1031 Personal Property Exchanges

Overview

Personal property refers to all property held for investment or productive use in a trade or business, tangible and intangible, that is not considered real property. See Tables 1 and 2, below. A personal property exchange provides the opportunity to defer capital gains taxes and depreciation recapture.

Depreciation recapture is of great concern due to the shorter, more favorable depreciation periods allocated to personal property. (Footnote 1) Depreciation is an income tax deduction that allows a taxpayer to recover the cost of property over several years. It is an annual allowance for the wear and tear, deterioration or obsolescence of the property. The taxable gain on personal property is largely due not to appreciation but depreciation in value taken over the life of the asset.

The 1031 Tax Regulations introduced a “like class” safe harbor to determine whether items of depreciable tangible personal property were “like kind” to each other. The “like kind” requirement is most challenging for depreciable tangible property, since the relinquished and the replacement properties need to be in either the same class or same product code if they are not identical.

The interpretation of “like class” or “like kind” is highly technical. You should consult your legal counsel or tax advisor with regard to the particulars of your exchange.

Tangible Property

1. Introduction

Tangible Depreciable Personal Property is property that has a physical existence that can be felt or touched. Examples of such property include equipment, tools, trucks and cars, and artwork. Please see Table 1 for a more comprehensive outline of this kind of personal property. Under the Tax Regulations to Section 1031, replacement property must be of a “like class” or “like kind.”

The Regulations provide that tangible depreciable property is “like kind” if the relinquished and replacement properties are identical and put to the same use, such as the exchange of a road grader for another road grader both used exclusively by a general contractor building a new stretch of freeway for the state, as an example.

If not of “like kind,” relinquished property and replacement property must be of the same “General Asset Class” or same “Product Class.” Tangible depreciable property may not be classified within more than one General Asset Class or within more than one Product Class. Property that is classified within in any of the general asset classes may not also be classified within a product class. The general asset classes take precedence over the product classes, so that if relinquished and replacement properties are within the same product class but different general asset classes, they would not be considered as “like class.”

Table 1 — Examples of Tangible Depreciable Personal Property

Category Examples
Aircraft Commercial & Business Jet or Piston Engine, Helicopters
Artwork Painting, Printmaking, Sculpture, etc.
Collectibles Coins, Dolls, Stamps, Sports Memorabilia, etc.
Construction Equipment Cement Mixer Trucks, Dump Trucks, Earthmovers, Excavators, Milling Machines, Road Graders, Rock Crushers, Skid Steers, Wheel Loaders, etc.
Electronic Devices Avionics, Computers, Radios, Printing Systems, Robotics, Telecommunication, Voice Logging, etc.
Forestry / Logging Equipment Grapple Skidders, Hydroseeders, Log Loaders, Feller Bunchers, Stump Grinders, Wood Chippers
Furniture for the Office or Hotel Beds, Chairs, Cubicles, Desks, Ergonomic Seating, Fixtures, Ice & Vending Machines, Tables, etc.
Maritime Barges, Container Ships, Dry-Docks, Ferry Boats, Supply Boats, Tanker Ships, Trawlers, Tugboats, etc.
Medical Devices CT scanner, MRI and Ultrasound machines, Lasix Surgery Equipment, Surgical Instruments. etc.
Livestock Beef cattle
Paper Handling Equipment Box Sheet Feeders, Cutters, Mailing Systems, Roll-to-Cut, Roll-to-Fold, Roll-to-Roll and Roll-to-Stack Equipment, Stackers, Unwinders, etc.
Railroad
Equipment Locomotives, Rolling Stock, etc.
Restaurant Equipment Air Screen and Glass Door Merchandisers, Commercial Display Freezers, Hood Systems, Prep Tables, Reach-In Freezers & Refrigerators, Walk-In Freezers, etc.

