How do you treat a negative basis value assigned to a replacement property as the result of a 1031 Exchange?

[jamie-m-todd]

I completed a 1031 Exchange in 2023 in which the relinquished property was replaced by 3 replacement properties.  One of the replacement properties is a convenience store/fuel center.  The other two properties are really mineral rights which generate royalty payments -  in which there is no physical land.

Please note, I am using the "2 schedule" method, which addresses each property separately versus combining all 3 - from a tax filing perspective. 

From speaking with other Turbo Tax experts I believe the following is true:

1. Royalty Properties, as in the case of oil and gas mineral rights, cannot be allocated any land tied to the relinquished property’s original basis or any replacement property’s additional basis.
   1. I’m interpreting that into 100% of the land value tied to both basis numbers gets assigned to the convenience store.  Is that correct?
2. While you cannot depreciate a basis amount assigned to a Royalty Property, you must assign a reasonable value to it as it was also a property received in the trade.  It can be used when and if I sell those rights to reduce any gain in the future.  Is this correct?
1. Seeing the 2 Royalty Properties represent 74% of the total replacement value, I’ve assigned 74% of the original and additional basis values to these 2 properties.  Once assigned, that 74% will remain untouched until the mineral rights are sold.
2. The remaining 26% of the basis numbers have been assigned to the convenience store.

The negative basis number assigned to the convenience store is just a matter of subtracting 100% of the land from only 26% of the remaining basis that has yet to be depreciated.

Here are how the numbers played out between the relinquished property and the convenience store replacement property.

Relinquished Property:

• $320k cost
• $64k land value
• $166k prior depreciation
• $89k remaining basis

Convenience Store Replacement Property:

• $84k apportioned cost
• $64k apportioned land value
• $44k apportioned prior depreciation
• Calculation = $ Apportioned Remaining Depreciable Basis = (Apportioned Cost minus (Apportioned Land Value from Relinquished Prop + Apportioned Prior Depreciation from Relinquished Prop)
• $84k – ($64k + $44k) = -24k

To note, the additional basis coming from the convenience store (which has a structure that can be depreciated), after factoring in the relinquished property's loan/debt, AND after being allocated across all 3 properties, is not enough to offset the negative basis coming from the Relinquished property to the convenience store replacement property.

MAIN QUESTION:

What do I do when it is a negative basis value?  Do I enter the -24k, or the value $0?  How is this usually handled?

Any guidance here will be greatly appreciated!

Thanks!

As a reference, TurboTax experts that assisted me last year, just in case they can address this question

@DianeW777

@AmyC 

[DianeW777]

Let's simplify the best way to handle this.  Keep the original property in tact and change the name to the new store. Split all the up charges (additional money you paid including loan you took over minus any loan given up on the old property) and split it between the new mineral properties.  This could make it all much simpler and there should be no negative basis.  This would be the amounts that are not depreciated and remain with the mineral property until sold.  A paper tracking for a future sale.

The land is causing the issue, however, there should be no negative basis in the equation.

Let me know if this makes more sense to you.

@jamie-m-todd 

[jamie-m-todd]

@DianeW777 

Hello Diane.  Great to hear from you!  Thank you for your response.

I'll need a little more guidance to be truly grounded in your recommendation.  However, before I ask follow-up questions on that front, can you please tell me if this approach strays away from the "2 schedule" method that you recommended and we applied for my 1031 event last year?  What I like about the 2 schedule approach is that each replacement property is truly broken out and tracked separately, which makes future exchanges between each respective property/entity much easier to apply.  It can also possibly be beneficial when the different replacement properties have different depreciation terms.  Please let me know your thoughts here.  Ideally, it would be nice if each of my 1031 exchange events followed the same structure.

Thanks so much!

Jamie

[DianeW777]

The '2 schedule' approach is fine, however the confusion begins because there is no negative value based on the overall 1031 exchange.

As noted last year, the information was provided when it was not yet clear with respect to receiving only one building in the trade for three properties when only one building (convenience store) was actually received.  See a portion of last year's notes:

1. 'Part 2: All fees with the exception of marketing would be added to the cost basis as part of the buy up charges.  Add those fees to the assets mentioned above before apportioning it.'
2. You did not acquire another building: 'When you enter the new properties (Add another property for each building), you will select as noted above and they will be depreciated using the correct 39 year recovery.'

• NOTE:  **** Although the actual trade did include mineral property, the land must be a factor that must be used in the formula to arrive at the correct amount for purchase of the mineral property regardless of the fact it cannot be depreciated or be called land.
• This will actually reduce the land value associated with the convenience store as it should.  There is no negative amount in the exchange.

The added up-charge we originally calculated of $118,000 which requires a portion assigned to the mineral properties. This, as you noted, is not depreciable so it stays on-hold until you trade or sell the mineral properties.  It doesn't have to be the entire amount that is assigned to the  mineral properties, however the formula must work out in a positive result.  You did NOT have a section 1031 trade that resulted in a loss.

