Calculating depreciation on a like-kind exchange or an involuntary conversion: temporary regulations have modified the rules for computing depreciation on exchanged or converted property. This article focuses on the use of the optional tables for like-kind exchanges and involuntary conversions.

• Author: Mason, J. David

EXECUTIVE SUMMARY

* For like-kind exchanges and involuntary conversions, annual depreciation on carryover basis is split between the portion allocable to the relinquished property and to the replacement property.

* Temp. Regs. Sec. 1.168(i)-6T(e) provides a transaction coefficient and other rules for applying the optional depreciation tables to exchanged and converted property.

* Taxpayers can opt out of using the optional tables and compute depreciation manually.

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The Service issued Temp. Kegs. Sec. 1.168-6T in February 2004 in the belief that taxpayers were inconsistently taking depreciation on property acquired in like-kind exchanges under Sec. 1031 and involuntary conversions under Sec. 1033. (1) The IRS was concerned that, for depreciation purposes, some taxpayers had been regarding the replacement property as a continuation of the relinquished (converted) property, while others had been considering it as new property, resulting in inconsistent treatment.

The new regulation generally requires treating the replacement property as a continuation of the relinquished property, to the extent of the carryover (exchanged) basis. In addition, it addressed other important issues, such as the (1) determination of the depreciation allowance under Temp. Kegs. Sec. 1.168(i)-6T(c), (2) treatment of passenger automobiles under Temp. Kegs. Sec. 1.168(i)-6T(d) and (3) use of the optional depreciation tables (2) under Temp. Kegs. Sec. 1.168(i)-6T(e). This article focuses on the new rules for using the optional depreciation tables when applying the regulations to like-kind exchanges or involuntary conversions. (3)

The new rules apply to a like-kind exchange or an involuntary conversion of MACRS property for which the time of disposition and the time of replacement both occur after Feb. 27, 2004. The IRS initially provided guidance to taxpayers in Notice 2000-4, (4) which was considered interim guidance until the new regulation could be issued. (5)

General Effect on Taxpayers

Even a cursory reading of the new regulation reveals how it restricts many of the tax planning opportunities apparently available under Notice 2000-4. In addition, it makes recordkeeping more difficult and complex than before, as the new rules require taxpayers to bifurcate the basis of property received into an exchanged (or carryover) basis and an excess (boot) basis. The portion of the basis treated as exchanged basis is considered, in general, to be a continuation of the old asset for depreciation purposes. The portion deemed to be excess basis is treated as if it were a new asset, which results in the excess basis receiving a new life (i.e., a new recovery period) and depreciation method.

In short, tax professionals will be hard-pressed to argue that this guidance is taxpayer-friendly. For example, if the replacement property would normally have a longer life for MACRS purposes, the taxpayer has to convert to that life for the portion of the basis that is the exchanged (carryover) basis. The same is true in selecting the depreciation method. If the replacement property would normally have a less accelerated depreciation method, the taxpayer has to use that method for the portion of the basis that is the exchanged basis, even though the regulation treats the replacement property's exchanged basis as a continuation of the relinquished property for depreciation purposes.

Use of Optional Tables

The regulation's guidance on using the optional depreciation tables also reflects a pro-government bias. If taxpayers elect to use them to calculate depreciation, they will be at a comparative disadvantage. Thus, it is generally to the taxpayer's benefit to opt out of using the optional tables for calculating depreciation on replacement property.

Background

Historically, tax advisers have often relied on the optional depreciation tables, rather than on the more tedious manual approach, because the tables simplified the calculations and were more time- and cost-efficient. The tables made it unnecessary to determine book value (the remaining undepreciated basis) each year, as this information was incorporated into the rates. Instead, each year, the calculation merely involved multiplying the applicable rate times the original unadjusted basis. For example, for five-year MACRS property (assuming the half-year convention applies) acquired for $10,000 and placed in service in January 2001, the calculation for 2003 depreciation involved identifying the applicable rate from the table 6 for year 3 (0.192), and then multiplying the $10,000 undepreciated basis by this rate, thus making year-3 depreciation $1,920.

By comparison, calculating the depreciation for 2003 by hand involved multiplying the remaining undepreciated basis by 200% of the...