By
Brent Abrahm
In seeking alternative methods of increasing tax deferrals, many
companies have, at one time or another, taken a look at IRC Section
1031 to derive the potential benefit, and weigh the associated
costs of performing Like-Kind Exchanges (LKE). That said, the vast
majority did not have the sales volume to rationalize the results
of this cost-benefit analysis. The labor involved in administering
this paper-based process was simply not economical except for those
businesses with extraordinarily large-ticket items (such as airplanes,
ships and railroad equipment).
Today, however, with an effectively managed, technology-based
LKE program, businesses of all sizes are able to reap the rewards
of deferring gain taxes; in most cases, indefinitely.
The leasing industry has long been adept at utilizing various provisions
of the tax code to create mutually beneficial lease structures
for lessee and lessor alike. While the majority of these tax
provisions represent timing differences, which allow for a positive
tax cash flow in early years, they are subsequently followed
by reversals and ultimately recapture in future periods, including
end of term or early termination. The benefit of these added
tax cash flows could mean substantial increased pretax yield
to the lessor.
The use of a repetitive LKEs as described below
may "unlock
the door" for increased yields in your lease portfolio by
avoiding this tax recapture and deferring it into future periods
(see number l under LKE Process Overview).
Section 1031 of the Internal Revenue Code allows for companies
to sell a depreciated asset and defer any associated gain (and,
therefore the tax) when the proceeds of the sale are used to
purchase an asset of similar classification. There are three
fundamental rules that must be abided by for a transaction to
qualify as an LKE:
1. Personal property must be exchanged.
2. The exchanged property must be of similar classification.
3. The exchanged property must be used in a trade or business.
While these guidelines outline the general requirements of defining
a transaction as a LKE, there are several additional regulations
that strictly moderate the LKE process.
When adopting an effective LKE program, a business must take into
account very specific regulations as to the entire process of
performing an LKE. This is exactly where the historical expense
of managing an LKE program was prohibitive. In large-ticket industries,
these functions used to be performed by the members of an accounting
staff, however the technology-based services offered today have
opened LKEs to a much broader range of asset-owning businesses.
Furthermore, with the release of LKE guidelines in revenue procedure
2003-39, the ambiguities around a repetitive LKE program have
mostly been removed.
The single most important modification an LKE participant must
make is the inclusion of a Qualified Intermediary (QI) in the
sales and purchasing processes. As stipulated by Section 1031,
to qualify as a safe-harbor LKE, all proceeds from an asset sale
must be held by a QI until such time as a replacement asset is
acquired or an associated liability is relieved. In using a QI,
an asset owner (exchanger) first assigns the rights (but not
any associated obligations) to the QI to sell his asset. Then,
the QI is paid directly by the purchaser of the asset. Finally,
the QI uses these proceeds to purchase a replacement asset on
behalf of the exchanger. The proper facilitation of exchanges
by these third-party providers ensures participants in an LKE
program are not considered to be in active or constructive receipt
of funds; a critical component in creating a qualified LKE program.
Typically, repetitive LKE relationships with a QI are governed
by a Master Exchange Agreement, wherein a participant assigns
future purchase and sale rights to their QI, thus reducing the
paperwork burden normally associated with individual transactions.
In a qualified LKE program, there are very specific timelines that
must be actively managed. The clock starts on the date of the
original asset sale and has two critical milestones: the 45-day
Asset Identification Requirement and the 180-day Acquisition
Requirement. According to Section 1031, a participant in an LKE
program has 45 days after the original sale date to either acquire
or identify replacement property. In the case of identifying
replacement property, the participant has three choices: the
two most common are to either identify three potential replacements
from which the selection will be made (the Three-Property Rule)
or identify replacement property of a value not to exceed 200%
of the original sales proceeds (the 200% Rule). In either case,
this replacement property must be acquired before 180 days have
passed since the original disposition date in order for the program
to be a safe-harbor LKE.
The single most important modification an LKE participant
must make is the inclusion of a Qualified Intermediary in the
sales
While in real estate applications of Section 1031 there is leniency
as to what can be considered to be of like-kind, recent regulations
(TD 9151 and REG-116265-04, 8/12/04) modified the requirements
for tangible depreciable personal property to be considered of
the same product class. Effective August 11, 2004, all assets
to be exchanged must be of the same North American Industry Classification
System (NAICS) product class, rather than the historical matching
by Standard Industrial Classification (SIC) code. The NAICS system
is a "production-oriented" method, rather than SIC's
demand or production criteria. Thus, these new regulations streamline
the identification process considerably. Additionally, this tightening
of the regulations was an important step forward, as the SIC
system had not been updated since 1987. In addition to the NAICS
codes, the assets, if eligible, may first be classified by a
General Asset Class (GAC) as defined by classes 00.11 through
00.28 as outlined in Revenue Procedure 87-56.
One of the more manual procedures involved in an effective
LKE program has been tracking of depreciation schedules as they
relate to disposed and purchased assets
One of the more manual procedures involved in an effective LKE
program has been tracking of depreciation schedules as they relate
to disposed and purchased assets. Effectively, when one depreciated
asset is exchanged for another asset, the depreciation schedule
of the disposed asset continues even though the original owner
no longer owns the asset.
Additionally, the newly purchased asset begins
its own depreciation schedule. The amount to be depreciated on
the new asset is the difference in value between the sold asset
and the new asset (i.e., the "new cash" added to the exchange process to acquire
replacement property). Through this "step-in-the-shoes" method
of depreciating a new asset, a participant in an LKE program is
allowed, if they choose, to continue to reap the benefits of depreciating
assets, without invalidating the LKE program.
Where this process becomes most challenging is the future layers
of depreciation that will grow exponentially with each successive
generation to participate in an ongoing LKE program. Again, effectively
managed, technology-based services are capable of tracking these
numerous depreciation schedules on an asset level, without a significant
increase in headcount on the part of the LKE participant.
LKE transactions can take many forms, however, at the base
level, these exchanges follow some very simple guidelines and
steps.
1. A personal property owner (i.e. exchanger) assigns the sales
rights of an asset to their QI.
2. The QI "sells" the asset.
3. Revenues from the sale are directly deposited with a QI.
4. The owner identifies replacement property of the same GAC or
NAICS code within the established timeline of 45 days after the
date of disposition.
5. The QI "purchases" the replacement asset for the owner
and assigns ownership.
6. A gain that might have been taxed on the original sale is deferred
— in most cases, indefinitely.
7. Replacement property establishes a new layer of depreciation
on top of the continuing depreciation of the sold asset.
In researching LKE service providers, it is important to consider
three elements of a successful program: Qualified Intermediary,
cash management and LKE transaction administration (including asset-level
tracking and depreciation calculation). Inclusive programs will
seamlessly integrate these components to ensure the participating
business is afforded the largest benefit without an increase in
internal headcount. Additionally, with a complete program, a participating
business will be able to leverage its existing tax advisor to guarantee
the LKE program is in line with the company’s strategic goals and
current tax paradigm.
is the executive
vice president, Business Development of Accruit. Accruit, headquartered
in Denver, CO, and founded in 2000, is the only Qualified intermediary
to provide full managed personal property 1031 LKE services. Accruit
is the preferred provider to numerous transportation and equipment
industry associations, CPA networks and equipment manufacturers. Accruit
is also a member of the Federation of Exchange Accommodators,
the country’s association for Qualified Intermediaries and LKE
industry (). For
more information call 877.793.9215 or visit www.accruit.com
(As
printed in the November/December 2006 issue of The Monitor.) |
