Basis, Depreciation and QBI after 1031 Like-Kind Exchange

[cparke3]

So I completed a 1031 like-kind exchange last year, complete with filing Form 8824 to declare to the IRS the amount of Deferred Gain (Line 24) and Adjusted Basis of the Replacement Property received (Line 25).

So this year I have to resume depreciation using the new property.  From what I have gathered, this also confusing time with several issues that I need to wrestle with.

Election

I can either continue the relinquished property's depreciation schedules on the the replacement property like the exchange never happened (which IRS prefers), or I can elect to start over with a single new depreciation schedule (which usually results in a lower depreciation deduction).  Nevertheless, I am intending to do the election for my case, but I am also considering the following questions and issues both ways to be sure that I really want to do that.

Not all cost is included in the basis

Either with or without the depreciation election, the weird thing is that after the 1031 Like-Kind exchange, not all acquisition costs are in the costs basis! The reason is the realized gain (comprised of prior depreciation and capital gain beyond that) on the sale of the relinquished property has actually been used to acquire the replacement property, but it must remain as "deferred gain" until the replacement property itself is sold?

Placed in service date

If I don't make the election, the placed in service date for each depreciation schedule also remains the same?  If I make the election, the placed in service date resets to the date I acquired the replacement property?

Land

While land does not depreciate, it does get subtracted from the basis when computing depreciation.  If I continue using the original depreciation schedules, I guess it's a simple matter and just ignore the change in land value, consistent with pretending nothing ever happened?  However, if I elect to start a new depreciation schedule on the replacement property's adjusted basis, then do I apportion the land value of the replacement property between the adjusted basis and the deferred gain that was used to acquire it?  It doesn't seem right to carry over the relinquished property's land value verbatim in this case.

State depreciation after taking bonus depreciation

Yes, I took some bonus depreciation in the past that is not allowed on my state return.  This means I have a different adjusted basis for state taxes vs. federal taxes (adjusted basis on the state return is higher).  In the past, the "Placed in Service Date" was used by tax software like TurboTax to determine whether to even ask about bonus depreciation, but if I elect to start new schedules, I need to somehow trick the software now to produce the adjustment on the state return?

QBI Property Limit test using Unadjusted Basis

Now this is where the confusion gets the worst.  Forget about discussing the safe harbor requirements for a rental real estate enterprise, I know that I don't qualify there but believe I do nevertheless under the general definition of a business in Section 162.  I know Land value is not qualified property for the test and excluded in the calculation.  And obviously, all prior depreciation has to be added back.  But how do I handle the Deferred Gain?  Is this also part the Unadjusted Basis for QBI purposes or not?  It certainly was part of the amount paid to acquire the replacement property.  However, it will be taxed at capital gain rates in the future.

Hopeful someone has some useful insight on how to tackle these issues...

[DianeW777]

Let's take this one step at a time. First, there's not a choice to begin new depreciation or placed in service date for any asset from the original property traded. 

1. Even if you choose to enter new assets under the new received property in the trade the can be renamed however they will be the same assets, date placed in service, cost, etc.
   • Any new assets would be the 'boot' or what is called the 'buy-up' costs.  This asset is money paid in addition to the property given up and begins depreciation on the traded date.
   • This can include any cost you had to pay including acquisition costs.
   • Placed in service remains the same for any asset on depreciation immediately before the trade, any buy-up begins on the trade date.
   • The state return differences is one reason why my want to enter the assets exactly as they were on the original property even if you do choose to re-enter each asset with a new name/location.
   • Deferred gain is taxed later which is why the assets must remain in tact and ready for a future sale to capture this when there is not a trade or a trade that can have taxable consequences such as a trade where unlike property could be in the mix. 
   • Land remains the same - the deferred capital gain is factored into any increase in value, which is why it is a tax deferred exchange.

Depreciation Rules:

The basic concept of a 1031 exchange is that the basis of your Old Property rolls over to your New Property. In other words, if you sold your Old Property for $100,000, and bought your New Property for the same, your basis on the New Property would be the same. It makes sense then that your depreciation schedule would be exactly the same, and does not change! In other words, you continue your depreciation calculations as if you still own the Old Property (your acquisition date, cost, previous depreciation taken, and remaining un-depreciated basis remain the same).

If you choose to enter the assets under a new rental property to allow for the changes to location you can use the steps below.

