Many contractors, rental companies and dealers are taking advantage of Like Kind Exchange (LKE) transactions to defer taxable gains on qualified sales of used equipment. If you meet the LKE requirements, there is little reason not to use the concept if you have current taxable income to offset, or are likely to have taxable income in the near future.
While a LKE may sound like an easy thing to do, it can get very complicated. Staying in compliance can be a real challenge. There is flexibility in the process, however, giving taxpayers the ability to choose to use a LKE or have the taxable gain reflected in their taxable income.
Principles of LKEs
Here's the way LKEs work. An equipment owner can sell a business asset at a gain and defer the gain (calculated using tax depreciation) to some future date, as long as the sales proceeds are used to purchase a qualified replacement unit. The amount of the gain deferred has to reduce the tax basis in the replacement property. As a result, the depreciation deduction going forward is now lower than it would have been had the LKE not been used.
For example, say a machine is sold for $50,000 with zero tax basis (fully depreciated). A new machine is then purchased for $200,000. With a LKE, the $50,000 gain is deferred; you have a $20,000 LKE benefit; and the tax basis in the new unit is $150,000. Depreciation going forward without a LKE is $40,000 the first year vs. $30,000 with a LKE. It's a simple example, but you get the idea.
Another LKE requirement is that the sales proceeds be restricted until they are used to purchase replacement property or to pay down equipment-related debt, or are removed from the account as a taxable distribution. In the interim, they should be held by a "qualified intermediary".
As you can see, this subject can get complicated. And with more and more equipment owners using LKEs to manage their tax position and cash flow, it is imperative to be
certain of your tax position.
Is it a LKE or not?
Every once in a while, some people go off the reservation, pushing the envelope and creating a potential problem for the rest of the tribe. We're starting to see some things along those lines now. You need to be aware of them to help avoid having your LKE transactions reversed.
What we're starting to see are "pass-through" transactions. The machine is provided to a dealer, which sends it to auction and receives the sales proceeds to offset the cost of the new unit - with the customer believing the transaction is a LKE. Dealers are also taking this same transaction and treating the used unit as a "trade-in", thus charging a lower sales tax (where applicable). Using our previous example, they would be charging sales tax on the $150,000 and not the $200,000.
So the question becomes:
1. Is the pass-through transaction, as described, a LKE?
2. And can the auction sales proceeds be treated as a trade-in for sales tax purposes?
The answer is maybe to the first question and probably to the second, depending on how the transaction is structured and documented.
Reviewing this transaction, you find no third-party intermediary is used to hold the restricted funds. In addition, the "sold" unit was actually sold and proceeds collected, thus potentially negating the trade-in for tax purposes.
One way the transaction can be a LKE is by simultaneously transferring the original unit and taking possession of its replacement the same day. If you do this, the LKE is available without use of an intermediary.
Sales tax law differs from state to state. So you would be smart to get some expert advice before trying to turn this type of transaction into a trade-in transaction, and to understand who winds up with the tax liability should there be one.
To back up my feelings on this topic, I asked two of the leading LKE service providers if they believe the transaction described would provide LKE benefit, other than as a simultaneous (same-day) transaction. Guess what - I received two different answers.