Author: Ray M. Beck
Published in The Enterprise May 6-12, 2013 Focus: Trucking & Logistics edition
Mention the term “1031 exchange” in the real estate world and almost everyone you talk to has completed one or knows someone who has. The tax benefits of like-kind exchanges, especially since the adoption of deferred exchange regulations, have long been touted as the tax nirvana of real estate. But if the truth be known, in terms of shear numbers, real estate exchanges represent the lighter half of the industry. The tax deferred exchange of tractors, trailers, airplanes, rolling stock, rental and lease cars, etc., far exceed the number of real estate parcels exchanged each year. In fact, the origins of IRC § 1031’s predecessors were grounded in personal property, specifically, the desire back in 1923 not to tax farmer Jones when he traded in his old swather for a new one.
Granted, 1031 exchanges are well suited for real estate. Over time, real estate naturally generates significant long-term capital gains, or recapture through its appreciation in value or its depreciation of taxable basis. Further, real estate investors are comfortable with real estate and tend to reinvest in real estate. The opportunity to defer material tax obligations in a manner consistent with an investor’s overall investment strategy makes the 1031 exchange a natural fit for the real estate investor.
But, with only limited exceptions, IRC § 1031(a) applies to all “property held for productive use in a trade or business or for investment” including tractors, trailers, etc. The tax savings on personal property exchanges can be even more dramatic than those of real estate but are often overlooked. Unlike real property, personal property depreciates quickly for tax purposes over relatively short periods of time due to the application of IRC §179, “bonus depreciation” and other accelerated depreciation methods. The tax depreciation rate for personal property far exceeds the physical or actual market depreciation rate. While personal property seldom appreciates, the spread between its taxable basis (usually $0) and its fair market value upon sale generates the taxable event which is usually taxed at recapture or ordinary income rates.
For example, ABC Trucking purchases a tractor in year 1 for $100,000. Over the course of the next 4 years, or less, ABC fully depreciates the tractor such that its taxable basis after year 4 is zero. In the ordinary course of its business, ABC sells the tractor in year 5 for 40% of its original value, or $40,000. That $40,000 sales price is offset by ABC’s zero basis resulting in a $40,000 taxable event and a $16,000 tax obligation assuming an applicable 40% tax rate. This leaves ABC with $24,000 to reinvest in the replacement tractor. ABC would have to come up with $74,000 to buy the replacement tractor assuming no inflation occurred over the five-year period. If ABC participates in a 1031 exchange, the $16,000 which would otherwise be used to pay taxes is retained by ABC. ABC only needs to come up with $60,000 to buy the replacement vehicle when coupled with the exchange proceeds. Without altering its operations or investment strategy, ABC has effectively obtained a $16,000 interest free loan from the government for each tractor it replaces. Now multiply that result by the fleet of tractors operated by ABC and the benefits can become dramatic.
As with all exchanges, the general requirements of IRC § 1031 apply to personal property exchanges. Specifically, the exchange must be administered by an independent Qualified Intermediary subject to a written exchange agreement. The replacement property must be identified within 45 days, and acquired within 180 days of the sale of the relinquished property. Most significantly, the replacement property must be of a like kind with the relinquished property. This standard is extremely broad in the real estate realm where a Parowan alfalfa field and a Manhattan skyscraper are considered to be “like kind.” But in the personal property arena, the standard is very narrow where a tractor is like kind to another tractor but not to the trailer that it is pulling. Surgical care, usually provided by the Qualified Intermediary, must be taken to maximize the matching of relinquished and replacement properties.
Given the “free lunch” (i.e. interest free loan) attitude associated with exchanges, skeptics have raised various concerns. Some are well founded, but most are not. Some argue that a 1031 exchange is simply a deferral mechanism and the tax piper will have to be paid sometime. This argument is ill founded on two fronts. First, tax deferral, by itself is the underlying principle of all accelerated depreciation provisions including § 179 deductions and “bonus depreciation.” These mechanisms are almost universally adopted, so at worst, § 1031 provides an equivalent, if not better alternative to traditional depreciation methods. More importantly, recapture, or the repayment of the “loan” need only be recognized at the election of the taxpayer when it sells its fleet and does not purchase replacement vehicles. Typically, this only occurs in declining years when offsetting losses could be applied against the taxable events. Otherwise, so long as replacement vehicles are purchased, the deferred tax will never be recognized. The interest free loan may never need to be repaid.
Some argue that adopting a 1031 strategy only provides a one-time benefit in the initial years but saddles the taxpayer with ongoing administrative burdens without a corresponding benefit in subsequent years. While it is true that the greatest benefits of implementing an exchange program are recognized in the early years, the taxpayer will always derive a significant positive tax benefit in every year the program is in place because each vehicle acquired will have a depreciable basis due to the need to supplement tax deferred exchange dollars with previously taxed dollars from other sources (i.e. the $60,000 investment in the example above). Those dollars, and the associated depreciation, form the basis for future depreciations deductions and the need for continuing deferral. So long as the taxpayer maintains its fleet, a 1031 program will provide a significant benefit in every year of its operation.
This article is not intended to constitute legal or tax advice and cannot be used for the purpose of avoiding penalties under the Internal Revenue Code or promoting, marketing or recommending any transaction or matter addressed herein.
Contact Ray M. Beck at ray@crslaw for more information.
- On May 10, 2013