Although the Tax Cuts and Jobs Act (TCJA) was written into law more than a year ago, it continues to play a strong role in our tax planning conversations. One of the tax reform provisions our clients ask us about is the changes to Internal Revenue Code Section 1031 (§1031). Section 1031 allows for the tax-free exchange of two similar pieces of property under specific circumstances. These exchanges are often called “like-kind exchanges” because the relinquished property must be replaced with property of a like kind. The TCJA did not eliminate §1031, but it did alter it in one significant way – it disallowed like-kind exchanges of personal property.
Before the TCJA was passed, taxpayers had the opportunity to exchange their business-use property for something similar without incurring a tax obligation. Both personal property (like machinery, vehicles, and computers) and real property (like land and buildings) were eligible for this treatment. Since the TCJA altered the like-kind exchange rules, personal property can no longer be exchanged tax-free. Going forward, only real property is eligible for §1031 treatment.
Like-Kind Exchanges Under the TCJA
Other than the exclusion of personal property (which is, admittedly, quite impactful), the like-kind exchange guidelines have not changed. Therefore, much of what you are familiar with regarding like-kind exchanges remains in effect for real property. A few of the key requirements of §1031 are:
- The property must be used in a business. Individuals cannot utilize §1031 for personal-use land or buildings.
- The property must be of like kind. The definition of “like kind” is quite broad. The replacement property does not have to be exactly equivalent to the relinquished property. For instance, you can trade an office building for an apartment complex, or raw land for farmed land.
- You must designate replacement property within 45 days. Very few exchanges of real property can be done simultaneously, so most business owners will choose a “delayed exchange.” Under a delayed like-kind exchange, you must select your replacement property within 45 days of the sale. You can designate three different properties as long as you ultimately close on one or more of them.
- You must close on the deal within six months. You must complete the transaction within 180 days of the sale of your relinquished property.
Because personal property is no longer eligible for §1031 treatment, many taxpayers are relying on accelerated depreciation to help them upgrade their equipment. The gain from the sale of their old property will be taxed, but the additional depreciation they can take on replacement property purchases can help offset that tax burden. In 2018, bonus depreciation was increased from 50% to 100%, and Section 179 depreciation allows owners to deduct up to $1 million of property purchases each year.
Even with the use of accelerated depreciation, this alteration to our tax code may have a significant impact on your business. Beginning January 1, 2018, the TCJA completely eliminated the ability for taxpayers in all industries to defer their tax gains under §1031 for the following types of personal property:
- Intellectual property
This change may be most acutely felt by businesses that had relied on §1031 to defer gains when trading in vehicles. Today, these taxpayers will have taxable gains each time they upgrade a car, truck, or SUV in their fleet.
But businesses who only use §1031 for real property may feel an effect, as well. Personal property that is included in the sale of real property is also excluded from §1031 treatment. The law requires you to bifurcate the sales price between real and personal property components. For instance, if you sell a warehouse that includes a $100,000 piece of equipment to be used by the new owners, you must allocate $100,000 of the sales price to that piece of equipment and recognize gain on that portion. This new requirement may require you to pay for an appraisal or cost segregation
Taxpayer solutions will be dependent on specific circumstances. Some taxpayers will be content to use bonus depreciation to offset the forfeiture of their tax deferrals. Others will not reap the same benefits from accelerated depreciation, and more calculated planning will be needed for them to move forward. Leasing property rather than purchasing it may be a solution. Taking advantage of opportunity zone credits to offset capital expenditures is another. For help in determining the best course of action for your business, contact your LaPorte tax advisor.