Most professionals are aware of how Internal Revenue Code Section 1031 can be used to defer gain on the exchange of real estate. But the scope of the exchange rule extends far beyond real estate and covers most business and investment property, such as manufacturing equipment, transportation equipment and office furniture and equipment. It also extends to certain non-real estate investment property, including an entire range of collectibles.
Think of it this way. Just about every business owns personal property that is used in that business. When an old asset is sold, gain will often be realized. Even if there is no increase in value of the asset, there will often be ordinary income recapture--the excess of the residual value of the old asset over its depreciated book value.
Most business assets, when sold, are replaced. So why pay tax on the disposition just to purchase replacement property out of after-tax dollars? Code Section 1031 allows the replacement of business assets to be accomplished on a pre-tax basis, quite the same way as real estate investments are exchanged.
Here are some typical illustrations of personal property exchanges: a manufacturing company sells production equipment at more than book value, to be replaced by a newer model of the same machine. An automobile leasing company sells its vehicles once they come off lease and uses the proceeds to buy new vehicles which are available for lease to new customers. A restaurateur sells his suburban restaurant and uses the proceeds for a new location in the city.
While one type of real estate is generally of like-kind to another (for example, an office building can be exchanged for a shopping center), in the case of personal property exchanges the like-kind exchange rules are quite a bit narrower. Where there was once considerable confusion, however, a safe-harbor rule brings a measure of certainty to the matter. Depreciable property held for use in a business will be of like-kind to other property if it is within either the same General Asset Class for depreciation purposes or if it is within the same Product Class under Division D of the Standard Industrial Classification (SIC) codes. There are some nuances to the application of this safe-harbor rule. For example, even if two properties are in the same Product Class (have the same SIC code), such as an automobile and airplane, they are not of like-kind if they are in two different General Asset Classes for depreciation purposes. In addition, miscellaneous SIC codes (which end with a ׇ") cannot be used for safe-harbor purposes.
Intangible and non-depreciable property are not subject to the safe-harbor rule described above. But in certain circumstances, one can determine that this type of property is of like-kind. For example, copyrights may be of like-kind to one another if the rights relate to assets of a similar nature or character. Exchanging two coins in a coin collection may be of like-kind. However, an exchange of a collectible coin for a bullion-type coin (where the value is determined solely by prevailing prices and metal content) would not be of like-kind. Goodwill associated with two different businesses are not of like-kind, so when one talks about exchanging one restaurant business for another, one is looking at exchanging the underlying tangible assets and not the two businesses as wholes. Interestingly, franchise rights, F.C.C. broadcast licenses and professionals sports player contracts can often be exchanged.
The usual statutory exclusions from like-kind exchange treatment also apply to personal property. Thus inventory cannot be exchanged. Securities (such as stocks, bonds and partnership interests) cannot be exchanged. And personal use property cannot be exchanged.
As with real estate, domestic and foreign property cannot be exchanged. In the case of real estate, this rule depends upon where the real estate is situated. In the case of personal property, it depends upon where property is "predominantly used," and while the like-kind exchange rules themselves do not define predominant use, reference is made to the depreciation rules of Code Section 168, which deal with a similar concept of predominant use.
Structuring an exchange of personal property involves the same basic transactional approach as with real estate. We begin with the requirement that the proceeds of sale cannot be held by the taxpayer, and so they will ordinarily be held by a qualified exchange intermediary such as Cole Taylor Deferred Exchange Corp. (CTDEC). Within 45 days of the disposition of the old asset, the taxpayer must identify the new asset to the intermediary. There are rather specific rules about how replacement property must be identified--in the case of transportation vehicles, for example, designation of make and model number is advisable. Within 180 days of the date that the old asset is sold, the new asset must be acquired, using the proceeds being held by the intermediary. This 180 days period is cut short by the tax return filing deadline for the year in which the sale took place, but the full 180 days will be available if the taxpayer extends the due date for its return.
A completely successful exchange will involve "trading up or even," which generally means that the new asset's purchase price will equal or exceed the selling price of the old asset. In addition, all of the proceeds in the exchange account maintained by the intermediary should be utilized in the purchase. To the extent of any left-over proceeds in the exchange account, or to the extent that replacement property involved a trading down in price, there is "boot" and the transaction may be partially taxable.
While many personal property exchanges are structured as "one off" transactions like real estate exchanges, Cole Taylor has special programs for accommodating mass asset dispositions. Examples include special programs for automobile leasing companies that sell and purchase thousands of vehicles each year. Other examples include energy companies that sell and purchase hundreds of components for their production facilities. These master exchange agreements allow businesses to run their sales and purchases through an exchange account in a way that is nearly transparent from an operational standpoint, allowing substantial tax benefits to be realized from year to year with minimal cost.
A few miscellaneous points are worthy of note. As with real estate, related party exchanges are not permitted with respect to personal property, so special structuring is required if, for example, a company wants to purchase replacement equipment from a corporate affiliate. New assets must be acquired after the old assets are sold-so-called reverse exchanges are not permitted; however, special structuring may allow the taxpayer to "warehouse" or "park" the new asset with an independent party, from whom the new asset can be acquired after the old asset is sold.
While most of us think of real estate when we think about like-kind exchanges, even greater tax savings abound by looking at other business and investment assets.
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In conformity with U.S. Treasury Department Circular 230 this document and any tax advice contained herein is not intended to be used, and cannot be used, for the purpose of avoiding penalties that maybe imposed under the Internal Revenue Code, nor may any such tax advice be used to promote, market or recommend to any person any transaction or matter that is the subject of this document. The intended recipients of this document are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this document.