Tax on Depreciation Recapture in a 1031 Exchange - Posted by Hawkster

Posted by Merez(IA) on November 24, 2006 at 11:29:47:

Based upon chapter 3 of IRS publician 544 I would disagree that the 2002 accountant made a mistake. Unless you received cash or other boot, the depreciation recapture should be included in the basis of the new property.

Tax on Depreciation Recapture in a 1031 Exchange - Posted by Hawkster

Posted by Hawkster on November 24, 2006 at 07:29:05:

IRS Form 8824 (Like-Kind-Exchanges), Line 35 is labeled ?Ordinary income under recapture rules. Enter here and on Form 4797, Line 16 (see instructions).?

A related caution in J.K Lasser Tax Guide, Section 6.1 (Trades of Like-Kind Property) says, ?Recapture provisions supersede tax-free exchange rules. Thus, if you exchange a depreciable building placed in service before 1987, depreciation recapture may apply.?

In 2002, I did a 1031 Exchange. The relinquished property had been put into service in 1982 and had been depreciated on the accelerated schedule allowable at that time. The fair market value (FMV) of the property received was higher than the FMV of the relinquished property. I added additional cash to get it and did not receive any boot. So, except for potential taxes related to depreciation recapture, I owed no taxes in 2002 related to the 1031 exchange.

My slowly developing understanding of the Form 8824, Line 35 instructions and of the J.K. Lasser guidance is that in 2002, when the exchange was done, Form 8824, Line 35 should have shown the total accelerated depreciation that had already been taken on the relinquished property and that I should have paid taxes on it in Tax Year 2002 as ordinary income.

Question # 1: Does this seem correct? Or, is my understanding totally screwed-up?

Assuming that my understanding is correct, here is my current problem and question:

Specifically because of the 1031 Exchange, I had my 2002 Tax Return prepared by a CPA who his highly regarded locally and who was relatively expensive to use. In preparing my 2002 tax returns, the CPA put a value of zero in Form 8824, Line 35. Consequently there was no depreciation recapture and no tax paid on it in 2002.

This year I have sold (not exchanged) the property received in the 2002 exchange. In trying to figure out how to treat the recaptured depreciation on the property sold in 2006, I stumbled across the above-described potential error in the 2002 tax return.

My choices for 2006 tax reporting seem to be 1) just ignore the 2002 tax return error and figure recaptured depreciation on the tax basis determined for the property received in 2002 (which was based on depreciation previously taken on the relinquished property); or 2) submit an ammended return for Tax Year 2002 ? which could open a can of worms and which also would result in dual taxation of the depreciation recaptured from the property relinquished in 2002 unless I make a corresponding increase in the tax basis of the property received in 2002.

Question # 2: Either course of action is acceptable to me financially. I just want to choose the one that seems least likely to cause me future problems with the IRS. Given the fact that the IRS has already failed to notice the 2002 error, I am inclined to choose Option # 1 (let sleeping dogs lay). However, I would appreciate any comments or suggestions from members of this forum?