Before the enactment of the recent tax reform package—commonly known as, but not officially titled, the Tax Cuts and Jobs Act (the “Act”)—every discussion of tax reform raised fears that Congress might repeal Section 1031 of the Internal Revenue Code, which allows for what are often referred to as “like-kind exchanges.” While like-kind exchanges of real estate, which is the most common type of property exchanged, were not repealed or even further restricted, the Act repealed the ability to defer income with respect to a like-kind exchange of any other type of property.
Before the enactment of the Act, Section 1031 allowed a taxpayer to defer gain on the transfer of most types of property if the property was exchanged solely for the same type (hence, the “like kind”) of property. By following guidance provided by the IRS, the so-called exchange of property did not have to be with only one other party, or even at the same time. For instance, if the applicable rules were followed, a taxpayer could sell property to Party A and then later buy property from Party B, and avoid recognition of gain on the sale to Party A.
While to be eligible for exchange the property had to be held for productive use in a trade or business or be held for investment, Section 1031 applied to all property meeting these requirements that was not expressly listed as being ineligible (such as stocks, bonds, or partnership interests). The types of property that were known to have been involved in like-kind exchanges included artwork, equipment, aircraft, cars and trucks, boats, sports contracts, patents and trademarks, and even livestock.
Act Limits Like-Kind Exchanges to Real Property
The Act did not change any of the substantive rules applicable to like-kind exchanges, so that portion of the summary above still applies, but the Act did revise Section 1031 to limit its applicability to only “real property.” This should include land and improvements that are treated as real property.
Therefore, starting January 1, 2018, personal property is no longer eligible for deferral of gain under Section 1031.
How Might This Affect Me?
One of the most significant impacts that businesses might see is with respect to the trade-in of vehicles or equipment. For example, assume that a farmer wishes to buy a new tractor for $3,000. To pay for his new tractor, the farmer trades in his old tractor, which has a tax basis of $0 (because it has been fully depreciated) and a trade-in value of $1,000, and gives the tractor dealer $2,000 cash. Under Section 1031 before January 1, 2018, the farmer would have recognized no gain on the disposition of his old tractor and would have a tax basis in his new tractor of $2,000. Because of the changes in the Act, this same transaction results in the farmer’s recognizing $1,000 of gain on the disposition of his old tractor and a basis in his new tractor of $3,000.
All might not be lost, however, since other changes in the Act may allow the farmer to deduct or expense the entire $3,000 cost of his new tractor, putting the farmer back in essentially the same position that he would have been in before the effective date of the Act. These expensing and depreciation rules can be complicated, in some cases sunsetting or phasing out, and are beyond the scope of this article. Also, there may still be state sales tax benefits to trading in equipment or vehicles as opposed to selling them outright. As always, you should talk to your tax professional for more information.