Many business owners or investors may not think about exchanging personal property because personal property in most cases does not appreciate in value over time to cause a taxable capital gain upon the sale of such items. However, business owners and investors often depreciate personal property on an annual basis.
UPDATE: The Tax Cut and Jobs Act was signed into law on December 22, 2017, and took effect on January 1, 2018. It is a complex modification to the Internal Revenue Code that will take some time to fully understand, notwithstanding that it became effective just nine days after signing. The major change to Section 1031 is the complete repeal of personal property exchanges. The Code section now refers exclusively to real estate assets, and has been retitled, “Exchange of real property held for productive use or investment.” Learn more about the Tax Cut and Jobs Act here.
This depreciation could cause the business owner or investor to experience a significant amount owed in depreciation recapture once the property items are sold.
If the business owner or investor is planning to replace these depreciated items, they would benefit from a 1031 exchange that would allow them to defer the depreciation recapture amount and leverage the income for greater returns.
In part 1 of this blog, we gave examples of property that could qualify as exchangeable personal property. We must now talk about how to determine what property can qualify as replacement personal property.
Section 1031 of the Internal Revenue Code stipulates that property must be exchanged for “like-kind” property. Per this regulation, real property cannot be exchanged for personal property. But personal property that was held for rental purposes, investment, or use in your trade or business can, in fact, be exchanged for like-kind personal property that will be held for the rental purposes, investment or use in your trade or business.
“Like-kind” means that the properties are of the same nature, character, and class. Quality or grade is not a factor in determining if properties are like-kind. While most real estate is like-kind to other real estate, the rules determining whether or not personal properties are like-kind are stricter. For example, cars and trucks are not of a like-kind nature.
Tangible, depreciable personal properties are considered like-kind if they are like-class. Such items are like-class if they are categorized within the same General Asset Class or Product Class. Product Classes are found in Sectors 31 through 33 of the North American Industry Classification System (NAICS).
Intangible personal property is not classified by the NAICS, and is, therefore, more difficult to determine if it is like-kind to another intangible personal property item. “Like-kind” for intangible items depends upon the nature or character of the rights involved and also on the nature or character of the underlying property to which the intangible personal property relates. A good rule of thumb is to determine if the underlying tangible personal properties to which the intangible assets relate are like-class and categorized within the same General Asset Classes and Product Classes. If so, the intangible assets will probably qualify as like-kind.
If you have replacement personal items that are like-kind to your relinquished personal items, then you can qualify for tax deferral through a properly completed 1031 exchange. It is important to remember that personal property exchanges must be conducted following the same rules and regulations as real property exchanges. This includes using a qualified intermediary and abiding by the 45-day identification and 180-day exchange periods.
Finally, if you intend to complete multiple exchanges at the same time with the same buyers and sellers, you should complete each exchange as a separate transaction. Avoid confusion and complications by using separate contracts for each exchange. Don’t include a real property exchange with a personal property in the same transaction. These items are not like-kind, and, if they appear to be exchanged for one another because both transactions occur together, they could disqualify your 1031 exchange.
As always, we recommend you consult a tax advisor to help you throughout your exchange process to ensure a compliant exchange of eligible, like-kind properties.