2. General Asset Classes

Items of tangible personal property will be considered to be “like kind” if they are within the same General Asset Class. The Regulations established thirteen (13) such classes:

1. Office furniture, fixtures and equipment
2. Information systems, such as computers and peripheral equipment
3. Non-computer data handling equipment, such as copiers.
4. Airplanes, helicopters, air frames and engines
5. Automobiles and taxis
6. Buses
7. Light general-purpose trucks
8. Heavy general-purpose trucks
9. Railroad cars and locomotives
10. Over-the-road tractor units
11. Trailers and trailer-mounted containers
12. Vessels, barges, tugs and marine transportation equipment
13. Industrial steam and electric generation and distribution systems

3. Product Classes

The Regulations for determining Product Classes require reference only to the 6-digit product class designations within Sectors 31, 32 and 33 of the North American Industry Classification System (NAICS). NAICS Sectors 31-33 concern specialized manufacturing industries for products and equipment. Copies of the NAICS Manual may be obtained from the National Technical Information Service of the Department of Commerce and may be accessed, with a more complete listing of manufactured products and manufacturing industries, on the Internet. (See footnote 2)

4. Examples in Tax Regulations

The Tax Regulations provide the following examples:

  • Example 1. Taxpayer A transfers a personal computer (asset class 00.12) to B in exchange for a printer (asset class 00.12). With respect to A, the properties exchanged are within the same General Asset Class and, therefore, are of a like kind.
  • Example 2. Taxpayer C transfers an airplane (asset class 00.21) to D in exchange for a heavy general-purpose truck (asset class 00.242). The properties exchanged are not of a like class because they are within different General Asset Classes. Because each of the properties is within a General Asset Class, the properties may not be classified within a Product Class. The airplane and heavy general-purpose truck are also not of a like class. Therefore, the exchange does not qualify for non recognition of gain or loss under Section 1031.
  • Example 3. Taxpayer E transfers a grader to F in exchange for a scraper. Neither property is within any of the general asset classes. However, both properties are within the same product class (NAICS code 333120). The grader and scraper are of a like class and deemed to be of a like kind for purposes of section 1031.
  • Example 4. Taxpayer G transfers a personal computer (asset class 00.12), an airplane (asset class 00.21) and a sanding machine (NAICS code 333210), to H in exchange for a printer (asset class 00.12), a heavy general purpose truck (asset class 00.242) and a lathe (NAICS code 333210). The personal computer and the printer are of a like class because they are within the same general asset class. The sanding machine and the lathe are of a like class because they are within the same product class (although neither property is within any of the general asset classes). The airplane and the heavy general purpose truck are neither within the same general asset class nor within the same product class, and are not of a like kind.


5. Tangible Property Example

You acquire an airplane for $1,000,000, which is its initial tax basis. Over time you take depreciation deductions in the amount of $250,000, and add capital improvements in the amount of $50,000. Your original purchase price, minus the depreciation of $250,000, plus the capital improvements of $50,000, results in an adjusted basis of $800,000. If you sell the airplane in a taxable sale for $1,200,000, you will have to recognize all of the gain of $400,000 and pay the associated tax shown below.

Original purchase price $1,000,000
Depreciation -250,000
Capital improvements +50,000
Adjusted basis $800,000
Sale price $1,200,000
Adjusted basis -800,000
Gain $400,000
Depreciation recapture ($250,000 x 35%) (max.) $87,500
Capital gains tax on balance of gain ($150,000 x 15%) 22,500
Total tax on sale $110,000

6. Depreciation Recapture

The recapture provisions of Internal Revenue Code Section 1245 generally apply only to depreciable personal property (“Section 1245 property”). In a taxable sale of Section 1245 property, depreciation is recaptured as ordinary income [and taxed at ordinary income rates (maximum rate of 35% for individuals)], but only to the extent of gain recognized. In the above example, if the taxpayer were to dispose of the airplane in a taxable sale, since his gain is greater than the depreciation taken, all of the depreciation taken ($250,000) would be recaptured at ordinary income rates. In a 1031 exchange, however, depreciation recapture on Section 1245 property is only applicable to the extent of: (1) the taxable boot recognized in the exchange, plus (2) the fair market value of any non-Section 1245 property received in the exchange, but which still qualifies for nonrecognition under Section 1031. Therefore, in the above example, if the taxpayer acquired a replacement airplane in a 1031 exchange for $3,000,000, and reinvested all of his equity, there would no boot recognized in the exchange and no non-Section 1245 property received. Consequently, no depreciation recapture or capital gains tax would be due.

