A tax update for oil and gas firms: A new wrinkle in the depreciation rules for MACRS property acquired in link-kind exchanges or involuntary conversions

Petroleum Accounting and Financial Management Journal, Fall 2001 by Ward, Dan R, Metrejean, Cheryl T, Ward, Suzanne Pinac

Firms in the petroleum industry, producers as well as service-related companies, often engage in like-kind exchanges and frequently have assets that are involuntarily converted. These firms should be aware of a significant change in the depreciation of certain property that has resulted from the issuance of IRS Notice 2000-4' which seeks to clarify the depreciation of Modified Accelerated Cost Recovery System (MACRS) property acquired in a Section 1031 like-kind exchange or an involuntary conversion covered under Section 1033. The notice may materially affect the timing of depreciation allowed or allowable on the asset and could result in the firm reporting a change in accounting method.

Background and Overview

Under current tax law certain property transactions are not taxable even though a gain or loss from the sale or disposition of property may be realized. The code provides that gain or loss may be postponed (i.e., not recognized) at the point of sale or disposition.' Two common circumstances under which a gain or loss may be postponed are (1) like-kind property exchanges and (2) involuntary conversions of property that is replaced with qualified property.

General Like-Kind Exchange Rules

The exchange of property for the same kind of property is the most commonplace nontaxable exchange. Section 1031 states that "(n)o gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like-kind which is to be held either for productive use in a trade or business or for investment."3 Section 1031 is not elective. If the like-kind exchange conditions are met, the deferral of the gain or loss is mandatory.

Totally tax-free exchanges result only when the property received in the exchange is "solely" like-kind property. lf cash or other non-like-kind property (i.e., boot) is received in the exchange, then a gain is required to be recognized to the extent of the lesser of the realized gain or the boot.' Additionally, if a liability is assumed, or if the property exchanged is taken subject to a liability, the liability is considered as money (i.e., boot) received.' It is important to remember that, while the receipt of boot may result in the recognition of a realized gain, boot does not trigger loss recognition. Additionally, a taxpayer may also be required to recognize a gain or loss if boot is given and the boot's adjusted basis is different from its fair market value (FMV).

The basis of the like-kind property received in the exchange can be calculated in one of two ways. First, the basis of the like-kind property acquired can be computed as follows:

Adjusted Basis of Old Adjusted Basis of Boot Given Up Gain Recognized - FMV of Boot Received - Loss Recognized.

Alternatively, the company may find the adjusted basis of the newly acquired property by simply subtracting/adding the postponed gain/loss from the FMV of the new. The fundamentals of a like-kind exchange are illustrated in Example 1.

General Involuntary Conversion Rules

Sec. 1033 provides that an involuntary conversion results from the destruction, theft, seizure, requisition, or condemnation of property.6 The destruction ofthe property may be partial or complete! Taxpayers who realize a gain as a result of an involuntary conversion may elect to defer recognition of part or all of the gain if (1) qualifying replacement property is acquired within a specified time and (2) the amount invested is equal to or greater than the amount realized from the converted property (usually the insurance proceeds). Sec. 1033 does not apply to losses.

The gain from an involuntary conversion is deferred to the extent that the taxpayer acquires replacement property that is similar to or related in service or use to the converted property and the cost of such property equals or exceeds the proceeds (amount realized) from the conversion.8 If the cost of the replacement property is less than the proceeds, then the excess is recognized gain to the extent of realized gain. Gain deferral requires that the proceeds be reinvested within the replacement period. This period begins at the date of the involuntary conversion and ends two years (three years for condemned real property used in a trade or business) after the close of the first tax year in which any part of the gain on the condemnation is realized.9

For most firms, to qualify as similar to or related in service or use, the replacement property must meet the functional use test; i.e., it must be used in the same manner as the converted property." However, business or investment property that is involuntarily converted as a result of a presidentially declared disaster may be replaced with any tangible property that is held for productive use in the trade or business.11

The basis of the replacement property in an involuntary conversion is its cost minus the deferred gain on the conversion." Example 2 presents an illustration of an involuntary conversion and computation of basis.