If you believe the full land value should remain with the new convenience store, then you would simply leave the original building in tact as it was and continue to depreciate it even if you enter it again to rename it.  Keep in mind this retains the same character as if it was never traded.  The purpose is to defer any gain until you fully dispose of the replacement property.

• As stated earlier, then the $118,000 would be split between the two mineral properties and suspended until sold.  

@jamie-m-todd 

[jamie-m-todd]

@DianeW777 

Hello Diane,

Thank you so much for your follow-up!

I'm now finding these 2 recommendations in conflict:

1. From last year's correspondence: 
   1. "No, if you do not own the land and only the mineral rights then no amount of the assets should be applied to land for the oil & mineral property.  It was not previously clear there was no land ownership with this property."
2. From this year's correspondence:
   1. "NOTE:  **** Although the actual trade did include mineral property, the land must be a factor that must be used in the formula to arrive at the correct amount for purchase of the mineral property regardless of the fact it cannot be depreciated or be called land."

I agree, if I can allocate a good portion of the $64k from the relinquished property to the 2 oil and gas properties it will solve for the negative depreciable basis for the convenience store.  I could use each replacement properties value as a percentage of the entire replacement cost to apportion that land.  In the case of the convenience store, its value is only 26% of the whole.  Thus only 26% of the $64k land value of the relinquished property would be tied to the convenience store; or $16.6k.  Please let me if I misunderstood you last year, and this is possible.

Last year I did not have to apportion any land to the single oil and gas property to have a positive depreciable basis for each of the 3 replacement properties.  More-than-likely this is due to having assets and land on 2 out of the 3 properties which accounted for about 72% of the overall replacement value.  Based on your most recent reply, please let me know if this wasn't the correct (or best) decision.  Allocating some of the land value to the single oil and gas property would provide more depreciable basis to the 2 other properties with assets that can be depreciated.

Thanks again Diane for your great insight!

Jamie

[DianeW777]

Yes, allocating all of the cost basis (including land) of the assets traded along with the additional added funds would be the appropriate action which will include the land from the original property.  The new property in total must be represented with a basis that makes sense.

I agree there was much detail last year that could be confusing.  You should do as you indicate here: 'I could use each replacement properties value as a percentage of the entire replacement cost to apportion that land.'

@jamie-m-todd 

[jamie-m-todd]

@DianeW777 

Good morning Diane,

Thanks for the clarification.  I think I am slowly learning that preparing your taxes is more like an artform than a science.  🙂

Here are my thoughts for next steps based on our discussion:

Original Basis from Relinquished Property:

1. Apportion the cost/value of the asset/improvement, land, and prior depreciation to all 3 replacement properties using the same method - using each replacement properties value as a percentage of the entire replacement cost.
2. For the 2 oil and gas properties, those apportioned values will for all intensive purposes reside outside of the tax return, to be used once those properties are sold or exchanged for another property.

Additional Basis from Replacement Properties:

1. Once I subtracted the remaining loan amount of the relinquished property ($107k) from the loan amount of the convenience store replacement property ($118k), I only have $11k of additional basis that can be used.  (no loans on the 2 oil and gas properties)
2. I then broke up the $11k across the 3 replacement properties using the same method from above - using each replacement properties value as a percentage of the entire replacement cost.
3. Here's where I run into questioning my approach in regards to apportioning the land.  As we know, the convenience store is the only property that has land, and it is worth 20% of the total value of that property.  Right now, I am assigning the land a value of 20% of the total $11k additional basis, which equates to a $2.2k land value.  I am then subtracting the $2.2k land value ONLY from the convenience store's portion of the $11k additional basis; which is $2.8k minus $2.2k equaling $600 that can be depreciated.  I am not assign any of the land value to the 2 oil and gas properties.
   1. Is this correct?  Should that 20% land value be applied against the entire $11k additional basis number, and the convenience store has to absorb its land portion AND the land portion that would have been allocated to the 2 other properties if they were not mineral rights? 
   2. OR, is the land value calculation really taking 20% of ONLY the convenience store's portion of the additional basis number; which would be 20% of $2.8k equaling $560? 
   3. If #2 above is true, is the entire $560 land value assigned to the convenience store, OR it is split up across the 3 properties?

Your thoughts on the above steps/questions would be so greatly appreciated Diane.

Thanks so much!

Jamie

[DianeW777]

Of course, I'm here to help.

• Yes, to both questions 1 & 2.
• Yes,  the land value calculation really taking 20% of ONLY the convenience store's portion of the additional basis number; which would be 20% of $2.8k equaling $560?  This makes sense in the big picture of the 1031 exchange in your situation.
• The entire $560 should remain with the convenience store.

