Basis Rules and Gifted Property: Determining Depreciation Schedules

What rules apply to determine the donee’s applicable recovery period?

Table of Contents

1. Intro

2. Where this Applies

3. An Imperfect Answer from a Proposed Regulation

4. Calculating Carryover Basis?

5. Conclusion

Intro

In a prior article, we covered the general rules that apply to determine the income tax basis of gifted assets. To recap, the default is a carryover basis rule under IRC Section 1015(a) along with a tacked holding period for long-term capital gain purposes. But, a carryover basis may not always be the outcome. Special circumstances such as gifts of loss property, payment of gift tax out of pocket, and gifts of interests in passive activities can lead to a different basis for some or all purposes in the hands of the donee.

The income tax basis has significance beyond the determination of gain or loss upon the sale of an asset by the donee, however. It also drives the question of whether, and to what extent, depreciation and cost recovery deductions can be claimed by the donee. Generally, these deductions can be found in the following Code Sections for assets that are used in a trade or business:

• IRC Sections 167 and 168 – depreciation and bonus depreciation, over the statutorily-defined useful life of assets by class;

• IRC Section 179 – deduction in year of purchase for certain property, up to a certain dollar limit; and

• IRC Section 197 – amortization of certain intangible assets over a 15-year period.

These are not the only deductions of this type (for example, oil and gas working interests may be subject to depletion deductions), but these are the deductions most often encountered. These deductions all have the effect of reducing basis under IRC Section 1016. And, upon disposition of assets subject to depreciation, amortization, or cost recovery, any positive difference between the amount realized and the adjusted basis (previously reduced for such deductions) may be characterized as “recapture” under IRC Sections 1245 (for tangible personal property) or IRC Sections 1250 and 1(h)(1)(E) (for real property improvements). Recapture is often taxed as ordinary income for personal property, or (for real property improvements) at a capital gains rate of up to 25%, unless such property is recharacterized as Section 1231 property.

This is somewhat of an oversimplification of a complex set of rules. But, they all lead back to a certain timeline we must be aware of when involving gifts of property used in a trade or business – the useful life of such property. The useful life often starts with an event that establishes a new cost basis (usually by purchase or taxable exchange) in the property under IRC Section 1012 or, if later, when the property is placed in service in a trade or business by the owner, but is typically not considered to start with an event resulting from a carryover basis (by gift, contribution to capital, nontaxable exchange or otherwise). The useful life usually ends when the basis is reduced to zero.

Most gifts of property used in a trade or business occur somewhere during this useful life timeline, meaning that the donor has partially depreciated the property (whether by virtue of direct or deemed individual ownership, or ownership through a passthrough entity such as a tax partnership or S corporation). This brings us to a question that does not seem to be directly addressed by our current Code and Treasury Regulations:

If we gift property during its useful life, does the donee step into the shoes of the donor for purposes of determining the property’s remaining useful life? Or, is the property treated as being newly placed in service by the donee?

The former is often assumed to be the result. But, as alluded to above, this outcome is not directly supported by the Code or Regulations. This begs the question – are we doing anything wrong if we treat the donee as taking on the same depreciation schedule as the donor? Certainly, it seems folly that for certain property (such as real estate, which might have a 27.5 year useful life for residential property or a 39 year useful life for commercial or industrial property) that the useful life would be reset for the donee – especially with a (usually much lower) carryover basis. This would be catastrophic for the donee, as it would mean depreciating this lower basis over a longer useful life that is reset at the time of gift.

Let’s explore this further.

Where this Applies

Apropos of Shakespeare, the issues in this article may be described as “Much Ado About Nothing.” Why? Because depreciable property is often held by an entity, rather an individual. And, gifts in pass-through entities or a C corporation generally do not result in a change from a basis perspective. This will generally only be an issue where the depreciable property itself is gifted – a rare outcome but an important one nonetheless.

What if, however, we make a gift of an interest in an LLC that is a disregarded entity (DRE)? (This could also be the case, potentially, for a state-law partnership owned by spouses as community property that elects out of filing Form 1065.) In such a case, we must consider whether the entity remains a DRE after the gift. Generally, this would only be the case if, for example, there was only one donee of the entire 100% interest or a grantor or deemed owner transferred an interest in the DRE to a grantor trust (such that a new income taxpayer was not added as a member).

Where, however, a new member is added – even a spouse – this could be treated as a partnership formation under IRC Section 721. Such an event ironically supports no disruption to the remaining useful life, as IRC Section 168(i)(7)(A) generally provides:

In the case of any property transferred in a transaction described in subparagraph (B), the transferee shall be treated as the transferor for purposes of computing the depreciation deduction determined under this section with respect to so much of the basis in the hands of the transferee as does not exceed the adjusted basis in the hands of the transferor. In any case where this section as in effect before the amendments made by section 201 of the Tax Reform Act of 1986 applied to the property in the hands of the transferor, the reference in the preceding sentence to this section shall be treated as a reference to this section as so in effect.

IRC Section 168(i)(7)(B) – the aforementioned “subparagraph (B)” above – goes on to provide that the following transactions lead to this treatment:

[A]ny transaction described in section 332, 351, 361, 721, or 731… .

This generally means depreciable property going into or out of a corporation (C or S), or tax partnership, in a nonrecognition transaction will cause the transferee to step into the transferor’s shoes for purposes of the computation of the depreciation deduction. In other words, there is no change to or resetting of the depreciation schedule where a carryover basis is applied. The remaining useful life of the property so transferred is not independently determined with respect to the transferee.

Note, however, that these Code Sections listed in IRC Section 168(i)(7)(B) do not describe all carryover basis transactions. Importantly, gifts are missing from this analysis. And, it may surprise you to find out that the Code does not provide a direct answer. So, where might this answer be found?

An Imperfect Answer from a Proposed Regulation