1031 Exchange to 3 DSTs - How to Calculate and Convert Exchange Basis, Retire Relinquished Property, and Setup Replacement Properties

[jamie-m-todd]

@DianeW777 

Hello Diane,

In respect to your 2nd answer, now that we are all of the understanding the the Oil and Gas property is only for mineral rights, and not the land, the answer below would be in the context of only 2 properties, being the Ford Distro Center and the Senior Living Center.  Please confirm.

"Yes, the additional basis should be applied to all three properties because they are all tied to your original property traded in the transaction. All cost basis belongs to all three properties."

Thank so much!

Jamie

[DianeW777]

Although you cannot depreciate the amount assigned to the oil & gas property, you must assign a value to it as it was also a property received in the trade. 

If royalties are produced the depletion allowance is one way to have a deduction. Since minerals are a finite source and will eventually play out, the IRS code generally allows royalty owners to deduct up to 15% of the income from their mineral interests.

• IRS Publication 535

[jamie-m-todd]

Hello Diane,

Yes, the depletions have already been setup at 15% for the Oil and Gas property.  TurboTax did that for me...very handy!

Can you please break this statement down a little further for me?  "Although you cannot depreciate the amount assigned to the oil & gas property, you must assign a value to it as it was also a property received in the trade." 

1. Are you saying that the value of the Oil and Gas property ($250,000) still needs to be included in the "Fair Market Value of like-kind property received" in the "Sale of Business Property" section?  If YES, I still have that populated.
2. Or, are you implying that a portion of the original property's land ($62,000) still needs to be apportioned to the Oil and Gas property, even though I technically only own the minerals?  Is this a must have step to connect it to the 1031 Exchange?  Or is that done with #1 above?
3. Even if #2 is YES, I would not apportion any of the "additional" basis to the oil and gas property?  Is that correct?  I believe that is what you said in your earlier email today.

Thanks so much!

Jamie

[jamie-m-todd]

Sorry Diane, I forgot to tag you on the earlier message.  Please see above.

@DianeW777 

Thanks!

Jamie

[DianeW777]

You do not apportion any of the land since there is no land associated with that property but part of the $90,000 and the $118,000 are a cost of purchasing the these mineral rights since that asset is part of the trade.  Whatever portion you decide is appropriate, will be a cost basis and will not be depreciated. It will be used when and if you sell those rights to reduce any gain in the future.

You have a value for this in your first post and this property wasn't just added as a gift as part of the total like kind exchange.  I hope that makes it more clear for you.

[jamie-m-todd]

@DianeW777 

Hello Diane,

In all fairness, the appropriate cost basis for the Oil and Gas property would be based on its share of the total cost across all 3 replacement properties.  Do you agree in principle, and with the numbers below?  This is a shame, as it leaves about $56,000 of depreciable basis unusable (written down on a piece of paper).  Are there different sound arguments/methods of apportioning a basis that the IRS would accept that would decrease the Oil and Gas property's share of the original and/or additional basis values?

Replacement Properties (3) – DSTs 

• $903,000 = Total Replacement Cost to determine basis allocation
  • 27.7% = $250,000 = Based on Oil and Gas Purchase Price (Equity)
  • 54.6% = $493,000 = Ford Distro Center Purchase price =  $250,000 (Equity) and $243,000 (Loan)
  • 17.7% = $160,000 = Senior Living Center Purchase price (Equity)
• Original Basis = $90,000
  • $24,930 = Oil and Gas = 27.7% * $90,000
  • $49,140 = For Distro Center = 54.6% * $90,000
  • $15,930 = Senior Living Center = 17.7% * $90,000
• Additional Basis = $112,000
  • $31,024 = Oil and Gas = 27.7% * $112,000
  • $61,152 = For Distro Center = 54.6% * $112,000
  • $19,824 = Senior Living Center = 17.7% * $112,000

Thanks so much Diane!

