How to Make the 1.168(i)-6(i) Depreciation Election
For property from a like-kind exchange, taxpayers can opt out of complex depreciation rules. Learn about the election for a simplified, unified basis treatment.
When a business acquires property through a like-kind exchange under Internal Revenue Code Section 1031 or as a result of an involuntary conversion, specific depreciation rules apply. The Modified Accelerated Cost Recovery System (MACRS) provides the framework for calculating depreciation on the replacement property. The governing rules in Treasury Regulation 1.168(i)-6 establish a default depreciation method and an alternative that allows a taxpayer to elect a different, simpler method for depreciating the asset.
The General Depreciation Rule for Replacement Property
When a taxpayer does not make a specific election, the default rule requires a multi-step approach to depreciation. This method is called the “step-in-the-shoes” rule, where the taxpayer essentially steps into the shoes of the old property for a portion of the new property’s basis. The basis of the replacement property is split into two components for depreciation: the exchanged basis and the excess basis.
The exchanged basis is the portion of the new property’s basis that is equal to the adjusted basis of the relinquished property at the time of the transaction. This part of the basis must continue to be depreciated using the same recovery period, depreciation method, and convention that were used for the old property. This ensures that the tax-deferred nature of the exchange is reflected in the ongoing depreciation calculations.
The excess basis is any additional value paid for the replacement property over and above the value of the relinquished property, which typically includes cash paid or additional debt incurred. This portion of the basis is treated as a new asset placed in service in the year of replacement. It is depreciated using the MACRS recovery period, method, and convention applicable to that property type as of the replacement date.
Consider a scenario where a business exchanges an office building with an adjusted basis of $200,000 for a new office building valued at $500,000. The business also pays $300,000 in cash. The exchanged basis of the new building is $200,000, and it will continue to be depreciated over the remaining recovery period of the old building. The excess basis is the $300,000 cash paid, which will be depreciated as a new asset, starting in the year of the exchange, with its own full recovery period.
Understanding the Election Out
As an alternative to the basis bifurcation method, taxpayers can elect to treat the replacement property differently. By making this election, a taxpayer forgoes the “step-in-the-shoes” approach and its requirement to maintain two separate depreciation schedules for a single asset. The primary benefit of this election is simplification.
When the election is made, both the exchanged basis and the excess basis are combined. This entire consolidated basis is treated as a single asset placed in service in the year of replacement and is depreciated using the MACRS method, recovery period, and convention applicable as if it were newly purchased.
This approach eliminates the need to track two separate basis components with different depreciation schedules. It can be particularly helpful when the remaining life of the relinquished property is short, as it streamlines record-keeping and tax preparation.
How to Make the Election
The election must be made on a timely filed federal income tax return, including extensions, for the year the replacement property is placed in service. To make the election, a taxpayer calculates the depreciation for the entire basis of the new property in Part III of Form 4562, Depreciation and Amortization.
A statement must also be attached to the return that includes the taxpayer’s name, address, and taxpayer identification number. It must clearly indicate that an “Election made under section 1.168(i)-6(i)” is being made and provide enough detail to identify the relinquished and replacement properties involved in the transaction.
The election is made on an asset-by-asset basis, meaning a taxpayer can choose it for one replacement asset but not for another acquired in a separate transaction in the same year. Once made, the election is irrevocable without IRS consent. The decision to elect out should be made after careful consideration of the long-term tax implications.