Most business owners and investors know that taxable gain from real estate can be deferred through an exchange under Section 1031 of the Internal Revenue Code. However, they often do not realize that the benefits of Section 1031 also extend to assets other than real estate. In fact, almost any type of property used in a business or held for investment can be exchanged under Section 1031.
Exchangeable business property includes equipment used in the business, such as the trucks and trailers in a shipping business, or cranes and other heavy machinery in a construction business. Aircraft can also be exchanged and these exchanges result in some of the largest dollar value exchanges, including corporate or charter aircraft, as well as commercial fleets. Equipment leasing and car rental companies do the highest volume exchanges, selling the leased equipment to individual purchasers and buying new equipment from the manufacturer. Intangible assets such as licenses and trademarks also qualify as exchange property. And finally, artwork and other collectibles held as investments may be exchanged under Section 1031.
This article first examines when a personal property exchange makes sense from an economic standpoint, and then will look at the types of personal property that can be exchanged.
When is a Personal Property Exchange Economical?
Personal property exchanges may not always be economical. The amount of gain deferred in the exchange should be enough to justify the accounting cost and administrative inconvenience of doing an exchange. For example, an exchange of a single item of lower valued property, such as an individual automobile used in a business, would most likely be cost prohibitive. The expenses incurred in doing the exchange would offset the value of the deferred gain.
However, Section 1031 is cost effective for both higher valued personal property items and repetitive exchanges of lower priced items, such are rental car fleets. The tax savings can be substantial because the adjusted tax basis of the property is typically zero, so all of the sale proceeds are taxable. This is due to the fact that tangible personal property is depreciated for tax purposes on an accelerated basis over a period of three to ten years (or even expensed). Compare this to real estate, which is depreciated on a straight line basis over 27.5 or 39 years.
Furthermore, the sale proceeds from tangible personal property are taxable at high ordinary income tax rates instead of the lower long term capital gain rates because the gain will be taxable as depreciation recapture under Section 1245 of the Internal Revenue Code.
Acme Construction owns a crane valued at $500,000 and wants to sell it to another construction company and buy a new crane from the manufacturer for $1.5 million. The crane has been owned for more than five years and is fully depreciated for tax purposes. Therefore, the entire $500,000 will be taxable at ordinary income tax rates of 40% (federal and state combined). By structuring an exchange, Acme Construction can defer the payment of $200,000 of taxes and reinvest that amount in the new crane.
The deferred gain of $500,000 is carried forward into the replacement crane, and the tax basis of the replacement crane will be $1 million rather than the purchase price of $1.5 million. Thus, the price for the deferral of the gain is the reduction in depreciation deductions attributable to the portion of the basis carried over from the relinquished crane. Cranes are depreciated over five years for tax purposes, so if the tax from the sale had been paid instead of deferred by the exchange, it would take Acme Construction five years to recoup the foregone tax savings through depreciation deductions (ignoring the time value of money).
Exchanges of Tangible Personal Property Used in a Business
Any tangible personal property used in a business can be exchanged under Section 1031. However, a property can only be exchanged for tangible personal property that is “like-kind” or “like-class”. While the definition of like kind for real estate is broad (i.e. any real estate for any other real estate, generally), the definition of what is "like kind" or "like class" for personal property is much more restrictive. For example, undeveloped land is like-kind to an office building, but a car is not like-kind to a truck.
Tangible personal property items will be like-kind if they come within the “like-class” safe harbor laid out in the IRS regulations. This safe harbor provides that items will be treated as like-kind for Section 1031 purposes if they are within the same general asset class for depreciation purposes. If an item is not found in a general asset class, the item is instead treated as like-kind to items found with the same product class consisting of depreciable tangible personal property as described in a 6-digit product class within the sectors for manufacturing industries of the North American Industry Classification System (NAICS).
In general, this means an aircraft can only be exchanged for another aircraft, a vessel for another vessel, etc. There can be little variance between the relinquished property and replacement property. This lack of flexibility limits a business owner to exchanging into the same type of property.
Program Exchanges of Equipment and Other Assets
Rental car companies and equipment leasing companies can exchange their leased items in high volume exchange transactions known as “program exchanges”. Other types of businesses can also conduct program exchanges of items used in their business, such as railroad cars or trucks.
Any company exchanging 100 or more items of tangible personal property may use a set of streamlined procedures provided by the IRS. These procedures simplify the exchange process and reduce the paperwork and administrative time and cost of running a program exchange. For example, these procedures allow a company to enter into a master exchange agreement and assignment for all the exchanges, present and future, instead of separate exchange agreements and assignments for each exchange. And the particular relinquished property and replacement property for an exchange can be matched after the respective purchase and sales are completed. The matching only needs to completed by the filing of the tax return for the exchange.
Exchanges of Intangibles
Sales of intangible assets also qualify for deferral under Section 1031. These include all types of intangibles, such as radio and television licenses, patents, copyrights, franchise rights, fishing licenses, trademarks and trade names, and other customer-based intangibles like mailing lists. Stocks, bonds, notes and other securities, while also intangible assets, are specifically excluded from Section 1031.
It can be difficult to determine if two types of intangibles are like-kind. The IRS has ruled that the intangible right involved must be the same, i.e. a patent must be exchanged for a patent. Furthermore, the underlying property to which the right relates must be like-kind, using the “like-class” safe harbor methodology discussed above. For example, under the IRS’s analysis, a patent for aircraft technology would only be like-kind to another patent right for aircraft technology and not like-kind a patent right for a marine technology.
Importantly, the IRS regulations state that the goodwill and going concern of a business can never be like-kind to goodwill or going concern of another business. Therefore, intangible assets are often characterized as something other than goodwill or going concern so that the assets can be exchanged.
Artwork and Other Collectibles
Artwork and other collectibles, such as antique cars and coins, can be exchanged provided they are held primarily for investment and appreciation, rather than personal enjoyment. While there may be some personal use, it should be minimal. The collectible should be shown on the owner’s tax return as an investment. This means reporting associated expenses such as insurance, any interest payments, maintenance, storage and other costs as “investment” expenses under Section 212 of the Internal Revenue Code. They should be treated like other investment expenses, such as expenses related to a stock portfolio or other investment investments.
The exchanged collectibles must be like-kind and little guidance exists on what constitutes “like-kind” in this area. With respect to artwork, there is only one IRS ruling that held that one artistic medium was not “similar or related in use” to a different artistic medium. Thus, the owner could not replace lithographs with other media such as oil paintings, watercolors sculptures or other graphic forms of art. This ruling was under Section 1033 of the Internal Revenue Code, however, the IRS used a “similar or related in use” standard in this instance rather than the “like-kind” standard of Section 1031. Nevertheless, it gives some indication that the IRS may use a relatively strict standard when applying the like-kind standard to an exchange of collectibles. With respect to coins, including silver and gold coins, they are not considered like-kind.
In summary, an owner who is selling tangible or intangible personal property assets and acquiring similar assets should consider the value of structuring the transactions as an exchange. This will make economic sense in higher value transactions, or for large volume transactions.The tax deferral can be significant, and reinvested back into the business or investment for the new like-kind assets.
About the author
Mary B. Foster is President of 1031 Services, Inc., and has been involved in thousands of exchanges as an attorney and intermediary. Mary enjoys working on day to day exchange matters as well as structuring creative and complex exchange transactions. Mary can be contacted by email or by phone at (425) 646-4020.