Personal Property Exchanges

Although the majority of exchanges involve real estate, tax deferred exchanges are not limited to exchanges of real estate. Personal property (property other than real estate which we will refer to as “business property”) held for investment or for use in a trade or business can be exchanged under Section 1031.

Usually, when property is sold any gain is taxable. Because business property is typically depreciated much faster than real estate, there may be substantial taxable gain when the property is sold or replaced. With business property, a substantial portion of the gain (depreciation or amortization re-capture) may be taxed as ordinary income.

For instance, assume a taxpayer has a piece of heavy construction equipment such as a grader or dirt mover which cost $750,000 when purchased. Assume further that the equipment has been fully depreciated but has a market value of $350,000.00. If the taxpayer is in a 35% tax bracket, selling the equipment and purchasing a new piece of comparable equipment could result in a tax of $122,500.00 (35% of $350,000.00). Structuring the transaction as an exchange under Section 1031 of the tax code could completely defer the tax.

To qualify to defer taxation, replacement property acquired to replace relinquished property (property sold in an exchange) must be either “like-class” or “like-kind property”.

There are two tests to determine if replacement property and relinquished property are like-class properties. The first test is to determine if they are both included in the same “General Asset Class” as defined by the IRS. If the properties cannot be determined to be like-class under this test, the second test is whether thay are both included in the same “Product Class” as determined by the 4 digit Standard Industrial Classification Codes in the SIC Manual. If the properties do not satisfy either of these two tests, they are not like-class property but may still qualify as like-kind property.

The like-kind qualifying tests for business property are much tighter than the like-kind test for real estate. For real estate the like-kind test is extremely broad. Almost any interest in real property will qualify as like-kind replacement property. For instance, you can exchange an apartment complex for a shopping center, or a ranch, or a high rise office building.

There is not much guidance from the IRS in determining whether business property is like-kind. However, if you exchange properties which have a similar use, the properties should qualify. For instance, the exchange of a dump truck for a dump truck, a road grader for a road grader, or gold bullion coins for gold bullion coins, should be acceptable. However, gold bullion for silver bullion or numismatic coins for bullion coins have been held not to qualify. A car for a truck probably does not qualify.

There are also entire classes of business property which cannot qualify for tax deferral such as inventory. Stocks, bonds, partnership interests, trust interests, and promissory notes are also disqualified property for exchange purposes.

An important aspect of any qualifying exchange is to insure that the taxpayer does not have constructive receipt of exchange funds. If you have access to or control of the funds, even though they are not in your possession, the IRS will assert that you have constructive receipt of the funds and the exchange will fail. IRS rules and regulations generally disqualify a friend, employee, or your accountant or attorney from holding the funds for you. Independent intermediaries, such as 1031 Exchange Corporation, can insure that you do not violate the constructive receipt rules. Please contact us for additional information or assistance.