Q: Explanation how a potential owner can depreciate against their cash flow.
A: Depreciation is based on the adjusted cost basis of the property. For a straight purchase this would include the debt plus the equity (i.e. the total purchase price). For a 1031 exchange, the total purchase price of the replacement property must be reduced by the gain that is deferred on the relinquished property so in the case of an exchange the depreciable basis is less than the total purchase price. Land is never depreciable. If depreciable property and land are exchanged for land (with no buildings or improvements), the entire basis of the relinquished property becomes the tax basis of the land acquired as replacement property. If land and improvements are exchanged for land and improvements, the allocation of basis to the replacement land must be reasonable and the exchanged basis will have to be reallocated between land and buildings.
Assume that a farm property is traded for a new commercial office building. The cost basis of the farm (land and depreciable improvements) was $100,000 and accumulated depreciation to date of sale was $60,000 so that the adjusted basis is $40,000. The sale price of the farm is $200,000 and the deferred gain is $160,000 ($200,000 minus $40,000 adjusted basis). The purchase price of the new office building is $500,000 ($200,000 equity from the farm plus $300,000 of new debt). The tax basis in the new office building is $340,000, its purchase price of $500,000 minus the deferred gain of $160,000. Assume that the basis is the new office building is allocated $75,000 to the land and $265,000 to the buildings. The taxpayer now has a basis of $265,000 that can be depreciated. The taxpayer can elect to use a simplified method and start depreciating this entire basis over the 39 years resulting in an annual depreciation deduction of $6,795. Alternatively, the taxpayer can continue to depreciate the “old basis” over the remaining useful life of the old property and the “new basis” over the new life.
Please note that the rules are very complicated and that the investor should refer to their own tax advisor. The rules regarding depreciation of property received in a like-kind exchange are in Regulation Section 1.168(i)-6.
Treasury Department Circular 230 Legend: Any advice contained herein was not intended or written to be used, and cannot be used, for the purpose of avoiding United States federal, state, or local tax penalties. Unless otherwise specifically indicated above, you should assume that any statement in this material relating to any United States federal, state, or local tax matter was written in connection with the promotion or marketing by other parties of the transaction(s) or matter(s) addressed in this material. Any taxpayer should seek advice based on the taxpayer’s particular circumstances from an independent tax advisor.