@jamie-m-todd 

[jamie-m-todd]

@DianeW777 

Thank you for those additional comments Diane.  I think I see the light at the end of the tunnel!

Based on your input, it could be financially beneficial to adjust the numbers for my 2022 tax return as it relates to the first 1031 exchange.  With that, I have these additional questions:  

1. Is it possible to make any 2022 adjustments in the 2023 tax filing, and it will "true itself up" for both the 2022 and 2023 years?  Any changes in funds owed or due to the Fed or state related to 2022 will be included within the funds calculated as part of the 2023 year?
2. OR, would I have to redo my 2022 tax filing as a separate event?  Once the 2022 tax return has been updated and refiled, I'd re-pull those changes into my 2023 tax file in TurboTax.  I believe you can redo/resend the 2022 tax return as part of TurboTax Premier?
3. Is it acceptable to keep the 2022 numbers as is even though they 1) are not optimizing the depreciable basis, and 2) the calculation/use of the land value differs from the second 1031 exchange?  As noted before, the calculation for the first 1031 exchange in 2022 did not result in a negative basis for any of the properties.

Just to reiterate, the main differences between the 2 years include:

• 2022 Year:
  • Did not assign a land value from the relinquished property to the single oil and gas property.
  • For the additional basis calculation, I applied the land value percentage for each of the 2 properties with the improvement and land against the TOTAL additional basis (across all 3 properties) versus applying it against ITS OWN allocated basis.
• 2023 Year:
  • Will assign a land value from the relinquished property to all 3 properties, including the 2 oil and gas properties.
  • For the additional basis calculation, will apply the land value percentage associated with the convenience store against ITS OWN allocated basis.

I so greatly appreciate your time!

Thanks!

Jamie

[DianeW777]

It depends, for 2022.  

1. If you would have had a greater depreciation amount and the difference is significant enough to provide a lower tax liability for you then you can amend; OR
2. If the difference is minimal then you could keep track of the depreciation you did use in 2022, and make sure to account for that when you sell.  See the instructions to amend below.

2023: Yes, use the allocation for the two oil and gas properties and the additional basis calculation appropriately for the land value percentage associated with the convenience store against ITS OWN allocated basis.

This was a detailed Section 1031 exchange which can create the need for the clarification you have provided.

Read all the instructions before you begin so that TurboTax knows the original figures and the new figures.  

If you want to make changes or add a document to a tax return that has already been submitted, you should follow these guidelines. 

• You must first wait until the initial return is completely processed. 
• You will have to use the same TurboTax account that you used for the original tax return. 
• Once you begin your amendment, you'll see your original return.  
• The refund calculator will start new at $0 and only reflect the changes in the refund or tax due 
• Only make changes to the areas of your return that need amending. 
• You have three years from the date you filed your return or two years after you paid the tax due (whichever is later) to file an amendment 

Select your product below and follow the instructions. Be sure to amend your state return as well.

Amend TurboTax Online 

Amend TurboTax CD/Download 

@jamie-m-todd  

[jamie-m-todd]

@DianeW777 

Good afternoon Diane,

Thank you so much for those details!  Very helpful.

In regards to adjusting my 2022 tax return with the land reallocation updates that we discussed, I am finding only a $200 gain in terms of a refund.  I don't think that gain may be worth it, even if I realize it each year for the next 5+ years.  However, what troubles me is it looks like I overinflated the replacement properties' costs (in the Asset section) for the 2 non-mineral properties.  With this error, I probably need to amend the 2022 return anyway.  Please see the questions below - Q2 related to this error.

Question 1:   For a mineral rights property, instead of depreciating an asset, you have depletion of 15% each year.  You mentioned this to me last year, and I used that 15% depletion as a deduction.  My question is, how does the basis allocated to the mineral rights property relate to this depletion?  For example, if I have only $20k of depreciable basis allocated to the mineral rights property, but over 5 years I take $40k worth of depletion, do I now have a negative basis?  Thus it makes sense to have perhaps more depreciable basis going towards the mineral rights property? 

Question 2:  Revisiting how I populated the Asset Cost numbers for my 2022 tax filing:

1. In regards to the Cost assigned to a replacement asset, that is simply its portion of the Additional Basis, in which the Additional Basis in my case equaled the new loan amount from the replacement properties minus the remaining loan amount from the relinquished property?  Correct?
   1. While it looks like I calculated and apportioned the Additional Basis correctly, I incorrectly added in the land value to that Cost number when the Additional Basis represents both the land and the asset.
   2. Example:
      1. Replacement Properties' New Loan Amount = $250,000
      2. Relinquished Property's Remaining Loan Amount = $100,000
      3. Additional Basis to allocate across Replacement Properties = $150,000
      4. Replacement Property 1 value as a percentage of all Replacement Properties = 30%
      5. Replacement Property 1 Apportioned Additional Basis:  30% * $150,000 = $45,000
      6. Replacement Property 1 Land Value of Property 1 Purchase/Cost:  20%
      7. Replacement Property 1 Apportioned Additional Basis allocated to Land:  20% * $45,000 = $9,000.  So far, is this correct?
      8. Error when populating Asset section:  Cost = $45,000 + $9,000 = $54,000. 
         1. I populated $54,000 in the Cost field when it should have been $45,000, correct?
         2. I populated $9,000 in Cost of Land field, which was right I believe, correct?

