Depreciation Planning for Real Estate Like-Kind Exchanges

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A “like-kind exchange,” or “Section 1031 exchange,” allows real estate investors that incur gains on real property sales to reinvest those proceeds and defer the gain—offering an advantageous tax planning strategy for real estate companies. However, like-kind exchanges do not come without complexities and additional compliance, especially regarding depreciation. Keep reading to learn more.  

Like-Exchange Rules related to Personal Property

Real estate concept 3d renderingPrior to 2018, a taxpayer could sell real or personal property and replace it with like-kind property and defer the gain. Under the 2017 Tax Cuts & Jobs Act (TJCA), personal property is no longer eligible for a like-kind exchange. Note: personal property can include machinery, equipment, furniture, fixtures, aircrafts, automobiles, and more. As such, personal property disposed of with the real property impacts the amount of gain that can be deferred, and thus the basis of the replacement property.

Recently, the IRS issued proposed regulations, which include a definition of real property to reflect the TCJA changes made for like-kind exchanges. These proposed regulations also provide guidance related to a taxpayer’s receipt of personal property incidental to the real property received (replacement property) in an exchange. Please click here for a copy of these proposed regulations.

Depreciation Planning for the Replacement Property Acquired in a Like-Kind Exchange

In general, every like-kind exchange should be looked at on a property-by-property basis. Special rules apply in the case of multiple property exchanges. The basis of the replacement properties is calculated in total and allocated to each replacement property in accordance with its respective fair market value. When tackling the depreciation schedule for replacement property, the first step is to calculate the cost of the replacement property. The original cost net of depreciation (basis) from the relinquished property (the property being sold) carries over to your replacement property. If the replacement property costs more than the net sales proceeds from the sale of the relinquished property, the excess amount is added to its basis. Another way to calculate the new basis is to take the cost of the replacement property and subtract the gain that is deferred in the like-kind exchange.

For example, a taxpayer sells a commercial building for $500,000 with an adjusted tax basis after depreciation of $150,000. The taxpayer decides to complete a like-kind exchange for this sale. In the like-kind exchange, the taxpayer acquires another commercial building for $550,000, investing an extra $50,000. The basis of the replacement property is calculated as follows:

  • Adjusted Basis of Relinquished (Original) Property
  • Plus: Additional Amount Spent on Replacement Property
  • Basis of Replacement Property

$150,000

50,000

$200,000

Alternatively, the basis can be calculated as follows:

  • Cost of Replacement Property
  • Less: Gain Deferred in Like-Kind Exchange
  • Basis of Replacement Property

$550,000

(350,000)

$200,000 

Once the basis of the replacement property is determined, the next step is to establish what method and life should be used to depreciate the property. There are two methods prescribed by the IRS that can be used to determine tax depreciation for like-kind property. The first method separates the replacement property into two components for depreciation: the basis of the original or relinquished property; and the additional or excess basis from the exchange. The treatment varies based on the method and recovery period of the replacement property in comparison to the original property. If the replacement property has:

  1. The same method and recovery period: the taxpayer should continue to depreciate the original property basis in the same manner as the original property. The excess basis should be depreciated starting with the date of replacement using the same method and life as the original property.
  2. A longer recovery period: the taxpayer should depreciate the original property basis over the remaining life using the longer recovery period. The excess basis should be depreciated starting the date of replacement using the longer recovery period.
  3. A shorter recovery period: the taxpayer should continue to depreciate the original property basis in the same manner as the original property. The excess basis should be depreciated starting the date of replacement using the shorter recovery period.
  4. A less accelerated depreciation method: the taxpayer will depreciate the original property basis using the less accelerated depreciation method. The excess basis should be depreciated as if placed in service at the time the original property was placed in service but using the less accelerated method.
  5. A more accelerated depreciation method: the taxpayer should continue to depreciate the original property. The excess exchange basis should be depreciated as if placed in service at the time the original property was placed in service using the same method as the original property.
  6. Non-depreciable property: if depreciable property is exchanged for land, the taxpayer cannot depreciate the replacement property. Both the original property and excess basis would be land.

In all cases, no depreciation is taken during the time between the sale of the original property and the acquisition of the replacement property.

The second method allows a taxpayer to elect to treat the basis of the replacement property as a new asset placed in service at the time the replacement property is acquired in the exchange. This election is made by the taxpayer deferring the gain; it is not made at the partner level in a partnership/LLC or at the shareholder level in an S Corporation. A separate election must be made for each like-kind exchange. This election can only be revoked with consent from the IRS. This method could be beneficial if the replacement property is of a shorter life or a more accelerated depreciation method. Another benefit of this method is its simplicity.

Please contact your Sikich tax advisor if you are interested in learning more about like-kind exchanges.

This publication contains general information only and Sikich is not, by means of this publication, rendering accounting, business, financial, investment, legal, tax, or any other professional advice or services. This publication is not a substitute for such professional advice or services, nor should you use it as a basis for any decision, action or omission that may affect you or your business. Before making any decision, taking any action or omitting an action that may affect you or your business, you should consult a qualified professional advisor. You acknowledge that Sikich shall not be responsible for any loss sustained by you or any person who relies on this publication.

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