For the property given up (property A), you can indicate the following:

1. First use the Search (upper right) > Type rentals > Press enter > Click on the Jump to... link
2. Or Wages & Income > Rental Properties and Royalties > Update > Continue to Rental and Royalty Summary > Edit the property
3. Scroll to Assets/Depreciation  > Click Update > Select 'Edit' next to each asset
4. Edit beside each asset > Continue to the Tell Us About This Rental Asset
5. Select the checkbox beside 'This item was sold, retired, .... traded in ....etc. > enter the date it was traded (sold/retired)
6. Answer the question about whether it was 100% business > Leave the original date it was placed in service (may be purchase date or later depending on your circumstances)
7. Continue to the screen 'Confirm Your Prior Depreciation'  
   • The amount displayed is only for prior years and does not include the current year. 
   • Continue until you see the current year amount displayed and make a note to add the two amounts together for the Section 1031 like kind exchange.
   • This completes the asset portion of the trade.
8. Answer 'Yes' to Special Handling
9. Assumed that Form 8824 is already completed
10. Enter the new property as indicated in the bullets above.

[DianeW777]

Let's take this one step at a time. First, there's not a choice to begin new depreciation or placed in service date for any asset from the original property traded. 

1. Even if you choose to enter new assets under the new received property in the trade the can be renamed however they will be the same assets, date placed in service, cost, etc.
   • Any new assets would be the 'boot' or what is called the 'buy-up' costs.  This asset is money paid in addition to the property given up and begins depreciation on the traded date.
   • This can include any cost you had to pay including acquisition costs.
   • Placed in service remains the same for any asset on depreciation immediately before the trade, any buy-up begins on the trade date.
   • The state return differences is one reason why my want to enter the assets exactly as they were on the original property even if you do choose to re-enter each asset with a new name/location.
   • Deferred gain is taxed later which is why the assets must remain in tact and ready for a future sale to capture this when there is not a trade or a trade that can have taxable consequences such as a trade where unlike property could be in the mix. 
   • Land remains the same - the deferred capital gain is factored into any increase in value, which is why it is a tax deferred exchange.

Depreciation Rules:

The basic concept of a 1031 exchange is that the basis of your Old Property rolls over to your New Property. In other words, if you sold your Old Property for $100,000, and bought your New Property for the same, your basis on the New Property would be the same. It makes sense then that your depreciation schedule would be exactly the same, and does not change! In other words, you continue your depreciation calculations as if you still own the Old Property (your acquisition date, cost, previous depreciation taken, and remaining un-depreciated basis remain the same).

If you choose to enter the assets under a new rental property to allow for the changes to location you can use the steps below.

For the property given up (property A), you can indicate the following:

1. First use the Search (upper right) > Type rentals > Press enter > Click on the Jump to... link
2. Or Wages & Income > Rental Properties and Royalties > Update > Continue to Rental and Royalty Summary > Edit the property
3. Scroll to Assets/Depreciation  > Click Update > Select 'Edit' next to each asset
4. Edit beside each asset > Continue to the Tell Us About This Rental Asset
5. Select the checkbox beside 'This item was sold, retired, .... traded in ....etc. > enter the date it was traded (sold/retired)
6. Answer the question about whether it was 100% business > Leave the original date it was placed in service (may be purchase date or later depending on your circumstances)
7. Continue to the screen 'Confirm Your Prior Depreciation'  
   • The amount displayed is only for prior years and does not include the current year. 
   • Continue until you see the current year amount displayed and make a note to add the two amounts together for the Section 1031 like kind exchange.
   • This completes the asset portion of the trade.
8. Answer 'Yes' to Special Handling
9. Assumed that Form 8824 is already completed
10. Enter the new property as indicated in the bullets above.

@cparke3

[cparke3]

The taxpayer election that I was talking about regarding starting a new depreciation schedule rather than continuing the old one is provided for under Treas. Reg. section 1.168(i)-6(i) and exercised by attaching a statement to Form 4562 (Depreciation and Amortization) for the tax year that the replacement property is purchased. The regulations permit the taxpayer to elect out of the final rules and treat the entire replacement property as a new asset. This is briefly discussed in the instructions of IRS Form 4562, Depreciation and Amortization, in Part III, Section B (bottom of the left column on page 8 in the 2023 edition).  I haven't figured out yet how to attach such a statement in tax software such as TurboTax when e-filing, but if I can't find it I will just mail the return in paper form.

I think you're confusing "boot" with "buy-up" in your post.  They are opposite things.  "Boot" is taking cash or something else not like-kind out of the sale of the relinquished property, while "Buy-Up" is adding additional cash or mortgage indebtedness when purchasing the relinquished property.  In my case, I took no boot but I did add buy-up.

That said, I absolutely appreciate your response!  Over the past few days, I think I have resolved on my own some of the questions that I posed when I made the original post. However, I would like to go over my understandings here, as I might not be entirely right.

