Legal ruling 409

Value is to be Ascribed to Replacement Property Acquired as the Result of an Involuntary Conversion or an Exchange for Property Factor Purposes

Question

What value is to be ascribed to replacement property acquired as the result of an involuntary conversion or an exchange for property factor purposes.

Decision

See Discussion.

Discussion

Revenue and Taxation Code Section 25130 provides in part:

Property owned by the taxpayer is valued at its original cost.

Cal. Admin. Code, titl. 18, § 25130(a)(1) provides in part:

Property owned by the taxpayer shall be valued at its original cost. As a general rule "original cost" is deemed to be the basis of the property for federal income tax purposes (prior to any federal adjustments) at the time of acquisition by the taxpayer and adjusted by subsequent capital additions or improvements thereto and partial disposition thereof, by reason of sale, exchange, abandonment, etc. [Emphasis added.]

In the case of an involuntary conversion, the basis of replacement property for federal income tax purposes is determined as follows:

(1) If the taxpayer receives property similar or related in use or service to the converted property, the basis of the replacement property is the same as the basis of the converted property. [IRC Section 1033(b)]

(2) If the taxpayer receives money or property not similar or related in use or service to the converted property, the basis of the replacement property will depend on whether or not the taxpayer elects to recognize the gain from the involuntary conversion [IRC Section 1033(b); Federal Reg. 1.1033(a)-2(c)].

If the taxpayer elects not to recognize the gain under situation (2) above, the basis of the replacement property for federal income tax purposes is the  same as the basis of the converted property [IRC Section 1033(b)]. As unrecognized gain is a federal adjustment (as is depreciation previously deducted), it is disregarded for property factor valuation purposes under Regulation 25130(a)(1). If the taxpayer elects to recognize the gain under situation (2) above, the basis of the replacement property for federal income tax purposes is the cost of the replacement property [IRC Section 1033(c); Federal Reg. 1.1033(c)-1].

Thus, where property similar or related in use or service is received, or money or property not similar or related in use or service is received and the taxpayer elects to not recognize the gain, the value of the replacement property for property factor purposes is the carry-over of the "original cost" of the converted property (i.e., the basis of that property for federal income tax purposes, adding back depreciation previously deducted and disregarding unrecognized gain). If, however, the election is made to recognize the gain in situation (2) above, the value of the replacement property for property factor purposes is the cost of the replacement property.

As indicated above, although federal adjustments, such as unrecognized gain and depreciation previously deducted, are disregarded in establishing "original cost," Regulation 25130(a)(1) provides for adjustments for subsequent capital additions and partial disposition by reason of sale, exchange, abandonment, etc. Thus, in the case of an involuntary conversion involving a cash award where the cost of the replacement property exceeds the amount of the cash award, the additional cost will be considered as a subsequent capital addition. If the cost of the replacement property is less than the cash award, the difference between the amount of the cash award and the cost of the replacement property will be deemed a partial disposition of the original property because part of the cash award was not converted into property similar to the original property. In the case of an involuntary conversion involving an award of similar property, improvement to that similar property will be considered as a subsequent capital improvement. If the award consists of both similar and dissimilar property, the receipt of dissimilar property will be deemed a partial disposition of the original property because part of that property was disposed of through receipt of dissimilar property.

In the case of property acquired by an exchange, the basis of replacement property for federal income tax purposes is the same as that of the property exchanged. [IRC Section 1031(d); Federal Reg. 1.1031(d)-1] The federal adjustments attendant to such a transaction (e.g., depreciation previously deducted) are disregarded for property factor purposes [Regulation 25130(a)(1)].

Thus, the value of the replacement property for property factor purposes is the carry-over of the "original cost" of the exchanged property (i.e., the basis of that property for federal income tax purposes, adding back depreciation previously deducted and disregarding unrecognized gain).

As in the case of involuntary conversions, adjustments are to be made for capital additions or improvements as well as partial dispositions (e.g., receipt of cash or other "boot" will be considered as a partial disposition because the property received was not the same type as the property transferred).