1031 Exchange of Aircraft and Aviation Equipment
Typically business aircraft remain suitable for service longer than the time allowed to fully depreciate their purchase price. When sold, gains resulting from the difference between sale price and depreciated value are taxable, although the timing of when those gains must be taken is extended if the owner replaces the aircraft with another model according to the provisions of Internal Revenue Code (IRC) Section 1031.
Also known as a like kind exchange, transactions covered by IRC Section 1031 permit the current owner of a business aircraft to defer recognition of gain, such as tax depreciation recapture, on the sale of its current aircraft (heretofore ‘relinquished aircraft’) and the purchase of a replacement aircraft.
In its simplest format, an aircraft owner agrees to sell its relinquished aircraft, enters into an agreement with a qualified intermediary to hold the sales proceeds, identifies a replacement aircraft within 45 calendar days of the sale of the relinquished aircraft, and closes on the acquisition of such replacement aircraft within 180 days of the sale of the relinquished aircraft. The qualified intermediary will apply any funds it holds, to be used in connection with the purchase of the replacement aircraft.
Exchanges structured in this simplest format are referred to as ‘forward exchanges’. In today’s business aircraft market, very few forward exchanges are structured, as most aircraft owners will identify and acquire their replacement aircraft prior to selling their relinquished aircraft.
For such situations we utilize what is called a reverse exchange, which has many of the very same procedural/mechanical requirements as a forward exchange. In this structure, either the relinquished aircraft or the replacement aircraft is transferred to a third party known as the exchange accommodation title (EAT) holder.
The EAT is typically the same party as the qualified intermediary, and this aspect of the structure is seamless to an aircraft owner.
However, it is important that whichever aircraft is transferred to the EAT is then leased to the aircraft owner, so the aircraft owner may operate such aircraft.
If the relinquished aircraft is transferred to the EAT, the transaction is structured as a sale with a lease of the relinquished aircraft back to the owner. If the replacement aircraft is acquired by the EAT, the transaction is structured as an assignment of the purchase contract for the replacement aircraft to the EAT, who then acquires the replacement aircraft and leases it to the aircraft owner.
For purposes of this article, we will refer to the acquisition of the relinquished aircraft by the EAT as a “front end exchange,” because the 1031 exchange technically occurs at the time of closing on the replacement aircraft, and we will refer to the transaction where the EAT acquires the replacement aircraft as a “back end exchange,” because the 1031 exchange technically occurs at the time the relinquished aircraft is sold to a third party buyer.
What’s new and interesting about reverse exchanges is coordinating federal income tax structuring requirements with state sales and use tax planning techniques, such as a sales tax trade-in credit strategy. A state law trade-in credit statute, in general, allows for an aircraft owner to reduce the amount of sales or use tax due on the acquisition of the replacement aircraft, by netting the sale proceeds from the relinquished aircraft against the purchase price of the replacement aircraft. As more states clamp down on utilization of “sale for resale” leasing structures as means for minimizing sales and use tax, trade-in credit tax strategies have become more compelling, however.
State sales and use tax law, like Internal Revenue Code Section 1031, is mechanically and procedurally oriented, and requires strict adherence to the statutory methodology. In many cases the statutory methodology may require the use of a “retailer” who holds a sales tax license or permit, as well as other procedural requirements. Reconciling the procedural requirements of federal tax law with state tax law rules is challenging.
In many cases, the requirements of the federal law and the state tax law are simply not harmonious, thus an aircraft owner must choose to structure the transaction to comply more squarely with one or the other. It is also true that state sales and use tax statutes and regulations tend to be vague on many procedural points, requiring an experienced “guess” on the structuring requirements.
In connection with the decision to structure the reverse exchange as either a front end exchange or a back end exchange, it is also necessary to consider federal income tax and state sales and use tax issues. For example, if the replacement aircraft is newly manufactured, in order to preserve the entitlement for bonus depreciation, a front end exchange must be structured. Even without the consideration of bonus depreciation, it is generally preferential to structure the exchange as a front end exchange, to enhance overall depreciation deductions.
Conversely, in the event that sales or use tax had been paid in full on the relinquished aircraft, structuring the reverse exchange as a front end exchange may be less desirable, as an additional sales tax can result on the transfer of the relinquished aircraft to the EAT. Existing debt and new debt issues also heavily factor in the structuring analysis.
Disclaimer: 1031 exchange made simple does not guarantee the performance of the QI's in our referral network and we can not be held liable for any misrepresentations or mistakes in regards to a 1031 exchange by one of the QI's that we refer to you. 1031 Exchange made simple does not provide tax advice nor can we make representations regarding the tax consequences of an exchange transaction. 1031 Exchange made simple is a 1031 QI Referral Network. 1031 made simple is not responsible (in any way) for the performance, creditability, and financial condition of any QI in our network. In this new economic environment it is imperative that all potential 1031 exchange customers do their own due diligence and research on any QI that they may use, on a 1031 exchange. Please verify and check the validity of the Bonding and Insurance of your QI. It may be wise to have your 1031 exchange accounts set up as separate, individual customer accounts. Our web site is to be used as a information based web site only. All parties doing a 1031 exchange must consult their tax advisors or attorney for this information.
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