Depreciation After an Exchange

The governing regulation is detailed, mechanical, and rarely read outside the return preparation function. It deserves attention from counsel because two of its rules change what a client should do, and one of them is an election that must be made by a deadline.

36.1 The carryover-basis and excess-basis split

The regulation supplies the rules for determining the depreciation allowance for MACRS property acquired in a like-kind exchange.¹ Its central move is to divide the basis computed under Chapter 35 into two pieces that are then depreciated on entirely different terms.

Exchanged basis is the lesser of the basis in the replacement property, as determined under section 1031(d), or the adjusted depreciable basis of the relinquished property.²

Excess basis is any excess of the section 1031(d) basis in the replacement property over the exchanged basis.³

In ordinary terms, the exchanged basis is the old basis carried forward and the excess basis is what the taxpayer paid on top. Each is then reduced, for depreciation purposes, by any portion attributable to non-business use and by adjustments required elsewhere in the Code, producing the depreciable exchanged basis and the depreciable excess basis.⁴

Excess basis is treated as new property. Any excess basis in the replacement property is treated as property placed in service by the acquiring taxpayer in the year of replacement, so its depreciation is determined using the applicable recovery period, depreciation method, and convention prescribed for that property at the time of replacement.⁵

The regulation's example states the division cleanly. A taxpayer placed a hospital in service in 1989 and in January 2004 exchanged it, plus $2,000,000 of cash, for an office building. The hospital's adjusted depreciable basis at the time was $1,500,000, and the basis of the office building after the exchange was $3,500,000. The depreciable exchanged basis of $1,500,000 is depreciated under the continuation rules examined at 36.2. The depreciable excess basis of $2,000,000 is treated as placed in service in 2004 and depreciated using the office building's own recovery period, method, and convention.⁶

The practical shape of that result is worth stating for a client. Cash added to an exchange buys a fresh recovery period. Basis carried over does not.

36.2 Continuation of the relinquished property's recovery period

The exchanged basis continues the relinquished property's depreciation rather than beginning a new one, and the regulation's rules for reconciling two properties with different recovery periods produce a result that is uniformly unfavorable.

Where the periods and methods match, the depreciation allowances for the depreciable exchanged basis beginning in the year of replacement are determined using the same recovery period and the same depreciation method as the relinquished property.⁷ The exchanged basis simply continues over the relinquished property's remaining recovery period.

Where the replacement property's prescribed recovery period is longer, the allowances are determined as though the replacement property had originally been placed in service by the taxpayer in the same taxable year the relinquished property was placed in service, but using the longer recovery period of the replacement property. The exchanged basis is depreciated over the remaining recovery period of the replacement property.⁸

Where the replacement property's prescribed recovery period is shorter, the allowances are determined using the same recovery period as the relinquished property, and the exchanged basis is depreciated over the relinquished property's remaining recovery period.⁹

Read the two rules together and the pattern is unmistakable. In both directions the taxpayer is held to the longer of the two recovery periods on the exchanged basis. There is no combination of facts in which the default rules accelerate the carryover basis.

For real property the two periods in question are twenty seven and a half years for residential rental property and thirty nine years for nonresidential real property. Two consequences follow directly.

A taxpayer exchanging a commercial building for residential rental property does not obtain the shorter residential period on the carryover basis. It remains on thirty nine years.

A taxpayer exchanging residential rental property for a commercial building moves the carryover basis to thirty nine years, losing the shorter period going forward.

The excess basis escapes both rules, because it is new property under 36.1 and takes the replacement property's own period. A taxpayer adding substantial cash to acquire residential rental property gets twenty seven and a half years on the new money and thirty nine on the old.

Two further points complete the picture.

The previous owner's treatment is irrelevant. If replacement property is acquired in a like-kind exchange, the depreciation treatment of that property by previous owners has no effect on the determination of depreciation allowances in the hands of the acquiring taxpayer.¹⁰ The seller's remaining recovery period, method, and accumulated depreciation do not transfer.

The rules are mandatory absent an election. The recovery period, depreciation method, and convention determined under the continuation rules are the only permissible methods of accounting for property within the regulation's scope unless the taxpayer makes the election examined at 36.3.¹¹

The modeling consequence is the one to communicate. A taxpayer thirty years into a thirty nine year building who exchanges has nine years of remaining recovery on the exchanged basis, not thirty nine. The annual depreciation deduction after the exchange may be far larger or far smaller than the client expects, and the after tax comparison between selling and exchanging cannot be run without this number.

