Handling Depreciation on Asset Trades

When a business (including an agribusiness or farm operation) buys an asset that has a useful life of more than a year, the business gets to depreciate the asset’s cost over its life in order to recover the asset’s gradual deterioration or obsolescence.  If the business later sells the depreciated asset, it could be a taxable event if the asset is sold for more than its depreciated value.  When that could happen, taxpayers often look for ways to avoid reporting gain including trading the asset in a non-taxable exchange.  Computing depreciation on the property received in the exchange can be tricky, and accounting for depreciation recapture complicates the matter. 

Today’s blogpost on this topic is authored by guest blogger Chris Hesse.  Chris is a Principal in the National Tax Office of CliftonLarsonAllen, LLP, Minneapolis, MN.  Chris is also a member of the AICPA Tax Executive Committee and a former chair of the AICPA S Corporation Technical Resource Panel and of the AICPA National Agriculture Conference.

Here are Chris Hesse's thoughts on the matter:

Sales of assets which have been depreciated often result in taxable gain. The taxpayer may have elected to write-off some or the entire purchase price  under I.R.C. §179, may have claimed bonus depreciation on new assets together with regular MACRS depreciation, or some combination of all three. In high income years, many taxpayers likely claim the I.R.C. §179 deduction in the year of purchase, resulting in no future depreciation deductions. Since the tax basis was fully expensed, the sale of the asset generates gain.  That gain would normally be capital gain, but it is treated as ordinary income (due to depreciation recapture).

Most taxpayers want to avoid gain. A popular way to defer gain recognition is to exchange the asset in accordance with I.R.C. §1031.  Asset exchanges can be very informal.  For example, a simple exchange can involve  a trade-in of equipment. Agricultural equipment qualifies for tax-deferred exchanges for replacement agricultural equipment. Thus, a combine may be exchanged for a tractor and tillage equipment. Real estate qualifies for exchange treatment for other real estate, as long as neither the property given up nor the property received in the exchange is held as inventory for sale or as inventory of a developer. Whether a simple trade-in of equipment or a more formal exchange of real estate, both result in the deferral of taxable income under I.R.C. §1031.

So, how is the depreciation computed on the replacement property? There are two methods:

• Add the remaining tax basis (i.e., the undepreciated portion) of the old property to the cost (after trade-in allowance) of the new property.  Then, the replacement property is depreciated as one asset, placed in service when acquired. Or—
• Continue depreciating the old property over its remaining life, and depreciate the cost (after trade-in allowance) of the new property as a separate asset.

The total depreciation to claim over the life of the replacement asset is the same under both methods. If the old asset was fully depreciated, there is no difference in the timing of depreciation deductions. However, if the old asset was not fully depreciated, the second method will provide depreciation deductions sooner than the first method.

What is the effect, however, when the replacement asset is later sold? Let’s say that the tractor traded-in has substantial value, but was nearly fully depreciated due to bonus depreciation. The replacement tractor ends up with very low tax basis on the depreciation schedule. If it is sold for an amount greater than the amount reflected as cost, does the farmer have I.R.C. §1231 gain, taxable as capital gain? Depreciation claimed on equipment is recaptured upon the sale of the equipment, up to the amount of the total gain (I.R.C.§1245). Gain in excess of the depreciation recapture is I.R.C. §1231 gain, which may be taxed as capital gain.

Example:

John purchased a tractor some time ago with a cost of $250,000. He traded it in when its basis was $40,000. The trade-in allowance was $150,000. Replacement tractor has a list price of $200,000; John pays $50,000 after the trade-in. The replacement tractor is put on the books at $90,000 (after trade-in cost of $50,000 plus remaining tax basis of the old tractor of $40,000). John sells the tractor for $120,000 next year.

While the “cost” of the tractor is listed on the depreciation schedule at $90,000 and the sales price is $120,000, is the $30,000 excess a capital gain? No. The depreciation potential on the old tractor (the trade-in) carries over into the replacement tractor (Treas. Reg. §1.1245-2(c)(4)). In this example, John’s entire gain upon the sale of the replacement tractor is ordinary income due to I.R.C. §1245 depreciation recapture.

Trade-ins are complex enough as it is, and depreciation recapture potential adds to the complexity.