Please let me know your thoughts.

Thanks so much!

Jamie

[DianeW777]

The answers are shown below.

Starting with Question 2. 

• Correct? Yes you are correct.  Your replacement apportionment appears reasonable and correct as well.
  1. I populated $54,000 in the Cost field when it should have been $45,000, correct? No, TurboTax will automatically reduce the cost by the land, enter $54,000
  2. I populated $9,000 in Cost of Land field, which was right I believe, correct? Yes, this is correct.
     1. Depreciation will be calculated on $45,000 with the entries above.

Question 1. The depletion expense is allowed because the extraction of oil and gas actually reduces the land value when before extraction the land has a much greater value. Percentage depletion cannot exceed the cost basis below zero.  This must be tracked manually and retained with your tax file.

• Percentage Depletion

@jamie-m-todd 

[jamie-m-todd]

@DianeW777 

Hello Diane,

Thank you for the quick reply!  I'm not quite following your thoughts.

Question 2 regarding land allocation:

1. If $45,000 represents the total apportioned additional basis for Replacement Property 1, and 20% (or $9,000) of that amount is allocated as land, shouldn't the Cost of the asset be $45,000, in which the Cost of Land field is populated with $9,000?  The $54,000 was a number I created by incorrectly adding the $9,000 to the $45,000 when it already contained it.  Please confirm.
2. FYI, the 20% allocation for land was based on the land value as it related to the replacement property purchase.

Question 1 regarding depletion:

1. I think we are on the same page here.  If the original basis (from relinquished prop) and additional basis (from replacement properties) that is apportioned to the mineral rights property (and saved outside of TurboTax) is for example $100,000, then the depletion accumulated over time cannot exceed the $100,000, or else you would have a negative basis amount.  Please confirm.
2. If this is correct, then having a greater basis value apportioned to the mineral rights property is beneficial, having the same weight/impact as assigning it to a property with a depreciable asset.  Please confirm.

Thanks so much!

Jamie

[DianeW777]

TurboTax knows to remove the land portion once you enter the full cost of the convenience store and then the land portion of that cost.  If you allocated a total cost to the convenience store of $54,000 (Building $45,000 and land $9,000) enter the total cost of $54,000 and then enter the land of $9,000.  You know the exact numbers. 

Close estimate of depreciation for one full year on the building only: 

• $45,000 x .03636 = $1,636  (the fraction changes every so many years by a miniscule amount. 
• See the table below.

Question 1:

1. Confirmed.
2. Confirmed.  The difference is it must be tracked by excel or pen and paper.

@jamie-m-todd 

[jamie-m-todd]

@DianeW777 

Hello Diane,

Seeing there was so much going on with last year's numbers, I thought it would be easier to clear things up on my side with a new example.  Therefore, in reference to that example (recaptured below), I have these comments/questions:

1. Are steps 1-3 correct in terms of calculating the additional basis, which you've referred to as "up-charges"?  Please confirm.
2. If yes, assume we portion 30% of that $150,000 up-charge to Replacement Property 1.  In turn, the total cost allocated to Property 1 would be $45,000.  Please confirm.
3. If yes, then the $45,000 needs to be split up to represent the asset and a portion set aside for land.  Please confirm.
4. If yes, and we assign the land value at 20% of the overall cost of Property 1, then $9,000 of that $45,000 would be allocated to land.  Please confirm.
5. If yes, then the Asset's Cost field would equal $45,000 and the Cost of Land field would equal $9,000.  In turn, the depreciable basis would be $36,000 ($45,000 - $9,000) and not $45,000 ($54,000 - $9,000).  Please confirm.

Here is that example again:

1. Replacement Properties' New Loan Amount = $250,000
2. Relinquished Property's Remaining Loan Amount = $100,000
3. Additional Basis to allocate across Replacement Properties = $150,000
4. Replacement Property 1 value as a percentage of all Replacement Properties = 30%
5. Replacement Property 1 Apportioned Additional Basis:  30% * $150,000 = $45,000
6. Replacement Property 1 Land Value of Property 1 Purchase/Cost:  20%
7. Replacement Property 1 Apportioned Additional Basis allocated to Land:  20% * $45,000 = $9,000. 

Thank you for the details on how to calculate the depreciation of an asset.  Very helpful!

Jamie