Jamie

[jamie-m-todd]

@DianeW777 

To further my last thought above Diane...  Is there a justifiable means to apply some sort of Non-Land/ Non-Asset "Adjustment Factor" to the Oil and Gas property that can defend the reallocation of a significant portion of both the original basis and additional basis that has been apportioned to the property to properties 2 and 3?  For example, can 75% of the $56,000 basis that has been apportioned to the Oil and Gas property be reallocated to properties 2 and 3?  The reallocation percentages to properties 2 and 3 would be based on what percentage each property makes of the total cost of property 2 and 3 (not including the Oil and Gas property).  

I agree that the Oil and Gas property did play role in the 1031 Exchange, and so it should bear some weight in the apportioning of the original and additional basis numbers.  However, it just seems like a totally different asset class/ category, being a royalty on mineral rights, that proportioning it without applying some sort of factor seems a little overreaching.

Your thoughts on this would be so greatly appreciated.

Thanks so much!

Jamie

[DianeW777]

Because the oil & gas property is eligible for the like kind exchange and based on the value percentages you have used, the allocation is an accurate reflection of cost basis for each of the three properties received.

[jamie-m-todd]

@DianeW777 

Good afternoon Diane,

I was afraid that you might say that.

Just to be fully grounded, to reiterate, based on your last comment, it seems like there is no argument that would be accepted by the IRS that would allow one to transfer any portion of the basis allocated to the Oil and Gas property to Properties 2 & 3 , either the original basis or the additional basis?  This is despite the property being considered non-land  mineral rights, and the fact that the asset/improvement portion of the exchange are the dollars that would be apportioned? ($90,000 of the original basis being associated to the structure and $112,000 of the additional basis before minor land apportioning, as the land is only 5% or less of the total cost of the property for properties 2 & 3)

I guess the other side of the argument is that one could say Oil and Gas/mineral rights has its own version of a depreciation deduction in terms of the 15% depletion.

In the future, if I exchange the Oil and Gas property for a like-kind property with an improvement that can be depreciated, can a portion of the $56,000 basis tied to the Oil and Gas property be used to depreciate the asset at that future property?

Thanks so much!

Jamie

[DianeW777]

Yes, you can allocate the basis of the oil & gas property to an exchanged property in the future where some or all of it would be depreciated depending on the situation in the future exchange.

[jamie-m-todd]

@DianeW777 

Thanks for the confirmation Diane!

I  have been updating TurboTax Premier based on your guidance.  I do have a couple more questions:

1. Do I need to be concerned with the Prior Depreciation value that TurboTax calculated for Properties 2 and 3 in respect to the "original" basis asset entry?  Can I assume that it is correct based on the cost, land portion of cost, and asset business use start date that I entered?
2. For Property 2 (Ford Distribution Center), the "original" basis value defaults to a 39 year depreciation schedule because the replacement property is a warehouse.  The same goes for the "additional" basis entry.  Is that correct, or do I need to somehow override that to 27 1/2 years...?...at least for the "original" basis depreciation?  If YES, how would I perform that override?

Thanks so much!

Jamie

[DianeW777]

Yes, the depreciation for the portion of the original building is correct.

Yes, it's correct at 39 years. One adjustment you need to make is to put in the full amount of prior depreciation when it shows that figure.  This will eliminate taking excess depreciation for the one asset that is the original basis of the building traded. 

[jamie-m-todd]

@DianeW777 

Hello Diane,

Thank you for your comments.

Can you please tell me if I interpreted these statements correctly?

"One adjustment you need to make is to put in the full amount of prior depreciation when it shows that figure.  This will eliminate taking excess depreciation for the one asset that is the original basis of the building traded. "

Here are the steps I performed:

