1031 Exchange from a GO Zone property to a non-GO Zone property without the recapture of the bonus depreciation?
My answer to this question…No!
In December of 2007, there were positions offered in tax literature that stated an IRC 1031-exchange from a GO Zone property to a non-GO Zone property would be allowed.
In my opinion, this position was (at best) aggressive.
In December of 2007, my advice to clients was as follows:
• At this time, I would base my economic decisions as if such an exchange would
not be allowed.
• At this time, I would restrict my planning use of IRC 1031-type exchanges between GO Zone properties which is still a rather large base of properties.
• If the IRS changes it general position from its current non-use to allowing GO Zone to non-GO Zone exchanges, a wise economic decision is only heightened.
• If the IRS changes its position, an option was only opened to you, no options were closed.
• If you are participating in a loan-forgiveness program, you need to hold the property for an extended period of time (usually 5 years) and so this issue has some time to play-out.
The tax world can move from development of appropriate tax planning tools to the development of very aggressive schemes to suit specific requests from their clients. The client wants a specific answer and the tax professional will substitute sound professional judgment and assistance to the client to provide such an answer no matter its aggression or risk level and no appropriate concern about its chance of support.
The result of that development are very aggressive programs based on an interplay of the following ideas: (A) Tax laws will change in the future and the client might be a beneficiary of that change, (B) The taxpayer’s return will never be audited on that issue, (C) If audited, the tax professional will somehow be able to win/settle the issue favorably for the client and (D) The tax professional’s opinion is so housed with disclaimers that they are protected from the effects of their aggressive advice.
I think the entire discussion on the use of IRC 1031-type exchanges from GO Zone to non-GO Zone properties is driven by a need for the very aggressive answers demanded by the client rather than providing the client sound tax advice.
In December of 2007, I called the appropriate department at the IRS and requested to speak to the individual which prepared the latest authoritative pronouncement on this question. The individual’s response was as follows:
• The IRS is aware of the debate regarding the use of a Section 1031-exchange from a GO Zone property to a non-GO Zone property.
• The IRS believes a key premise to the GO Zone legislation is the keeping of the GO Zone tax benefits within the GO Zone.
• The IRS is, at the current time, drafting a direct response to this GO Zone to non-GO Zone issue.
• The IRS will not provide any hints of their position on this issue at this time but did reaffirm their position that GO Zone benefits should stay in the GO Zone.
• The IRS appears to be giving tacit approval to the use of IRC 1031-type exchanges where two GO Zone properties are involved.
• There is not a public release date for the release of their position.
The safest tax answer at the present time is if you use an IRC 1031 exchange from a GO Zone status property to a non-GO Zone status property before the end of the depreciation period (use 27.5 years as a good guidance), you should plan on the need to recapture the bonus depreciation as ordinary income at the time of the exchange.
Those who think the answer is to recapture the bonus depreciation as ordinary income first pointed to Section 6 of Notice 2006-67 which is partially reproduced below:
If GO Zone property is no longer GO Zone property in the hands of the same tax payer at any time before the end of the GO Zone property’s recovery period…the tax payer must recapture in the taxable year in which… (it) is no longer GO Zone property the benefit derived from claiming the GO Zone additional first year depreciation…
Notice 2006-67 was replaced by Notice 2006-77 but, in my opinion, the fundamental position of Notice 2006-67 was affirmed.
Notice 2006-77 contains the following language which is very reminiscent of the superseded Notice:
SECTION 6. RECAPTURE RULES UNDER SECTION 1400N(d)(5)
.01 IN GENERAL. Section 1400N(d)(5) provides that for purposes of section 1400N(d), rules similar to the recapture rules under section 179(d)(10) and section 1.179-1(e) apply with respect to any GO Zone
property that ceases to be GO Zone property.
.02 APPLICATION. If GO Zone property is no longer GO Zone property in the hands of the same taxpayer at any time before the end of the GO Zone property’s recovery period as determined under section 167(f)(1) or section 168, as applicable, then the taxpayer must recapture in the taxable year in which the GO Zone property is no longer GO Zone property (the recapture year) the benefit derived from claiming the GO Zone additional first year depreciation deduction for such property. The benefit derived from claiming the GO Zone additional first year depreciation deduction for the property is equal to the excess of the total
depreciation claimed (including the GO Zone additional first year depreciation deduction) for the property for the taxable years before the recapture year over the total depreciation that would have been allowable for the taxable years before the recapture year as a deduction under section 167(f)(1) or section 168, as
applicable, had the GO Zone additional first year depreciation deduction not been claimed (regardless of whether such excess reduced the taxpayer’s tax liability).
Therefore, if I wanted to be beneficial for my clients, I would say IRC 1031-type exchanges appear to result in the recapture of the bonus depreciation when the exchange involves a GO Zone property to a non-GO Zone property.
There was an implied intent of the legislation to keep all of the tax benefits within the GO Zone due to their nature and benefit to the taxpayer. However, that intent is contrary to other parts of the legislation which implied an acknowledged for the need of capital outside of the GO Zone.
On 12 February 2008, the IRS issued Notice 2008-25 that solidified their position: An IRC 1031-exchange between a Go Zone property to a non-Go Zone property cannot occur without a recapture of bonus depreciation. In my mind, this is the practical settlement of the issue.
Why did I include so much background material on this issue?
Because I do not think it will go away and I think taxpayer-owners of GO Zone property are going to be approached with dubious tax schemes to try and avoid the recapture of the bonus depreciation.
Please stay tuned as additional information in this issue unfolds.