The following chart illustrates the benefits of completing an exchange over a taxable sale, assuming a loan balance of $300,000:

SALE EXCHANGE
Sales price $1,200,000 $1,200,000
Loan payoff – 300,000 – 300,000
Depreciation recapture and capital gains tax – 110,000 deferred
Available for reinvestment $790,000 $900,000

Intangible Property

1. Introduction

Intangible Personal Property is property that has only a legal existence rather than a physical existence, such as stocks, bonds, patents, copyrights and land use rights. The legal right to this kind of personal property is usually evidenced by a certificate, license or permit that fixes or approximates the value of the property and/or the right to control it. The world of intangible property rights is vast, warranting a careful consideration by you before concluding that you do not have a qualifying asset. Please see Table 2 for a more comprehensive outline of this kind of personal property.

Table 2 — Examples of Intangible Personal Property

Category Examples
Broadcast Licenses Cellular, Radio & Television Frequencies
Copyrights Songs, Books & Other Original Works, Software, etc.
Franchise Licenses Cable Television, Fast-food restaurants, etc.
Patents Ornamental and aesthetic logos (design patents), manufacturing processes and manufactured goods (utility patents), etc.
Permits Fishing permits, Development Rights, etc.
  • 1. Two-Part Test

Under the Tax Regulations to Section 1031, replacement property must also be of “like kind.” The rules are less clearly defined here and depend on the “nature or character” of the property rights involved in claiming a legal right to the intangible property. For instance, one can exchange a patent for a patent, or a Cable TV franchise in one state for a Cable TV franchise in a different state. You should consider this analysis as only the first step in meeting the “like kind” requirement of Section 1031, however. You must also consider the “nature or character” of the underlying property related to the intangible personal property right. For instance, one may hold a patent to a particular type of aircraft wrench (the patent being the claim to exclusive ownership of its design and function). While the patent is a form of intangible property, the patent can only be exchanged for another patent to a different type of wrench but not to a patent for a certain aircraft engine design.

In creating this two-part test, the IRS extended the methodology of the “like class” test for tangible depreciable property to intangible personal property, requiring an analysis of the underlying properties as to general asset or product classes. If the relinquished and replacement properties do not fall in either the same general asset class or same product class, they fail as “like kind” properties even if the legal claim (e.g., a patent) is identical. The IRS created such an exacting set of rules that the exchanger’s success in satisfying the “like kind” requirement of Section 1031 is nominal. Here, success likely rests in the rare circumstance in which the exchanger and buyer are actual competitors engaged in the same line of business involving the same underlying assets. See Technical Advice Memorandum 2006-02034.

2. Examples in Tax Regulations

The Tax Regulations provide the following examples:

  • Example 1. Taxpayer K exchanges a copyright on a novel for a copyright on a different novel. The properties exchanged are of a like kind.
  • Example 2. Taxpayer J exchanges a copyright on a novel for a copyright on a song. The properties exchanged are not of a like kind.

Exchange Process

1. Identification Period

The replacement property must be identified within 45 days of the sale of the first relinquished property. This 45-day rule may not be extended even if the 45th day should happen to fall on a Saturday, Sunday or legal holiday.

2. Manner of Identification

The Replacement Property or Properties must be identified in a written document signed by the taxpayer and hand-delivered, mailed, faxed, or otherwise sent and received before the end of the identification period. Written identification should be made to the party obligated to transfer the Replacement Property to the taxpayer, or any other person involved in the exchange other than the taxpayer or a disqualified person. Examples of persons involved in the exchange include any of the parties to the exchange, an intermediary, an escrow agent and a title company but not one’s spouse, attorney, real estate agent, or tax advisor.

3. Description of Personal Property to Be Exchanged – Special Requirements

The Tax Regulations to Section 1031 for description of relinquished and replacement properties are more restrictive for personal property exchanges than for real property exchanges.

The Regulations require you to unambiguously describe the particular type of personal property. For example, the Regulations provide that a truck is unambiguously described if it is described by a specific make, model, and year. In addition to the other requirements for a proper identification, replacement personal property must be identified by a specific description of the particular type of property.

4. Exchange Period

The acquisition of your replacement property must be completed by the earlier of (1) 180 days of the transfer of your first relinquished property or (2) the due date of filing your federal income tax return for the year in which you transferred the first relinquished property, including extensions. This 180-day rule may not be extended even if the 180th day should happen to fall on a Saturday, Sunday or legal holiday.