A 1031 exchange allows taxpayers who own and lease equipment to replace their equipment with new equipment and defer the resulting recaptured depreciation tax. Large rental car companies use the Section 1031 Exchange tax deferral to update their fleets. In addition, a variety of companies lease, sell and replace their equipment through 1031 exchanges including construction, agriculture, communication, oil and gas drilling. Personal property held simultaneously for both sale and lease is under review by the Internal Revenue Service (IRS) for so called “dual-use.”
Notice 2013-13
Recently, the IRS issued Notice 2013-13 requesting comments on whether construction and agricultural equipment simultaneously held for sale or lease by the dealer is “properly treated as inventoriable property or as depreciable property for purposes of Section 167 of the Internal Revenue Code.” Comments are requested by June 16, 2013 regarding “whether and under what circumstances, dual-use property may be eligible for like-kind exchange treatment under § 1031.”
Section 167 allows a depreciation deduction to compensate for the exhaustion, wear and tear and property at the end of useful life that is used in a business or held for the production of income. Section 1.167(a)-2 states that no depreciation deduction may be taken given the property is considered inventory or stock in trade.
Typically, agricultural and construction dealers purchase equipment from the manufacturer with the intent to sell to their customers. Depending upon the customer, the equipment may be leased before selling it. Upon lease termination, the equipment is returned to the dealer and held for sale or releasing. The customer may also purchase the equipment once the lease is over. Leasing companies will lease their equipment and use 1031 exchanges to replace the equipment. The dual use issue surfaces with dealers who lease and hold for sale.
Currently, audits are underway regarding the eligibility of dual use property for 1031 exchanges. IRS guidance is warranted to clarify whether dual use property qualifies for 1031 recognition.
Rental Tool Company Denied Depreciation and 1031 Exchange
The IRS issued Chief Counsel Advisory (CCA) 201025049 on June 25, 2010, determining that the taxpayer’s rental equipment did not qualify for depreciation under Section 167 or 1031 exchange. The taxpayer sells, rents, services and finances equipment. When ordering the equipment from the manufacturer, equipment is recognized as either for sale or for rent. Rental equipment is depreciated under Section 167. When the rental equipment is sold, it is exchanged for new rental equipment in a like-kind exchange.
Upon further review of annual revenues, the IRS determined that 91 percent of the taxpayer’s revenue came from sales and 9 percent from rentals. Furthermore, over 40 percent of the rental equipment was sold during the year with half of those transactions occurring within 90 days of receipt. Many of the rental items sold soon after they were acquired without being rented.
The Chief Counsel decided the designated rental equipment was not held for the express purpose of rental; rather, the equipment was held as inventory, which makes it ineligible for § 167 depreciation and 1031 exchange per Section 1031(a)(2)(A), which states that stock in trade or other property held primarily is excluded from nonrecognition treatment.
Automobile Dealer Dual Use
Contrast Latimer-Looney Chevrolet, Inc. v. Commissioner, 19 T.C. 120 (1952), acq. 1953-1 C.B. 5 where new automobiles “held for use in a trade or business” were provided by the automobile dealer to employees for use in the business prior to sale and Duval Motor Co. v. Commissioner, 264 F. 2d 548 (5th Circuit 1959), aff’g 28 T.C. 300 (1956) where new automobiles were property held for sale to customers and temporarily removed from the automobile dealer’s inventory for use by employees. It is difficult to determine if dual use property held primarily for sale to customers is designated as inventory or as an asset in the productive use of a business.
To learn more about how equipment users utilize 1031 exchanges in their business, read the following article:
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