The number of 1031 exchanges by equipment owners is expected to increase with the expiration of bonus depreciation, effective December 31st, 2013. Bonus depreciation allows profitable companies, such as automakers, utilities, heavy equipment manufacturers and service providers to write off large capital expenditures in the year the asset is acquired rather than over time. The Joint Committee on Taxation estimates the huge tax shelter in 2013 to be $34 billion. Taxpayers will lose those future savings as a result of already writing off the cost of the equipment unless Congress renews the tax break.
Tax Deferral Shift to 1031 Exchange
The consequence of no longer having bonus depreciation will be to once again utilize the tax deferral tax strategy of the 1031 exchange when selling and replacing outdated or worn equipment. For example, when the local excavating or earth moving equipment company replaces or upgrades old equipment with bonus depreciation, the company would be able to offset or shelter their company income by the amount of bonus depreciation. If the equipment purchase price is $250,000 and qualifies for fifty percent bonus depreciation, $125,000 could offset corporate income for that year. This is a tremendous boom for both the sellers and the buyers, providing an incentive to replace equipment.
With post bonus depreciation elimination, the equipment is depreciated over the life of the equipment as determined by straight line depreciation or the Modified Accelerated Cost Recovery System (MACRS). Under MACRS, the capitalized cost or basis of the tangible property is recovered over the Internal Revenue Code determined life of the equipment by annual depreciation deductions. That means that petroleum refining equipment is depreciated over ten years rather than the bonus depreciation of possibly 50 percent in the year it was acquired. The company was able to recoup their investment faster with bonus depreciation. Aircraft could be acquired with 100 percent bonus depreciation versus depreciating the capitalized investment over a five year period.
1031 Exchange
A 1031 exchange allows the taxpayer to defer the federal and state capital gain and depreciation recapture which is twenty five percent of what has been depreciated over its useful life into the replacement property, allowing an indefinite interest free loan. There are many 1031 exchange rules that must be strictly followed, including:
- Replacement property purchase price must be equal to or greater than the property sold
- Exchange must be completed within 180 calendar days of initiating the 1031 exchange
- A Qualified Intermediary must be engaged to provide 1031 exchange agreements and to hold the exchange proceeds towards the replacement property purchase; otherwise, should taxpayer touch or have access to the funds, the exchange is voided
- Tangible personal property must be exchanged for “like-kind” or “like-class” personal property
In a 1031 exchange, the tax is not eliminated; rather, it is deferred. The tax is ultimately due when the taxpayer cashes out. There is no limit to the number of 1031 exchanges a taxpayer can initiate.
1031 Exchange Property Examples
Though 1031 exchanges are used primarily for exchanges of real property, tangible personal property exchanges of aircraft, vessels, equipment, gold and silver bullion, collectibles, vintage musical instruments, memorabilia, railroad cars and locomotives, oil and gas equipment, thoroughbred race and show livestock and vintage cars are eligible for the 1031 tax deferred exchange. Intangible personal property, such as franchise and development rights, patents and copyrights are eligible for 1031 consideration.
Smart tangible personal property owners will seek ways to defer the federal and state capital gain when selling and replacing their equipment. 1031 exchanges will become more popular given the asset may have been depreciated potentially to zero with bonus depreciation implying that when sold a large gain and tax will be due if property is not replaced in a 1031 exchange.
To learn more about 1031 exchanges, download the complimentary “1031 Exchange Checklist” by clicking on the button below or ask us a question about the transaction you are considering.
