years but also an unexpected windfall in the next four years.

An example: Assume that a taxpayer ("T") purchases an office building for $1000, allocating $100 to non-depreciable land and $900 to depreciable improvements. The property has a statutory recovery period of 39 years. T therefore will be entitled to depreciation deductions equal to $23.08 each year. After twenty years, T has taken $461.60 of depreciation deductions, reducing the tax basis of the property to $538.40. T receives an offer to sell the property for $2000 that he accepts on the condition that the transaction is structured as a section 1031 tax-free exchange. In this manner, T will avoid paying tax currently on his substantial gain, will avoid the "recapture" of depreciation deductions and will be able to reinvest dollars that otherwise would be used to pay taxes. Accordingly, T exchanges his property in a tax-free exchange for a shopping center having a value of $2000.

The rules under section 1031 are clear that the replacement property received --- i.e., the shopping center --- succeeds to the income tax basis of the property transferred. Thus, the shopping center has an income tax basis of $538.40 (assume again that $100 applies to non-depreciable land and that $438.40 applies to depreciable improvements). Accordingly, if the property is sold in a taxable transaction at any time for an amount at least equal to its original cost, the gain deferred in the exchange will be realized at that time. Prior to Notice 2000-4, the $438.40 depreciable basis in the shopping center would be recovered over a new 39 year recovery period for an annual depreciation deduction of $11.24.

Pursuant to Notice 2000-4, not only does the income tax basis of the old property carry over to the new property, but the depreciation recovery period and method also carry over to the replacement property. Thus, in our example, if 19 years remained on the recovery period of the transferred office building, the same 19 year recovery period will apply to the shopping center resulting in annual depreciation deductions of $23.08, more than double the annual amount permitted under the prior method in our example. (If the basis of the replacement property is greater than that of the old property (e.g., the purchase price of replacement property is higher than the value of the transferred property), this excess basis is treated as newly purchased property, i.e., one with a new depreciation period, rather than one that is carried over from the old asset.)

If T had completed his exchange prior to the year 2000, T may opt into the faster depreciation method of Notice 2000-4 by filing Form 3115 (adopting a change in accounting method) and by complying with Revenue Procedure 99-49 (also addressing changes in accounting methods). To permit the taxpayer to "catch up" to where he would have been had the rule of Notice 2000-4 been available earlier, the Notice and Revenue Procedure allow T to deduct the adjustment amount - - - i.e., the excess of depreciation that would have been allowed under the Notice over that previously allowed - - - equally in each the succeeding four tax years. This adjustment may be "found money," in the sense that it may significantly accelerate depreciation deductions expected to be realized over several years in the future. For example, if T had closed his exchange in 1995, he would be able to deduct, unexpectedly, about $14.80 in each of the next four years.

All taxpayers who have participated in a section 1031 exchange in prior years should consider a change in depreciation method to take advantage of the accelerated depreciation deductions permitted by Notice 2000-4. However, situations do exist in which a taxpayer may be adversely affected by the new rule so an analysis must be conducted on a case by case basis. For example, if the taxpayer swapped into property having a shorter recovery period than the property transferred, the old method should be retained. This would most often be the case if the taxpayer exchanged non-depreciable property for depreciable property, or if the taxpayer exchanged nonresidential real property (39 year recovery period) held for less than 11.5 years for residential rental property (27.5 year recovery period).

©2000 Greenberg Traurig