With property values continuing their upward trend, many owners who purchased their businesses years ago are now discovering that the building housing the woodworking business is the most valuable part of their business. But how to benefit from that asset or the other assets so necessary to the success of the business?
Tax-free, like-kind exchanges often provide an extremely useful strategy, substantially reducing the annual tax bite. Those Section 1031 like-kind exchanges or swaps are not, however, limited to real estate.
Old business equipment traded as part payment on new equipment is a like-kind exchange. In fact, virtually any type of business asset can be exchanged. There are also a variety of techniques for handling the exchange, treating it and structuring it — as well as increasingly more complex tax rules to follow.
In its simplest form, the basic “ trade-in,” the basis or value at which the new property or equipment is carried on the books and used for gain, loss or depreciation purposes, is usually the same as the basis or value of the trade-in plus whatever additional cash is needed. In effect, the basis of the new property is its purchase price, increased or decreased according to whether the trade-in value of the old equipment is greater or less than its depreciated cost.
PRO SHOP
Under Code Section 1031, owners of property used in a trade or business — or for investment purposes — can defer capital gains taxes by rolling the proceeds from the sale of the relinquished property into another investment property or into property used in a trade or business that is of equal or greater value. Obviously, this can help defer taxes for any woodworking operation. What many woodworking shop and business owners forget, however, is that the same technique can be used to reduce taxes on the sale of other assets, such as machinery, equipment and even the operation’s intangible assets, contracts, licenses, trade name or trade mark.
Although the process is simple, many woodworking business owners do not successfully complete their tax-deferred exchanges because they do not know how to navigate the complexity of timing requirements set forth by our lawmakers or are confused by the ambigui-ties of the tax law.
The deadlines for qualifying a transaction as a like-kind exchange are fixed. A shop has, from the date of the transfer, only 45 days in which to identify replacement property, and only a total of 180 days from the transfer date to close on the purchase of the replacement property.
These deadlines are not extended by weekends or holidays and cannot be extended due to a change in a woodworking shop’s circumstances. As a result, professional woodworkers often
change rules, real estate may be exchanged for real estate, an automobile for another automobile, but not real estate for an automobile. Those 1031 exchanges, named for a section of the Internal Revenue Code, require an exchange of property that is of a “ like-kind.” Property is of like-kind if it is of the same nature or character.
Fortunately, most exchanges of real property, which is land and whatever is erected or growing on it, qualify as like-kind exchanges. Personal properties, such as moveable equipment and inventory, are like-kind only if they are actually of a like-kind or class. Depreciable equipment, assets and properties such as business equipment are of a like-kind if they fall within the same general asset class or the same product class. Those classes generally follow those used for depreciation purposes.
Exchanges involving intangible personal property or non-depreciable tangible personal property may qualify for like-kind exchange treatment but only if the properties are like-kind. An exchange of a copyright on a novel for a copyright on a song would not be a like-kind exchange. Similarly, an exchange of goodwill or going concern value of one business for the goodwill or going concern value of another business is not a like-kind exchange.
feel pressured to rush to close the transaction or are placed in a poor bargaining position in order to satisfy those artificial deadlines.
An exchange may qualify for like-kind treatment even if the replacement property is received after the relinquished property has been transferred by the shop — provided, of course, that specific identification and receipt requirements are satisfied. These transactions are often referred to as “Starker exchanges.”
The tax rules contain a unique “safe harbor” for Starker exchanges (i.e., an exchange in which replacement property is acquired before the relinquished property is transferred) that involves “parking.” In a parking transaction, the woodworking shop “parks” the desired replacement property with a third party until the shop’s owner arranges for the actual transfer of the relinquished property to the ultimate transferee in a simultaneous or deferred exchange.
After transferring the relinquished property, a woodworking business must identify replacement property within 45 days and must receive the replacement property within 180 days. Best of all, if the rules for this safe harbor are complied with, the IRS will not challenge or look too closely, so long as the rules are closely followed.
Under the Section 1031 like-kind ex-
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One of the biggest concerns with like-kind exchanges is the receipt of so-called “boot,” which may be taxable. If the replacement property is equal or greater in value than the property given up, there is no boot. If cash is received, however, boot results. What’s more, discharges of mortgages or other debt are taken into consideration as value received. There are also other instances where boot can arise such as when the first year’s insurance or warranty payment is paid from exchange funds. That payment is boot because neither insurance coverage nor warranty protection is like-kind property.
A major misconception about like-kind exchanges is that the property owner is trading property with someone else. In reality, most like-kind exchanges are deferred exchanges involving several parties or, in many cases, an intermediary.
In an exchange of real property involving three parties — i.e., the shop, the transferee (perhaps a qualified intermediary), and a third-party that supplies the replacement property — the exchange may qualify as like-kind even if the third party deeds the replacement property directly to the woodworking business. It is not necessary for the transferee to take title to the replacement property and then transfer title to the shop.
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