1031 Exchange

WHAT IS A 1031 EXCHANGE?

1031 exchanges, also called like-kind exchanges, LKEs or tax deferred exchanges, were first authorized in 1921 when Congress recognized the importance of encouraging reinvestment in business assets. Today, companies use 1031 like-kind exchanges to increase cash flow by deferring taxes on gains realized through the sale of business assets, as long as they reinvest those gains in replacement assets.

With “personal property” (tangible or intangible business assets other than real estate, such as vehicles, manufacturing machinery, oil & gas drilling rigs, etc.), the like-kind rules are defined by General Asset Class or NAICS classifications. These rules can be broader than you’d imagine. For instance, NAICS 333120, the classification for Construction Machinery Manufacturing, is a large category that includes both bulldozers and cranes. So these two very different types of equipment are like-kind. Your Gavel Roads representative can provide you with the guidelines you need to determine specifically what asset types are like-kind for your situation.

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 a1031 exchange or like-kind exchange:

  1. The disposition and acquisition of the assets must be structured as an exchange within the prescribed timeline.
  2. Exchanged assets must be of similar classification.
  3. Exchanged assets must be used in a trade or business or held for investment purposes.

A “qualified intermediary” (QI) provides Safe Harbor protection for 1031 exchanges, and this entity must be a “disinterested third party” who has not acted as your agent in any way. You can’t use a lawyer with whom you’ve had an attorney-client relationship in the preceding two years, nor can your CPA serve as the QI if he or she has prepared your tax return within the last two years. An equipment dealer who sells you equipment is not a disinterested party as described in the tax code, so they can’t be your QI, either.

If you don’t employ a qualified intermediary, your exchange may be disqualified by the IRS. It’s also important that you are utilizing an appropriate QI when executing an exchange through an auction house. The auctioneer isn’t legally a disinterested party if they assisted you in your sale; they are by definition the agent for the buyer and/or the seller.

While these guidelines outline the general requirements that define a transaction as an LKE, there are several additional regulations that strictly moderate the process.  Contact a Gavel Roads representative at connect@gavelroads.com or call 316-425-7732 for a checklist to complete a 1031 Exchange.