36.3 The election out and when it makes sense

A taxpayer may elect not to apply the regulation for any MACRS property involved in a like-kind exchange. The election applies only to the taxpayer making it, and it applies to both the relinquished property and the replacement property.¹²

The effect. For depreciation purposes only, the sum of the exchanged basis and the excess basis in the replacement property is treated as property placed in service by the taxpayer at the time of replacement, and the adjusted depreciable basis of the relinquished property is treated as being disposed of at the time of disposition.¹³

The election therefore does what the default rules refuse to do. It restarts the entire basis on the replacement property's own recovery period, method, and convention.

What it does not do. The election does not affect the application of section 1031 or section 1033, and the regulation makes the point explicitly: a taxpayer who does not recognize gain under section 1031 does not change that result by electing. Nor does it affect the application of sections 1245 and 1250 to the relinquished property.¹⁴ It is a depreciation election and nothing more.

Time and manner. The election is made separately by each person acquiring replacement property. It is made by the common parent for a member of a consolidated group, by the partnership rather than by the partners, and by the S corporation rather than by the shareholders. A separate election is required for each exchange. It must be made by the due date, including extensions, of the return for the year of replacement, in the manner provided on Form 4562 and its instructions, and it may not be made in any other manner, including through a request to change a method of accounting under section 446(e).¹⁵

Two features of that paragraph deserve emphasis. The deadline is the extended due date of the return for the year of replacement, which is another reason the extension recommended at 26.2 is worth filing as a matter of routine. And the exclusion of the accounting method change route means the election cannot be recovered later.

When to elect. The comparison is between two periods.

Under the default, the exchanged basis is recovered over the remaining period of the longer of the two properties, and only the excess basis gets the replacement property's own period.

Under the election, the entire basis is recovered over the full recovery period of the replacement property.

Elect where the replacement property's full recovery period is shorter than the remaining period the default would impose. The paradigm case is a taxpayer early in the life of a thirty nine year commercial building who acquires residential rental property: the default holds the exchanged basis on thirty nine years with more than twenty seven and a half years remaining, while the election puts the whole basis on twenty seven and a half.

Do not elect where the taxpayer is far along in the relinquished property's recovery period. A taxpayer with nine years remaining recovers the exchanged basis over nine years under the default and would spread it over a full new period by electing. The default is dramatically faster.

One narrower rule interacts with the choice. In applying the section 179 election, only the excess basis in the replacement property is taken into account.¹⁶ Expensing is available against new money and not against carryover basis, which matters where the replacement property includes components eligible for it.

36.4 General asset accounts and the distinct-asset interaction

A taxpayer who has placed depreciable property in a general asset account has elected into a regime in which dispositions ordinarily produce no gain or loss and the account continues to be depreciated as though nothing had happened. A like-kind exchange overrides that regime, and the override is mandatory.

Where the exchange disposes of the whole account. If all the assets, the last asset, or the remaining portion of the last asset in a general asset account are transferred in a like-kind exchange, the taxpayer must apply the special rule rather than the ordinary general asset account disposition rules. The account terminates as of the first day of the year of disposition. Gain or loss for the account is determined under section 1001(a) by taking into account the adjusted depreciable basis of the account at the time of disposition, and the depreciation allowance for the account in the year of disposition is determined in the same manner as for relinquished MACRS property under the exchange regulation.¹⁷

Where the exchange disposes of less than the whole account. If an asset in a general asset account is transferred in a like-kind exchange and the rule above does not apply, general asset account treatment for that asset terminates as of the first day of the year of disposition, and gain or loss for the asset is determined by reference to its adjusted depreciable basis at that time.¹⁸

Three practical points follow.

Termination is not elective and is not a year end adjustment. It occurs as of the first day of the year of disposition, which means the account is unwound retroactively to the beginning of the year in which the exchange closes. The computation should be identified before the exchange, not discovered during return preparation.

Identify general asset accounts during diligence. A relinquished property whose components were placed in a general asset account, which is common where a cost segregation study was followed by an account election, requires the account to be broken out and each asset's adjusted depreciable basis determined. That information may be years old and held by a prior accountant.

The component question is now also a qualification question. Property broken out of a building by a cost segregation study is frequently section 1245 property, which after 2017 is not eligible for nonrecognition at all. It is non-qualifying property under Chapter 32, it produces ordinary recapture under Chapter 37, and its presence in a relinquished property changes both the boot computation and the character of the gain. A taxpayer who accelerated deductions through cost segregation has borrowed against the exchange, and the bill comes due when the property is exchanged.

That interaction, between accelerated depreciation taken during the holding period and the character of gain on disposition, is the subject of Chapter 37.