Now Is the Time to Consider Expanded LKE Opportunities

Many taxpayers have reviewed Sec. 1031 to consider whether to enter into a like-kind exchange (LKE). With the exception of high value, one-off exchanges involving real estate, airplanes or other “big-ticket” items, the technical complexity and administrative costs of establishing and maintaining a personal property LKE program can potentially outweigh the benefits. However, with an effectively managed, technology-based LKE program, businesses of all sizes can reap the benefits of deferring gain.

Qualifying LKEs

Generally, Sec. 1031 allows taxpayers to sell an asset and defer any associated gain when the proceeds from the sale are used to purchase an asset of similar classification. There are three fundamental rules that must be followed for a transaction to qualify as a LKE:

1. Personal property must be ex-changed for personal property, and real property for real property;

2. The exchanged property must be of similar classification; and

3. The exchanged property must be used in a trade or business.

While these guidelines outline the general requirements of defining a transaction as a LKE, several additional regulations refine the LKE rules.

Although the concept of a LKE program is deceptively simple, the statutory and regulatory requirements make this area technically complex. In designing an effective LKE program, it is important to understand the Sec. 1031 regulations that provide detailed guidance on establishing and maintaining a qualified program. In this area of the Code, form matters; missteps, even unintentional ones, may cause individual exchanges to be reversed.

QIs

The most important aspect of an LKE program is the use of a qualified intermediary (QI) in the sales and purchasing process. To qualify, proceeds from an asset sale must be deposited with a QI until such time that a replacement asset is acquired or an associated liability is relieved. In using a QI, an asset owner assigns the rights (but not any associated obligations) to sell the asset to the QI. The QI is paid directly by the purchaser of the asset. The proceeds are then used by the QI to purchase a replacement asset or relieve another obligation.

The proper facilitation of exchanges by these third-party providers ensures that participants in an LKE program are not in actual or constructive receipt of funds. Repetitive LKE relationships with a QI are usually governed by a Master Exchange Agreement, in which a participant assigns future purchase and sale rights to the QI. This reduces the paperwork burden normally associated with individual transactions. Generally, the QI’s activities cannot be performed by tax practitioners.

LKE Program Administration

In a qualified LKE program, there are two important timelines to be managed. They start on the date of the original asset sale and include (1) a 45-day asset identification requirement and (2) a 180-day acquisition requirement. A participant in an LKE program has 45 days from the original sale date to acquire like replacement property or identify the intended replacement property. In the case of the former, the participant has two choices—to identify three potential replacements from which the selection will be made (the three-property rule) and to identify replacement property of a value not to exceed 200% of the original sales proceeds (the 200% rule). In either case, the identified replacement property must be acquired within 180 days, to ensure that the individual transaction will qualify as an LKE.

Although defining like-kind property in real property transactions is very broad, personal property exchanges are not afforded the same luxury. The regulations (TD 9151, 8/12/04, and TD 9202, 5/18/05) modified the determination of like-kind for tangible depreciable personal property. These pronouncements require that all assets to be exchanged must be of the same North American Industry Classification System (NAICS) Product Class, rather than by the Standard Industrial Classification (SIC) code. The use of the NAICS system streamlines the identification process considerably. This tightening of the regulations was an important step forward, as the SIC system had not been updated since 1987. In addition to the NAICS codes, the assets, if eligible, may first be classified by a General Asset Class as defined by classes 00.11 through 00.28 (as outlined in Rev. Proc. 87-56).

Perhaps the most manual task in administering an LKE program is tracking depreciation. When one depreciated asset is exchanged for another asset, the depreciation schedule of the disposed asset continues. The newly purchased asset begins its own depreciation schedule. The amount to be depreciated on the new asset is the difference in value between the sold asset and the new asset (i.e., the “new cash” added to the exchange process to acquire replacement property). This process becomes most challenging in future layers of depreciation created by an expanding program. Effectively managed, technology-based services are capable of tracking these depreciation schedules on an asset level.

Conclusion

Although individual LKE transactions may take several forms, the process itself can be simplified into a series of common steps. In assisting taxpayers with starting and maintaining an LKE program, practitioners need to ensure that the selected QI is capable of handling its responsibilities, including cash management and transaction administration. By working in partnership, practitioners and QIs can help ensure a successfully operating LKE program and meet their stated objectives.

From Tony Szczepaniak, CPA, Minneapolis, MN