Another 1031 exchange question...

I see a lot of 1031 exchange questions but I think mine is fairly unique and I thought I'd find out if anyone had run into this. I have a client who did a fully legitimate 1031 exchange. Client sold land and bought land -- no boot or mortgages to worry about. Both pieces of land had depreciable assets on it. Let's keep it simple and say just fencing. Can the sale and purchase of the fences be handled outside of the 1031 exchange even though they were included in all of the paperwork -- in other words, can I simply sell the first fence on Form 4797 and start depreciating the new fence as if they were separate transactions? In essence, can I cherry pick the items that I want to have a deferred gain and those I don't? Another question might be...if a taxpayer goes through all the trouble of doing the 1031 paperwork with a QI, but decides not to defer the gain, can he act as if the exchange was just a separate by and sell or does the QI force you into the 1031 exchange? Thanks for any thoughts or guidance.

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4 Replies

dublincpa

Contributor

10/09/10 2:32pm PDT

I have never known the deferral aspect of the LKE rules to be voluntary if you qualify. The benefits of qualifying are usually sought and care is taken to qualify, but I have never seen anything that would allow an opt out. I have never looked for an out though. So, I can't say it doesn't exist.

Is there anything about the situation that can be done to intentionally disqualify it now? Can the client throw a few parties on the land or allow friends/family to hunt or ?? in order to disqualify it with personal use?

Are you certain that the depreciable property exchanged is in fact like kind. If you can distinguish personal property from real property improvements, that might help your cause. You may consider a cost segregation study to disqualify elements of depreciation from like kind if that is an appealing strategy.

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angelacpa

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10/09/10 2:56pm PDT

Everything purchased and sold was business (Sch F) related so there isn't any personal property. The goal is to pay capital gains taxes on the fence sold and depreciate the new fence. To do the 1031 exchange on the land, it wouldn't make sense financially to buy the land separate from the improvements because of all the attorney and document fees, I assume.

I guess one angle I come at it from is that the 1031 exchange allows you to defer a gain. So if you don't want to defer the gain (or just not all of it in this case), wouldn't the IRS look somewhat favorably on that since they would be getting paid sooner? Also, in the event they said the taxpayer can't separate the depreciable assets from the land in the exchange, they wouldn't owe any tax because the gain would be deferred. Would you get penalized for erroneous reporting?

What's the worst that could happen if we report the depreciable assets bought and sold separately and the IRS says, no, it should have been part of the exchange?

Thanks for your thoughts.

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dublincpa

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10/11/10 6:42am PDT

Best Answer - Chosen by the Community

If it's not already closed, boot could be received to trigger income recognition. Depreciation gets recaptured first before cap gain is recognized though. I don't know if the fencing gets the favorable 25% 1250 treatment though. Has the FMV of the fence increased beyond the original basis?

I have to reiterate that I have no reason to believe that the deferred treatment is permissive or an allowance. I have seen nothing that allows recognition if you qualify for deferral of income. You should really check that out.

As far as getting paid sooner, being a motivation for the IRS to pass on an audit adjustment, what about shifting income to lower current rate years and deductions to future higher rate years? If one of the subsequent years with too much depreciation is audited after the three year refund statute is up on the over reported income for the year of the exchange, would the client be out the extra tax? I have only had experience defending how accelerated deductions impact future years and basis, never accelerated income.

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TaxProf

Contributor

10/11/10 12:14pm PDT