Tax Update - Rental Tool Company Denied Depreciation and 1031 Exchange

On June 25, 2010 the National Office of the Chief Counsel of the IRS issued Chief Counsel Advisory (CCA) 201025049 which concluded that taxpayer’s rental equipment did not qualify for depreciation under IRC § 167 or for like-kind exchange treatment under IRC § 1031. 

Taxpayer is in the business of selling, renting, servicing, and financing equipment.  When it orders equipment from the manufacturer, it designates that equipment as either for sale or for rent.  When it receives rental equipment, it capitalizes the cost, which is depreciated pursuant to IRC § 167. 

Equipment initially designated as rental may be subsequently sold to a renter or other purchaser.  There is no prior agreement with renters as to what portion, if any, of rental payments will be credited toward purchase.  If the renter elects to purchase equipment, the price is negotiated.  When rental equipment is sold, it is exchanged for new rental equipment through a QI pursuant to an LKE program. 

During the year examined 91% percent of taxpayer’s revenue came from sales and 9% came from rentals.  There was no discussion in the Advisory of a separate allocation for repairs and financing.

The IRS examined sample transactions.  Of the transactions that were examined, many items designated as being held for rental purposes were disposed of shortly after they were acquired and none of the items were rented prior to disposition.  Overall, 40% of taxpayer’s rental equipment was disposed of during the year and half of those dispositions occurred within 90 days of receipt.

Based on these facts, Chief Counsel concluded that equipment designated as rental was not held for that purpose.  Rather, the equipment was inventory, ineligible for depreciation under IRC § 167 and like-kind exchange treatment under IRC § 1031.  The later by reason of IRC § 1031(a)(2)(A) (exclusion for stock in trade or other property held primarily for sale).  Chief Counsel noted that temporarily withdrawing property from inventory or incidental use of inventory (such as an automobile dealer using a car as a demo) does not convert the property from inventory into property used in the ordinary course of business.

The Advisory states that resolution of this issue is heavily dependent on the specific facts.  The determination of whether property is held for use in trade or business must be made on a property-by-property basis.  Different or additional facts might change the conclusion.

A Chief Counsel Advisory is not binding on the IRS, on any court, or on any party (including the taxpayer under discussion).  However, it provides insight into the current understanding of the IRS concerning the subject that is discussed.

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