In the general course of business, a taxpayer who sells an asset may be subject to the payment of capital gains taxes on the gain realized from the sale of the property. Section 1031 of the Internal Revenue Code, however, offers another option – an exchange instead of a traditional sale. When a taxpayer successfully utilizes Section 1031, the capital gains tax that would otherwise be due under a traditional sale is deferred. An example of a straightforward 1031 Exchange would be a taxpayer who relinquishes a piece of rental property and then acquires another similar property that will also be used as a rental. A Qualified Intermediary, or QI, must facilitate 1031 Exchange transactions in order for a taxpayer to benefit from the exchange. Some potential exchanges are considerably more complicated than the previous example; however, even these transactions can potentially qualify for Section 1031 Exchange treatment. Certain types of transactions, for instance, may be eligible for the “Like Kind Exchange Program”, or LKE Program.
Like-Kind Exchange Program
The LKE Program works best for taxpayers who typically own large quantities of a depreciable personal property asset and who regularly sell those assets and replace them with new ones. In addition, a taxpayer should typically be paying a substantial amount in taxes on the sales in order to justify using the LKE Program. A taxpayer who is an avid collector of valuable artwork, for instance, may be a good candidate for the LKE Program if the taxpayer routinely sells artwork and replaces it with like-kind artwork. Under the tax rules that apply to a traditional sale, the taxpayer could incur a tax obligation each time he or she sells a piece of artwork; however, if the LKE Program is used then the tax due would be deferred, freeing up capital for additional investment opportunities.
A taxpayer who wishes to benefit from the LKE Program must be careful to comply with all of the Section 1031 rules though or the transactions may be challenged by the Internal Revenue Service. A recent Field Attorney Advice, or FAA, memorandum illustrates a case in point.
IRS FAA 20124801
In FAA 20124801, a taxpayer claimed LKE Program treatment for vehicles that the taxpayer routinely relinquished and replaced. The taxpayer was in the business of leasing vehicles to car rental companies. As such, the taxpayer (a LLC treated as a partnership for tax purposes) routinely bought and sold vehicles. The taxpayer wished to use the LKE Program to defer the taxes that would otherwise be due on the transactions.
The central issues in the case were whether or not the taxpayer had actual or constructive receipt of funds and the taxpayer’s ability to direct funds. Under the Section 1031 rules “If the taxpayer actually or constructively receives money or other property in the full amount of the consideration for the relinquished property before the taxpayer actually receives like-kind replacement property, the transaction will constitute a sale and not a deferred exchange, even though the taxpayer may ultimately receive the like-kind replacement property”. In this case, the way in which taxpayer structured the accounts, the funds did go through a QI; however, the agreement under which the account operated stated “the Lessors [including Taxpayer] shall direct all payments representing Liquidation Proceeds with respect to Master Collateral Vehicles included in the Like-Kind Exchange Program to the Qualified Intermediary”.
Because the taxpayer was able to direct funds, the IRS concluded that the taxpayer had actual or constructive receipt of the funds, disqualifying the transactions for the LKE Program. Furthermore, the QI in the transactions was not able to limit taxpayer’s “rights to receive, pledge, borrow, or otherwise obtain the benefits from the proceeds held in this account”, another criteria that can disqualify a potential Section 1031 transaction.
Ultimately, taxpayer’s transactions were not found to be compliant with the LKE Program rules. To learn more about like-kind exchanges for personal property, contact our office or click on the button below for a consultation with our Certified Exchange Specialist©.