My post was mostly about how to depreciate after acquiring the new property, how should the deferred gain and any buy-in be properly apportioned in the new adjusted basis between building and land.  Let's try an example:

Old (relinquished) Property:

- Adjusted basis was $98,000 ($88,000 building and $10,000 land).

- Deferred gain was $52,000 (net proceeds of sale are $150,000).

New (replacement) Property:

- Purchase price $176,000

- Buy-in of $26,000 added (adjusted basis becomes $124,000)

- Replacement property is comprised of $160,000 building and $16,000 land

We necessarily bought the new property using a mix of remaining cost basis, deferred gain (which includes a certain amount subject to depreciation recapture in the future), and new money. 

1) Following the final rules and continuing all the old depreciation like nothing happened. The sum of the deferred gain and new money has to be properly allocated between building and land. We can't just say the first $6,000 of our buy-in funds went towards buying the new land, or new building, because some of the deferred gain of the transaction also went towards purchasing both the new building and land! The proper allocation may be found by first determining that the ratio of Deferred Gain to Buy-In, which in the example is 2:1 ($52,000 : $26,000), and then we apply that proportion to the $6,000 in new land actually purchased as $4,000 (2/3) paid from Deferred Gain and $2,000 (1/3) from Buy-In. As a result, from our total $26,000 of new cash/mortgage, we add $24,000 to building basis and $2,000 to land basis. The remainder was funded by the deferred gain, and that never goes into the cost basis! The new adjusted basis of $124,000 is therefore composed of $112,000 building and $12,000 land.  Just the new $24,000 is depreciated on a new schedule beginning on the date the replacement property is placed in service (the $2,000 towards land is non-depreciable).  Does that make sense?

(another approach to the building-land apportionment that I'm also considering is that since the $16,000 of land is 9.09% of the purchase price of $176,000, so land should only occupy 9.09% of the new adjusted basis and 9.09% of the deferred gain. In that case, $124,000 * 9.09% = $11,273 land allocated to cost basis, which means only $1,273 of the buy-in is allocated to land, with remainder of the buy-in added to building and depreciating. This is even better, but I am not sure if this reasoning is more correct!)

2) If we elect out of the final rules, then we treat the relinquished property as disposed on the date of its sale, and we begin new depreciation schedule on the entire new adjusted basis with a "placed in service date" on the date we acquired the replacement property. However, we still have deferred gain also funding the new purchase to deal with too. In this scenario, we also have to keep a permanent record of the accumulated depreciation when the old, relinquished property was sold, because while it was treated a disposed, no taxes were paid and that amount still needs to be recaptured one day even though it is no longer in our depreciation schedules. The same analysis for apportioning new basis between gain and buy-in still occurs, and the cost basis at acquisition is still $124,000 composed of $112,000 building and $12,000 land. However the depreciation of the old property's adjusted basis and the buy-in basis are instead combined into a new, single depreciation schedule which runs for the full life of the new asset. Obviously, since the old property's remaining basis will now depreciate for longer, the annual depreciation amount is going to be lower.

For QBI limit calculations, one of the tests calls for the unadjusted basis of the business's assets. After a 1031 like-kind exchange, that basically means to me that we take the new adjusted basis of building only and add back in all the accumulated depreciation.  Or just sum up all the original costs for building.  We do not include the basis of land, because land is not qualified property for the purpose of QBI.  We also do not include that portion of building cost that was funded by deferred gain, because that amount is not in the basis.  Sounds right?

For state tax returns in which prior bonus depreciation was not allowed by the state, it is simpler to just follow the final rules and continue the state depreciation as it did in the past. If you elect out instead, you can still handle this, but it is necessary to reduce the prior bonus depreciation by the amount of that has been already depreciated under state rules, and then declare this new amount on the new depreciation schedule as the bonus depreciation instead, and add the same amount also to the adjusted basis.  For the federal depreciation, this will have no net effect, as we just immediately subtract the remaining bonus depreciation off the equally higher adjusted basis (net change, 0) so the remaining depreciating basis will be the same as before. For the state return the adjusted basis will rightfully be higher as needed for computing the higher annual state depreciation expense deduction.

My reason for electing out of the final rules is I already had 12 running depreciation schedules on the old, relinquished property from various capital improvements over the years the I had it, including some that caused 50% and 100% bonus depreciation under the PATH Act and later TCJA.  Furthermore, I replaced one property with 15 properties in 8 states! As a result, I will need to enter 12*15 = 180 running depreciation schedules in order to follow the final rules! I also intend to keep doing Like-Kind Exchanges for as long as they remain allowed. For these reasons, I may prefer to take the hit of losing a few thousand dollars per year in annual depreciation expense deduction, for the benefits of slowing the decline in my adjusted basis and keeping depreciation expense amount more steady and going on for as long as possible.