If your business is like most, sooner or later you’re going to sell some equipment, machinery, furniture or other items known as business property.
When you do sell, you might be in for a rude surprise: If you have depreciated the equipment or other assets below the amount that you receive in the sale, you could find yourself liable for tax on the sale proceeds. That’s the bad news.
But I’ve got good news as well: You can work around this tax liability by structuring the sale of your old property as a tax-deferred exchange.
This tactic is known as a like-kind exchange or 1031 exchange, named after the section of the tax code outlining the requirements for such an exchange. Like-kind exchanges probably have their highest profile in the real-estate world, but they also work with sales of depreciable personal property used by work at home businesses.
Dealer trade-in: a straight-shot exchange
The most direct way to take advantage of the 1031 rules is to trade in your property on a new purchase of the same item. For instance, let’s say you have a truck that cost you $30,000 and that you use solely for business. Over the years, you’ve depreciated the purchase price fully, and you now want to sell the truck for $10,000.
If you were to sell the vehicle to another individual and buy a new truck from a dealer or some other seller, you’d have to pay a tax on the $10,000 sale. Reason: Your basis, or the amount you still can depreciate for the truck, is zero, because you’ve already taken the full depreciation. So the full amount of the sale is taxable, even though the amount is less than you originally paid.
If you wanted to take advantage of a tax-deferred exchange, you could trade the truck for a new vehicle. Let’s say the new truck costs $35,000, and the dealer gives you $10,000 on your trade-in. You treat the transaction as an exchange, and thus defer taxes on the value of the trade-in. After the trade, your new truck has a basis — the amount you can start depreciating — of $25,000 ($35,000 minus the trade-in value of $10,000).
When to use accommodators and tax pros
A dealer trade-in is a pretty straightforward example of an exchange. If you’re dealing with a third party — for example, you’re selling your old prop airplane to one party and have found another business that has the bigger, more powerful Cessna (hey, we can be optimistic in our examples, can’t we?) that you now need — you’ll need to use an accommodator, someone who can act as an intermediary and create an exchange between the sale and purchase.
“You probably wouldn’t use an accommodator on an exchange of $5,000, because you’re likely to be charged $500 or $1,000 for their involvement in the transaction,” says Leon Taylor, a CPA with Dethloff & Associates in Beaverton, Ore., which specializes in 1031 exchanges. “But if you have equipment that costs a couple hundred thousand dollars, as do many of the businesses we work with in the forestry and construction businesses, you’ll find that the services of an accommodator are well worth the fees.”
Sometimes, you can have a third party act as an accommodator without going to one of the firms that specialize in 1031 exchanges. “I have seen cases where a seller of equipment goes to a dealer and says, ‘Look, I want to trade this equipment in and I already have someone who is willing to pay X amount for it,’ ” Taylor says. “So what happens is the dealer accepts the equipment as a trade-in on a new piece of equipment that you’re going to purchase, and then completes the exchange by selling the old equipment to the purchaser you had identified.”
Personally, I recommend at least talking with an accommodator or tax pro before attempting all but the simplest of exchanges. The rules governing tax-deferred exchanges are in some ways stricter for personal property than for real estate. For example, you can’t exchange office furniture for a computer, or a light general-purpose truck for a heavy general-purpose truck. You can exchange an airplane for a helicopter (bet you’re glad to know that) but you can’t exchange gold that you’re holding as an investment for silver held as an investment.
Professionals can also help with the many potential traps involved in exchanges — for example, requirements for how the property you receive is formally identified; time limits on how long you have to complete the various aspects of the transaction, and tax forms that both you and the other party in an exchange have to file with returns. In short, it’s terribly easy to blow a 1031 exchange. The prudent business owner usually will benefit by remembering the phrase, “Don’t try this at home.”
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