The Bottom Line: Tax Incentives When Replacing Old Equipment
Tax items to consider when selling old equipment and replacing it with new equipment.
Contributed byTheresa Samples, CPA, Partner and Director of Real Estate Services, Mueller Prost
Mold builders who are selling their used equipment for a taxable gain should evaluate whether a Section 1031 like-kind exchange may be beneficial. The Internal Revenue Code allows companies to defer the potential gain on the sale of an asset when they are replacing the property with a like, or similar, asset. These “exchanges” are commonly referred to as “like-kind exchanges” or Section 1031 exchanges. Section 1031 refers to the part of the Internal Revenue Code that governs this favorable status for taxpayers. However, companies do not escape the capital gain tax entirely. Rather, they may defer the taxes related to the sale or disposition of the asset.
The majority of Section 1031 tax-deferred exchanges involve real estate, but there has been an increase in the number of personal property 1031 exchange transactions in the past decade. The accelerated depreciation provision of the tax code, such as bonus depreciation, has great tax-related developments for mold builders. However, accelerating the depreciation has sometimes left mold builders with very little tax basis in the asset (or the purchase price of the asset minus the tax depreciation allowed), which may create a larger gain when it is sold or otherwise disposed.
Personal Property 1031 Exchange
A personal property 1031 exchange allows an individual or small business to sell existing personal property (relinquished property) and purchase more profitable or more productive personal property (like-kind replacement property). A 1031 exchange permits an individual or a small business to make this substitution while deferring federal depreciation, recapture and capital gain income taxes on the sale of the relinquished property. In most cases, the 1031 exchange permits the deferral of these taxes when they are at the state level as well.
Companies selling their equipment must first determine whether they must recapture (or recognize as income) any depreciation that was claimed on the equipment. Companies must also determine whether any capital gain exists.
The basic rules that apply to exchanges of personal property also apply to exchanges of real estate. A company that plans to make an exchange needs to consider several requirements and other important items:
- The company must have held the relinquished property for rental, investment or use in the mold shop, and the company must have the intent to hold the like-kind replacement property in the same manner.
- The company must identify qualifying replacement property within 45 days of the sale of the relinquished property. Failure to properly identify the replacement property will result in a failed exchange, which triggers the tax on the sale of the relinquished property.
- Mold builders should keep in mind that they may not have access to the proceeds held in the escrow account. If a company is restricted and properly extends its return, it can have until the next tax year to close on the acquisition of the replacement property. If the company fails to close, it will have installment sale treatment on the transaction, meaning any potential gain will be recognized in more than one tax year.
- A company must close on the acquisition of the replacement property within 180 days of the sale of the relinquished property or by the due date of the federal income tax return, including extensions. However, there is no requirement to place the property in service by this date.
- The company must trade up in both value and equity, meaning that the value of the new equipment must be the same or greater than the selling price (or the fair market value) of the old piece of equipment. Debt is important to consider, as debt relief is taxable if there is not sufficient new debt on the replacement property. Equity in the new property must be the same or greater than the equity in the old property.
- A mold builder must also reinvest all of the cash proceeds to defer 100 percent of the gain. The mold builder may not have access to the money in escrow. It must be restricted. If a mold builder has access to the money, the mold builder is assumed to have taken it, which causes the Section 1031 exchange to fail. Further, if a mold shop pays for too many non-qualifying expenses from the escrow account, like taxes or loan fees, the shop will be taxed on the lesser of the cash taken, the non-qualifying expenses paid or the realized gain.
Personal Property Assets
Companies often note personal property assets do not appreciate in value, so they assume these assets have little or no gain to consider. However, tax depreciation leaves very little basis in the assets, resulting in a potential taxable gain when sold for consideration. Therefore it often has a lower tax basis at the time of sale or disposition, which could create a significant tax if it is not part of a tax-deferred exchange.
Often, these personal property assets used in a mold shop are depreciated at a more accelerated pace of five or seven years. In conjunction with Section 179 and bonus depreciation provisions, little tax basis remains at the time the shop sells the equipment.
The gain on the sale of personal property differs from real estate. Personal property, such as machinery and equipment, will have ordinary gain. Ordinary gain does not receive the preferential, capital gain tax rate. Even though the asset is worth less, the tax on the income subject to recapture can be significant.
