Property Used in a Trade or Held for Investment is Eligible for LKE Treatment
Some taxpayers and their advisors who are familiar with 1031 exchanges tend to associate that Internal Revenue Code section with real estate transactions, however, the regulations are in no way limited to exchanges of real property. Exchanges of personal property assets are equally viable, but because the tax benefits may not be as readily apparent, this opportunity for tax deferral is greatly underutilized. Personal property includes business use assets like construction equipment, aircraft, oil country tubular goods (OCTG), trucks and trailers, as well as items that may be held for investment such as collectible cars and works of art.
In the case of such personal property, it is not unusual for the property to have diminished in value during the time it was held for use in a business or trade. As a result, the property is usually (but not always) worth less when it is sold than when it was purchased. However, since taxpayers will typically depreciate this property, for tax purposes the basis for computing gain will be zero or close to zero. As a result, there is a tax due upon the sale, representing the difference between the sale price and the basis and this recapture amount is taxed at the ordinary income rate versus the capital gains rate. Of course, at times when the personal property has actually appreciated in value, the gain is even more evident. In either event, an exchange can save a client significant tax dollars and increase cash flow.
Section 1031 of the Internal Revenue Code allows for asset owners to sell a depreciated asset and defer any gain (and therefore tax) when the proceeds of the sale are used to purchase an asset of similar or “Like‐Kind” classification. By deferring taxes, you retain your cash, which can be up to 40% of the sale price, to be invested in new assets. As with any tax strategy, to see the benefit you must play by the rules. In order to properly structure a 1031 exchange or like-kind exchange:
- The disposition and acquisition of the assets must be structured as an exchange within the prescribed timeline.
- Exchanged assets must be of similar classification.
- Exchanged assets must be used in a trade or business or held for investment purposes.
While these guidelines outline the general requirements that define a transaction as an LKE, there are several additional regulations that strictly moderate the process.
The Role of the Qualified Intermediary in Personal Property Exchanges
In order to take advantage of the qualified intermediary (QI) “safe harbor”, the owner of the asset must engage a QI to facilitate the exchange. The written exchange agreement between the asset’s owner and the QI must expressly limit the owner’s rights to receive, pledge, borrow or otherwise obtain the benefits of the money or property held by the QI. The owner of an asset:
- assigns the rights (but not any associated obligations) to transfer the asset to the QI,
- the sales proceeds are paid directly by the purchaser of the asset, to the QI for the benefit of the owner; and,
- the QI uses these proceeds to purchase a replacement asset on behalf of the original owner.
The proper facilitation of exchanges by QIs ensures that asset owners leveraging LKEs—whether they’re conducting single exchanges or employing a like kind exchange program—are not considered to be in actual or constructive receipt of funds; this is critical in establishing a successful exchange.
Classification of Like‐Kind in Personal Property Exchanges
Regulations governing the exchange process stipulate the requirements for what is considered “like‐kind.” The assets may, if eligible, first be classified by a General Asset Class (GAC) and if not matched there, then by North American Industry Classification System (NAICS) Product Class. If the assets are not found within those two classification systems, then a general like‐kind analysis may be made.
Contact Accruit for Information About Structuring Personal Property Like-Kind Exchanges
- Simultaneous Exchange: In a simultaneous exchange the relinquished asset and the replacement asset transfer concurrently and utilizing the services of a qualified intermediary provides a safe harbor as outlined in the regulations.
- Forward Exchange: In a forward exchange or forward delayed exchange the exchanger first sells the relinquished asset, then acquires the replacement asset within the earlier of 180 days of the sale or the tax filing due date (as may be extended).
- Reverse Exchange: When an exchanger is unable to sell the relinquished asset before purchasing the replacement asset, the exchanger can structure the transaction as a reverse exchange.
- Like-Kind Exchange Programs: Personal property exchanges for businesses with extensive asset portfolios that dispose of assets on a routine basis at a gain under a Master Exchange Agreement.