1. I apportioned the $158,000 of prior depreciation from the relinquished property to the 3 replacement properties.
2. The Oil and Gas prior depreciation ($44,000) will not be captured in TurboTax, but saved on a worksheet with the other calculations.
3. The TurboTax calculated values for prior depreciation per asset for replacement properties 2 & 3 were much less than what I manually calculated using the $158,000 number:  :  Ford Distro ($21,000 vs. manually calc'd $86,000), and Senior Living Center ($10,000 vs. manually calc'd $28,000).
4. Consequently, the depreciation expense that I could claim from the apportioned $90,000 of "original" basis decreased down to a $0 value for both properties 2 & 3 after adding in the manually calculated prior depreciation values.  In essence, the apportioned original basis became unusable - receiving no benefit at all.  This seems wrong - somewhere there is an error or a misstep.
5. When I ran the Federal error check, it flagged the Schedule E for the Senior Living Center stating that the prior depreciation amount cannot be any higher than $18,000.  Therefore, I changed it from $28,000 to $18,000 as stated.
6. FYI, every time I step through "Confirm Your Prior Depreciation" page, it defaults the value back to the TurboTax calculated value.

As I mentioned above, I do believe I made an error at some point in the process above, as the original basis coming from the relinquished property should still be an expense deduction for the remainder of the depreciation schedule tied to each respective replacement property.

Any insight here will be greatly appreciated!

Thanks,

Jamie

[DianeW777]

Yes, it makes sense that the depreciation would calculate at less for the property that is now 39 year recovery.  This is why I mentioned this for the original basis.  You should enter the correct amount actually used so that you do not use excess depreciation at some point. The 39 year recovery period will show a lower amount.  Enter the correct amount you calculated, 

Example:Quick Calc: The following is an example and not exactly your actual numbers.

Depending on the age of the original property, according to your dates you depreciated that property since 2004 which is 18 years at basically .03636 per year (or using your numbers for basis and depreciation so far, 63% of the cost before the trade). The rate is for 27.5 years before the change and .02564 for 39 years after the change. There is an estimated $43k excess at this time.  If you allow the prior depreciation that is calculated to remain so that you continue to receive depreciation expense for this and some future years you need to manually track so you do not exceed the cost basis.  This only applies to the original assets.  As long as you track the total depreciation expense each year you should be fine.  Just keep in mind you will not be alerted if you use too much depreciation and you don't want to be surprised by it later.

The new assets should be calculated correctly without manual intervention with the exception of the cost basis.

As you note in #6 above each time you go through this section the amount calculated will again be populated.

@jamie-m-todd 

[jamie-m-todd]

@DianeW777 

Good morning Diane,

I apologize, but I'm not quite able to connect the dots, even with the example.  If we could, let's walk through the easier of the 2 replacement properties with the structures, the Senior Living Center, which has the same depreciation schedule of 27.5 years as the relinquished property.  Using rounded numbers, $16,000 of the $90,000 original basis (associated with the structure) was apportioned to this property.  To simplify the example, in TurboTax I changed the date for acquisition and start of business use to 1/1/2004, resulting in 18 years of the 27 1/2 depreciation schedule used, leaving 9.5 years remaining.  TurboTax in turn systematically calculated a prior depreciation of $10,452 and a depreciation expense of $581 for 2022 and future years.  If we multiply the $581 by the remaining 9.5 years, that comes to $5,519.50.  When I add the prior depreciation of $10,452 to the $5,519.50 projected depreciation for the remaining 9.5 years I get $15,971.50; which is within the apportioned basis of $16,000.  So it seems like TurboTax calculated it correctly, and I should be able to expense $581 for 2022 and future years without having an excess depreciation.  

However, when I apply my calculated $28,000 value as the prior depreciation using the Senior Living Center's 18% portion of the $158,000, the depreciation expense gets zeroed out (going from $521 to $0).  This doesn't seem correct, as how could you have a prior depreciation that is more than the basis itself?  The Federal check, which flagged the $28,000 as an error, seems to confirm that $28,000 is not the right number; and suggested $18,000, which is the $16,000 structure basis plus the $2,000 of land basis allocated to the Senior Living Center from the relinquished property.  But the $18,000 doesn't seem correct either, as shown in the paragraph above.

I'm not sure what I am missing here.  Your thoughts would be greatly appreciated.

If I can understand how the Senior Living Center works, which shares the same 27.5 years as the original relinquished property, I think I can better understand how the Ford Distro Center will work, with the 39 year depreciation schedule.

Thanks so much!

Thanks,

Jamie