Classification. Like-kind for personal property is a more stringent test than that of real estate. Despite federal law controls, state law is relevant in determining whether the asset is real or personal property. The replacement property must be either like-kind or like-class.
Personal property must fall within the same general asset class or product class to be considered like-kind. The North American Industry Classification System (NAICS) tables outline product classes. For example, an airplane is not like-kind property to a crane used in a manufacturing facility. However, an overhead crane could be replaced with a forklift, assuming all of the other requirements have been met.
Replacement properties. There is a three-property rule that limits the total aggregate number of replacement properties that a company can identify. This rule limits the number of replacement items a company can acquire to three. Instead, the company can use the 200-percent rule, whereby it can identify as many properties as it wants as long as the total aggregate fair market value (FMV) of the identified properties does not exceed 200 percent of the total net sales values of relinquished properties sold in the 1031.
For example, if a company sold a piece of equipment for $150,000, it can identify as many replacement pieces of equipment as it wants as long as the purchase price does not exceed $300,000. This is called the 200-percent FMV identification rule. However, an exception applies. There is no need to limit how many a company identifies as long as it closes and acquires 95 percent of those identified. This is called the 95-percent identification exception.
If you sold a piece of equipment for $150,000 you can identify as many replace pieces of equipment as you want as long as the purchase price does not exceed $300,000. This is called the 200-percent FMV identification rule.
Multi-asset exchanges. A company may also enter into multi-asset exchanges. Section 1031 exchange transactions involve significant quantities of personal property, such as multiple forklifts or CNC centers, and have become known as LKE (Like Kind Exchange) Program Exchanges. They are complex income tax transactions that always involve multiple assets and multiple 1031 exchange transactions with significant LKE Program Exchange documentation in accordance with a master LKE Program Exchange Structure.
Related-party transactions. Related-party 1031 exchange transactions occur when a company sells its relinquished property to a related party or it buys its like-kind replacement property from a related party.
Related party 1031 exchanges are permitted, as long as the mold shop follows specific rules and guidelines issued by the Internal Revenue Service. A company can avoid related-party issues if it eliminates the related-party relationship prior to structuring and completing the 1031 exchange transaction.
Related parties include, but are not limited to, immediate family members, such as brothers, sisters, spouses, ancestors and lineal descendants. Related parties do not include step parents, uncles, aunts, in-laws, cousins, nephews, nieces or ex-spouses.
Related-parties also include corporations, limited-liability companies or partnerships in which more than 50 percent of the stock, membership interests or partnership interests, or more than 50 percent of the capital interests or profit interests are owned by the taxpayer.
The company and the related party must hold the properties that each received as part of the 1031 exchange transaction for a minimum of two years. The two-year holding period starts running on the date of the transfer or conveyance of the last property involved in the Section 1031 exchange related-party transaction.
These related-party rules and guidelines do not prohibit any related-party transactions but merely require a longer holding period in order to qualify for the tax-deferred exchange treatment under Section 1031.
The tax-deferred status of the 1031 exchange will be disallowed, and the corresponding depreciation recapture and capital-gain income tax liabilities will be recognized should either the company or the related party dispose of either of the respective properties prior to the end of the two-year holding period. The gain or loss from such a disallowance will be recognized as of the date of the disposition of the subject property.
The Section 1031 exchange transaction will not be disallowed if either of the properties are disposed of within the two-year holding period, where and when:
- The related party from whom the replacement property was acquired defers his or her own tax liabilities by structuring and completing his or her own 1031 exchange transaction.
- The transfer occurs after the death of the related party.
- The related parties each own fractional interest in multiple properties and structure a 1031 exchange, so that each party ultimately owns 100 percent of one of the properties.
- The disposition occurs due to an involuntary conversion pursuant to the meaning within Section 1033 of the Internal Revenue Code.
- The company can prove that tax avoidance was not the purpose of the transfer of the property.
Don’t let the tax tail wag the dog. If new equipment is not necessary, a company should not let the possible tax deferral consume the decision-making process. However, most mold shops look to replace their more expensive pieces of equipment soon after retiring the old equipment, so a like-kind exchange is worth evaluating when disposing of old equipment.
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A Series of International Standards for Quality Management and Quality Assurance
A Series of International Standards for Quality Management and Quality Assurance