Like-Kind Exchange Updates

Gregory Smith, CPA, MBA (Jan, 2019)

As many business owners are aware, taxable income can be generated from activities outside the normal day-to-day operations of the business. For very successful business entities, investment income can generate significant taxable income. For virtually all business entities, selling unneeded assets can create considerable taxable income. Under Internal Revenue Code Section 1031, business entities are sometimes able to defer taxable income on the sale of assets with a like-kind exchange. The Tax Cuts and Jobs Act (TCJA) has changed some of the like-kind exchange rules.

As an example under the old rules, a business might have a bulldozer that was in service for eight years and was fully depreciated over the years. If the entity sold this bulldozer for $10,000 the entity would be faced with $10,000 of taxable income. Under Internal Revenue Code Section 1031, there was an opportunity for the entity to defer this $10,000 of gain on tangible personal property to a later year.

For this deferral of income the entity would need to purchase like-kind property within a specified period of time. Internal Revenue Code Section 1031 specifies a 45-day written identification requirement. In order for this requirement to be met the new property must be designated in writing as replacement property, the property must be clearly identified, and this must be done within 45 days after the date you transferred ownership of the old property.

From our example, if we identified and purchased a new bulldozer in compliance with the 45-day written identification requirement, the $10,000 gain could be deferred to a future year. To apply this concept, say a new bulldozer was purchased for $60,000. If done in compliance with Internal Revenue Code Section 1031, the $10,000 gain could be deferred and the basis of the new dozer would be reduced by the deferred gain. Therefore, the basis of the new bulldozer would be $50,000 ($60,000 less $10,000 deferred gain). This new asset, with a basis of $50,000, could be depreciated.

This Code Section has allowed entities to defer taxable income to future years, thus preserving cash to allow entities to grow. Under the TCJA, Congress narrowed the type of like-kind exchange property to real property held for use in a trade or business or for investment. For exchanges completed after December 31, 2017, Internal Revenue Code Section 1031 no longer allows for like-kind exchanges of machinery, equipment, vehicles, patients and other intellectual property, art and collectibles.

How does this change affect planning for future transactions?

Business owners and management need to be more conscientious of the effects of trading in vehicles, equipment, machinery, and other business assets. In past years, this activity did not warrant additional taxes, now these transactions will have a greater impact on the entities cash flow. It is important for business owners to communicate asset sales with their tax advisor so they are not blindsided by additional taxes as a result of selling off old, unused assets.

Under the pre TCJA law, getting like-kind exchange treatment was relatively simple. You brought the old equipment to the dealer and you came home with the new equipment. Real property on the other hand can be much more difficult to transact within the guidelines of a like-kind exchange. One major consideration is the use of a qualified intermediary. This intermediary will enter into an agreement with the taxpayer, acquire and transfer the old property, and acquire and transfer the new property. There are very stringent rules to ensure this process is done in accordance with the rules of a like-kind exchange, including who is eligible to be a qualified intermediary. There is also pertinent information that needs to be included in the agreement between the taxpayer and qualified intermediary.

As a result of the TCJA, the playing field for disposing of assets and deferring gains has changed significantly. It is vital the business owners stay in contact with their tax advisor to avoid unnecessary surprises. If considering swapping real property it is crucial that you seek guidance as the rules to navigate a successful real property like-kind exchange can be difficult. If you have further questions or are considering a real property like-kind exchange, please feel free to contact your Dermody, Burke & Brown tax advisor to further discuss your opportunities.

 

The information reflected in this article was current at the time of publication.  This information will not be modified or updated for any subsequent tax law changes, if any.

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