Swap Trade Exhange With A Later Tax Bill

By Mark E. Battersby

With property values continuing an upward trend, many owners who purchased their businesses years ago are now discovering that the building housing the composites fabrication business is the most valuable part of their business. But how to benefit from that asset or the other assets so necessary to the success of the business?

Tax-free, like-kind exchanges often provide an extremely useful strategy, substantially reducing the annual tax bite. Those Section 1031, like-kind exchanges or swaps are not, however, limited to real estate.

Old business equipment traded as part payment on new equipment is a like-kind exchange. In fact, virtually any type of business asset can be exchanged. There are also a variety of techniques for handling the exchange, treating it and structuring it - as well as increasingly more complex tax rules to follow.

In its simplest form, the basic “trade-in,” the basis or value at which the new property or equipment is carried on the books and used for gain, loss or depreciation purposes, is usually the same as the basis or value of the trade-in plus whatever additional cash is needed. In effect, the basis of the new property is its purchase price, increased or decreased according to whether the trade-in value of the old equipment is greater or less than its depreciated cost.

Tax Swaps
Under the Section 1031 like-kind exchange rules, real estate may be exchanged for real estate, an automobile for another automobile, but not real estate for an automobile. Those 1031 exchanges, named for a section of the Internal Revenue Code, require an exchange of property that is of a “like kind.” Property is of like-kind if it is of the same nature or character.

Fortunately, most exchanges of real property, that is land and whatever is erected or growing on it, qualify as like-kind exchanges. Personal properties, that is things moveable such as equipment, inventory, and the like are like-kind only if they are actually of a like-kind or class.

Depreciable equipment, assets and properties such as business equipment are of a like-kind if they fall within the same general asset class or the same product class. Those classes generally follow those used for depreciation purposes.

Exchanges involving intangible personal property or non-depreciable tangible personal property may qualify for like-kind exchange treatment but only if the properties are like-kind. An exchange of a copyright on a novel for a copyright on a song would not be a like-kind exchange. Similarly, an exchange of goodwill or going concern value of one business for the goodwill or going concern value of another business is not a like-kind exchange.

Benefiting
Under Code Section 1031, owners of property used in a trade or business – or for investment purposes – can defer capital gains taxes by rolling the proceeds from the sale of the relinquished property into another investment property or into property used in a trade or business that is of equal or greater value. Obviously, this can help defer taxes for any composites manufacturing operation. What many fabricators forget, however, is that the same technique can be used to reduce taxes on the sale of other assets, such as machinery, equipment and even the operation’s intangible assets, contracts, licenses, trade name or trade mark.

Although the process is simple, many composites fabricating business owners do not successfully complete their tax-deferred exchanges because they do not know how to navigate the complexity of timing requirements set forth by our lawmakers or are confused by the ambiguities of the tax law.

The deadlines for qualifying a transaction as a like-kind exchange are fixed. A fabricator has, from the date of the transfer, only 45 days in which to identify replacement property, and only a total of 180-days from the transfer date to close on the purchase of the replacement property.

These deadlines are not extended by weekends or holidays and cannot be extended due to a change in a fabricator’s circumstances. As a result, fabricators often feel pressured to rush to close the transaction, or are placed in a poor bargaining position in order to satisfy those artificial deadlines.

An exchange may qualify for like-kind treatment even if the replacement property is received after the relinquished property has been transferred by the manufacturer - provided, of course, that specific identification and receipt requirements are satisfied. These transactions are often referred to as “Starker exchanges.”

The tax rules contain a unique “safe harbor” for “starker exchanges” (i.e., an exchange in which replacement property is acquired before the relinquished property is transferred) that involves “parking.” In a parking transaction, the composites fabricator “parks” the desired replacement property with a third party until the fabricator arranges for the actual transfer of the relinquished property to the ultimate transferee in a simultaneous or deferred exchange.

After transferring the relinquished property, a fabricator must identify replacement property within 45 days and must receive the replacement property within 180 days. Best of all, if the rules for this safe harbor are complied with, the IRS will not challenge or look too closely – so long as the rules are closely followed.

More Than A Swap
One of the biggest concerns with like-kind exchanges is the receipt of so-called “boot,” which may be taxable. If the replacement property is equal or greater in value than the property given up, there is no boot. If cash is received, however, boot results.

What’s more, discharges of mortgages or other debt are taken into consideration as value received. There are also other instances where boot can arise such as when the first year’s insurance or warranty payment is paid from exchange funds. That payment is boot because neither insurance coverage nor warranty protection is like-kind property.

Qualified Intermediaries
A major misconception about like-kind exchanges is that the property owner is trading property with someone else. In reality, most like-kind exchanges are deferred exchanges involving several parties or, in many cases, an intermediary.

In an exchange of real property involving three parties, i.e., the composites fabricator, (2) the transferee (perhaps a qualified intermediary) and (3) a third-party that supplies the replacement property, the exchange may qualify as like-kind even if the third party deeds the replacement property directly to the fabricator. It is not necessary for the transferee to take title to the replacement property and then transfer title to the fabricator.

In many deferred exchanges, a qualified intermediary (QI) is used to transfer the properties and accomplish the like-kind exchange requirements such as the 45-day property identification rule and the 180-day closing rule, that must be complied with exactly. There are also rules for QIs. The QI cannot for example, be a related party to the person making the exchange.

On The Downside
While like-kind exchanges offer many tax benefits, there can also be potential pitfalls. One mistake that can prove quite costly is a misunderstanding of the 180-day rule. That rule refers to 180-days to close the deal or the earlier of the due date of the tax return. Fortunately, composites fabricators can get an extension of time to file the return just to take advantage of the full 180-days and still comply with the rule.

A major downside of 1031 exchanges is the replacement property’s reduced tax basis or book value. A significantly smaller depreciation write-off or a reduced valuation of business assets can hurt any composites operation’s financial picture. Finding replacement property at a good price is often difficult and compounded by the tight timelines.

Still another problem for many fabricators is matching equity, the requirement for reinvesting the entire proceeds. The rules allow a manufacturer or supplier to identify: (1) up to three replacement properties or (2) any number of replacement properties provided the aggregate value of each does not exceed 20 percent of the aggregate value of all relinquished properties.

In fact, fabricators who have significant capital loss carryovers might prefer not to defer the gain in a like-kind exchange. Generally, like-kind exchange treatment shouldn’t be used for any property that will generate a loss, as a like-kind exchange also defers any loss.

It should be obvious by now that like-kind exchanges, under Section 1031 of the tax law, can be an extremely valuable tool for every composites fabricating business owner wishing to defer or postpone taxes. Also keep in mind that a great deal of every Section 1031 exchange is “form” driven, dotting “i’s” and crossing “t’s.” Thus, it is important to have an advisor who can ensure deadlines are met.

A qualified advisor can also perform the calculations necessary to determine the value, debt and equity requirements for both the relinquished property and the replacement property so important for deferring the entire gain. That professional might also serve as a qualified intermediary, helping smooth the path of the Section 1031, like-kind exchange or swap. Again, however, the time to think about like-kind exchanges is now – not at tax time.

Mark E. Battersby is a freelance tax and financial writer with offices in the suburban Philadelphia community of Ardmore, Pa. For more than 25 years, Mr. Battersby’s features and columns have appeared in leading trade journals and magazines. He is the author of four books.