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.
According to Jeff Nelson at PricewaterhouseCoopers (PwC), "The transaction described is fairly common in the industry, and customers and dealers should be able to structure these types of contingent/consignment value contracts in compliance with the rules of IRC Sec. 1031, even without the services of a Qualified Intermediary. However, Like Kind Exchange is extremely dependent on the proper form of the transaction. There are no shortcuts and customers/dealers must be careful to respect that form when structuring their trade-ins."
On the other hand, Jim Burnett at Accruit LLC, states, "Pass-throughs without a Qualified Intermediary involved may fall outside of the safe harbor guidelines as established in IRC 1031. The fact that there is typically a delay between the time the original asset is transferred to a dealer and the date replacement property is acquired raises questions.
"Like Kind Exchanges are not optional," he continues. "Guidance suggests that 1031 exchanges are 'form over substance,' meaning that if it looks like an exchange, the taxpayer must follow a specific process, including execution of an exchange agreement; notification of assignment in writing; inclusion of a Qualified Intermediary (to avoid constructive receipt); and completion of Form 8824 as part of the taxpayer's tax filing. Additionally, given the tremendous benefit and low cost of single exchanges, even the smallest equipment transaction can be run as a safe harbor LKE."
Clearly, LKEs are complicated and even the experts have a hard time agreeing on certain issues. To obtain further clarification on this topic, Jeff Nelson can be reached at (612) 889-5973 or firstname.lastname@example.org. In addition, Accruit offers a document that discusses the issue in more detail. Please contact Accruit at (720) 963-5000 to receive a copy.
LKEs can provide a significant benefit for contractors if used properly. Please make an effort to understand the basic LKE qualification concepts, and be wary of any transaction where a qualified intermediary is not part of the process. The sales tax issues should also be reviewed with your tax advisor.
Garry Bartecki is director of dealer/distributor services at BDO Seidman, LLP of Chicago, as well as a consultant to the AED. He has also worked as an independent CPA and consultant to equipment dealers. He can be reached at (312) 616-4677 or email@example.com.
Disclaimer: This article is not intended to be tax advice. Contact your tax accountant for professional tax services.