Sec 1250 gain & like-kind exchange

[appelman]

If you sell rental property at a gain, the accumulated depreciation becomes unrecaptured Section 1250 gain, subject to taxation at up to 25%. If, instead, you carry out a Section 1031 or 1033 exchange, the accumulated depreciation folds into the calculation of the basis of the property received and appears to lose its Sec 1250 character. Is this a perq of the exchange, or am I missing something?

[Gary2]

The accumulated depreciation remains accumulated depreciation in the new property (other than amounts that must be recaptured and recognized at the time of the exchange, if any). You don't get to restart the depreciation clock.

For example, if you own a residential rental for 10 years, then do a totally tax free exchange with no boot either way, you don't get a new 27.5 year period on the new property. You only get the remaining 17.5 years, and the unrecaptured 1250 gain is the total from both old and new properties.

There are variations, elections, and complications, but that's the gist of it.

[appelman]

Election out?

See p. 50 of Pub. 946. If you make this election, tt seems as though you really are restarting the clock. How is the accumulated depreciation tracked in this case, other than being folded into the carryover basis?

[abby]

still need to keep track of this

We use a firm created spreadsheet to keep track of attributes like this - when the property is disposed or traded again, we then have record of the nature of the gain realized, deferred and recognized. Each additional trade is added and the amounts on the prior trade adjusted as need be, and the attributes of the latest property recorded.

This is also where we track state gain that has been deferred if the trade is to a different state from the old property - the same idea - the obligation is still there, but it must be tracked independently from the depreciation on the new property.

Incidently, we pretty much always make the election to start the clock anew. I followed the instructions to set up the old/new asset depreciation a couple of times back in the day and really thought any advantage to the taxpayer was eaten up in extra fees for the time consuming process of making the calculations.

[Gary2]

See p. 50 of Pub. 946. If you make this election, tt seems as though you really are restarting the clock. How is the accumulated depreciation tracked in this case, other than being folded into the carryover basis?

In order to make this election, you must "treat the adjusted basis as if disposed of...." That's not very clear, so I had to follow the links to the 4562 instructions and the IRS regs 1.168(i)-6, in particular -6(i) and -6(j) (which points back at the 4562). The regs say that this election doesn't affect the application of sections 1245 and 1250.

It's still not perspicuous, but my take is this: The standard rules require you to treat the carryover basis (i.e. from the original property) and the excess basis (e.g., from having to pay cash in addition to the original property) as two separate depreciation items. Electing out of this allows you to treat it all as excess basis. It doesn't change the total amount, and doesn't change the 1245/1250 issues. If the properties have the same recovery periods, then the main effect is that it will take longer to fully depreciate it.

[appelman]

Interesting!

Thanks for the research, Gary. But I still don't have a clear idea how you'd handle the accumulated depreciation of the property given up when you sold the replacement property. It has already been taken into account in the carryover basis, and you don't want to have it double taxed!

[Gary2]

I don't understand what the confusion is.

Let's try a very simple example. You exchange one 1250 property, residential real estate with a FMV of $120K for another residential real estate with a FMV of $120K, no boot either way. Your original property has a cost of $100K and five years depreciation of $20K, for an adjusted basis of $80K and $20K subject to the 1250 unrecaptured gain rule.

You realize $40K of gain, but recognize none of it. Your basis in the new property is $80K, deducted over the remaining 22.5 years (= 27.5 - 5 already taken), with $20K of accumulated depreciation that will be subject to the 1250 rules upon disposal.

For both the original property and the replacement property, you need to track both the adjusted basis and the accumulated depreciation.

[appelman]

Imho

The "confusion" is how you enter it into the return. In your example, you should not include the 20K on Line 22 of Form 4797, since it was already included in Line 21 when the carryover basis was calculated. So where do you put it? Perhaps put it on line 12 of the Unrecaptured Section 1250 Gain Worksheet in the Schedule D instructions, with the condition that the sum of lines 1 and 12 entries on the worksheet for a particular property cannot exceed line 24 of Form 4797 for that property. Doable, but messy!

[Gary2]

The "confusion" is how you enter it into the return. In your example, you should not include the 20K on Line 22 of Form 4797, since it was already included in Line 21 when the carryover basis was calculated. So where do you put it? Perhaps put it on line 12 of the Unrecaptured Section 1250 Gain Worksheet in the Schedule D instructions, with the condition that the sum of lines 1 and 12 entries on the worksheet for a particular property cannot exceed line 24 of Form 4797 for that property. Doable, but messy!

It wouldn't be included in line 21. Line 21 on Form 4797 is the unadjusted basis, or more precisely, the basis without taking into account any of the adjustments that belong on line 22. The instructions for Form 4797 give a long list of things that belong on line 22, but it's mostly depreciation, credits, and previous recaptures that affect basis. The instructions for this line then finish with a remark that this line might include depreciation from other assets, and hence line 21 might need additional adjustment.

[appelman]

But the 20K (in your example)...

...was, in fact, included in the calculation of the gain on disposition of the original property, and thus in the carryover basis of the replacement property. Perhaps you are suggesting that when the replacement property is disposed of, the basis should be adjusted upward by 20K (to take out the depreciation on the original property), and the 20K should be added to the depreciation taken since the exchange. I guess that would do the job. I think it may all come down to finding the best way to skin the cat!

[Gary2]

...was, in fact, included in the calculation of the gain on disposition of the original property, and thus in the carryover basis of the replacement property. Perhaps you are suggesting that when the replacement property is disposed of, the basis should be adjusted upward by 20K (to take out the depreciation on the original property), and the 20K should be added to the depreciation taken since the exchange. I guess that would do the job. I think it may all come down to finding the best way to skin the cat!

That's one way of looking at it, and indeed, the 4797 instructions point out that the cost basis may need to be "unadjusted" this way.

Another way of looking at it is to just allow that a given property can have different bases, depending on context, and thus you may need to track basis in multiple ways. For 4797 purposes, I just think of it as having both a cost basis and an adjusted basis. A simpler example is when someone converts a home to business use after the FMV drops below the original adjusted basis. The basis for depreciation is the FMV, but the basis for gain/loss starts with the original adjusted basis. Or consider a gift when the FMV is below the original basis, where the basis for gain/loss depends on the selling price.

In terms of double-entry bookkeeping (if I may venture far from my expertise), there would be an asset account and an offsetting accumulated depreciation account. On the like-kind exchange, you can't simply create a new asset account using the carryover basis for the new property with a zero balance accumulated depreciation account.

[appelman]

Sounds reasonable, if complicated.

Considering that you are one of the few people who have even understood my question, I suspect that a lot of preparers simply ignore the issue and let the Sec. 1250 gain disappear. And, of course, if the favored treatment of capital gains is revoked, the whole matter may become moot.