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Consider Like-Kind Exchanges for Equipment
Replacement
The
decision to purchase heavy machinery is a critical one for construction
firms. In addition to representing a substantial capital
expenditure, it also requires contractors to look closely at their cash flow
and debt in the current sluggish economy.
Before deciding, most contractors will analyze the "buy vs. lease"
and "new vs. used" scenarios. Increasingly, however,
savvy construction professionals are investigating how like-kind exchanges
can be used to lessen the burden of their heavy equipment needs.
Like-kind exchanges, also known as 1031 exchanges, enable construction
companies to swap existing assets in a tax-efficient manner. These
exchanges have long been popular in the real estate industry, but they offer
similar advantages to businesses with large capital equipment needs.
Ideal for Heavy Equipment
As a construction company evolves, its equipment needs are likely to
change. Nevertheless, most companies have limited funds available
for capital purchases, which makes choosing the right heavy equipment an
important decision.
Because heavy equipment generally has a long life span, it is not uncommon
for a company to swap in and out of these assets as its business
dictates. This can, however, pose a substantial tax problem when
the sale of equipment triggers the recapture of previous depreciation
deductions. The tax ramifications can be further compounded
because recapture amounts are taxed at ordinary income tax
rates. Unfortunately, these circumstances sometimes lead to
contractors holding on to equipment that sits unused or is
obsolete.
This is where like-kind exchanges can help. Section 1031 of the
Internal Revenue Code provides that no taxable gain (or loss) will be
recognized when property used in a trade or business is exchanged solely for
property of "like kind" which is also to be used in a trade or
business.
Under the IRS regulations for 1031 exchanges, depreciable personal property,
such as construction equipment, is considered like-kind if it comes from the
same general asset class or the same product class.
Some Basic Requirements
Contractors should keep a few rules in mind. Foremost is the
requirement that equipment being swapped must be of a like
kind. But since most heavy equipment falls within the same general
asset class or product class, any contractor pursuing a 1031 exchange can
still exchange heavy equipment in this tax-efficient manner.
Although there are a few instances where exchanges of equipment in different
product classes are allowable, contractors need to exercise caution in
determining this suitability.
Another requirement is that the seller of the heavy equipment cannot accept
cash from the sale. The seller must invest in replacement
equipment worth at least as much as the replaced equipment. This
is typical on a trade-in where one or more pieces of equipment make up a
significant portion of the purchase price on a new piece of equipment and the
balance is financed.
Even if an outright trade isn’t possible, a contractor can enjoy like-kind treatment
through a "deferred exchange." In such an exchange, a third party
"qualified intermediary" holds the proceeds from the original sale,
and the new equipment being purchased must be identified within 45 days of
the original sale (and purchased within 180 days).
Compare Costs vs. Savings
An additional savings comes from the depreciation of the basis remaining on
the equipment exchanged. The carryover basis is depreciated over
the remaining life of the asset traded in, while the new basis is depreciated
over the appropriate life of the new asset.
Like-kind exchanges offer contractors a way to address their changing
equipment needs in a tax-effective manner. But before pursing 1031
exchanges, contractors should determine whether the administrative costs for
facilitating such an exchange are more than offset by the tax savings from
deferring gains on equipment sales.
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