The Exchange Update
A Newsletter For 1031 Tax-Deferred Exchanges
Proposed Rules May Increase Ownership of Commercial Real Estate
Although accounting rules usually don’t end up as front page news, there are some recent proposals to change the Financial Accounting Standards Board (FASB) accounting rules that should have a significant impact on the commercial real estate industry. The rules may make it more likely that companies will choose to own property rather than rent it, and may also change lease negotiations for those who do rent.
Currently, a lease can be either a capital lease, which is reflected on the tenant’s balance sheet, or an operating lease, which shows up on financial statements in the form of rent as a monthly expense. The proposed rule would treat almost all leases as capital leases. FASB argues that this rule would encourage transparency and give a more accurate picture of a company’s financial condition.
Although the new rules may improve disclosure and transparency, they have the potential to have a significant effect on the commercial real estate and equipment leasing industries. Many large companies have thousands of operating leases and one reason some of them choose to rent rather than acquire property is the way the property is treated for accounting purposes. The new rules would require a company to include virtually all of its leases on its balance sheet, as if it had purchased the property and was making loan payments rather than paying rent.
What are the expected effects of these changes?
- The accounting benefits of leasing space versus buying property will be eliminated, so some companies are expected to decide to acquire property rather than lease it. This change should increase the volume of sales activity and 1031 exchanges.
- Financial covenants in loan documents will be affected by this change, so debtors will need to discuss this issue with their lenders in order to ensure that they do not breach the financial covenants in their loan documents.
- As currently written, the rules do not grandfather in any existing leases, so the administrative burden on tenants could be significant during the transition period.
- Because the lease term would affect what is put on the balance sheet, and because some option periods would be included when computing what the lease term is, lease negotiations may be affected. More tenants may want shorter term leases and may consider the accounting rules when deciding whether to ask for options to extend their leases.
These rules are not final, but if they are enacted in their current form, they will have a significant impact on some companies who lease property. There is additional information at www.fasb.org.
Personal Property Exchange Overview
Investors thinking of exchanging their business often have a variety of assets other than real property associated with that business, including equipment, computers, and other types of personal property. In any exchange transaction involving a business, the investor must examine what exactly is being sold in order to determine: (1) if the particular asset can be exchanged, and (2) what sorts of replacement assets will satisfy the like kind requirement for a successful exchange.
The first step for an investor thinking of exchanging his business is to itemize the various assets and determine which of those assets are exchangeable. Real property and many types of personal property can be exchanged under Internal Revenue Code §1031; however, assets such as goodwill, stocks, inventory, and covenants not to compete are not exchangeable.
Real property and personal property are not like kind and therefore cannot be exchanged for one another. However, personal property held for the productive use in a trade or business or for investment purposes can be exchanged for other “like kind” or “like class” personal property also held for the productive use in a trade or business or for investment. The Federal Regulations provide a safe harbor for tangible depreciable personal property in the same asset class. This means that assets falling within the same asset class are deemed to be like-kind.
The asset classes are described in Revenue Procedure 87-56. If the assets do not fall within the same asset class, they may still be considered like-kind if they fall within the same product class. Product classifications can be found under Sections 31, 32 and 33 of the North American Industry Classification System (NAICS), set forth in the Executive Office of the President, Office of Management and Budget, North American Industry Classification System, United States, 2002, as periodically updated (also called the NAICS Manual). An electronic version of the NAICS Manual can be found at: http://www.census.gov/epcd/www/naics.html.
Even if personal property assets are not considered like-kind under the regulations’ safe harbor, the assets may still be considered like-kind for purposes of the exchange if the assets are similar enough to each other. The IRS provides little guidance as to what types of assets are considered like-kind, and the minimal case law on this topic is very specific. For example, an SUV has been held to be like-kind to a passenger car, and fishing permits for a particular species and a particular location have been held to be like-kind to fishing permits for another species and location.
Personal property that is not like-kind under the rules described above cannot be exchanged. For example, an investor may own a truck worth $50,000 and a computer system worth $35,000. The truck can be exchanged for another truck, and the computer system for another computer system. However, an investor cannot combine the proceeds of the sale of these two items to purchase an airplane worth $85,000 because a truck, computer and airplane are not like kind.
Investors may also own intellectual property assets such as trademarks or trade secrets as part of their business. Intellectual property is considered intangible personal property and certain types of these assets, such as patents, trademarks, and software, may be exchangeable depending on (1) the nature or character of the rights involved and (2) the nature or character of the underlying property to which it relates. In other words, in order for an exchange to work, the character of the rights must be the same (i.e., a patent for a patent) and the underlying property to which the rights relate must be like-class or like-kind (i.e., a mail sorting machine for a mail sorting machine).
For multi-asset exchange transactions, identification of replacement property can be tricky. Fortunately, any replacement property purchased within the 45-day identification period is deemed properly identified. If an investor cannot close on his replacement property within the 45-day identification period, formal identification will be necessary. For personal property assets, each replacement asset needs to be described with as much detail as possible. For example, IRS Regulation 1.1031(k)-1(c)(3) states that, generally, a truck is unambiguously described by stating the model, make and year. Descriptive information such as a vehicle identification number or a serial number can also add to a precise description.
Personal property that is considered incidental to other larger personal property or real property does not need to be separately identified. In order to be considered “incidental”:
(1) the property must be typically transferred together with the larger property in commercial transactions (for example the transfer of a hotel building and furnishings and equipment used in connection with the hotel); and
(2) the aggregate fair market value of all of the incidental property cannot exceed 15% of the aggregate fair market value of the larger item of property (for example, if the real property portion of the hotel is worth $1 million, then the personal property value does not exceed $150,000). It is important to note that this exception relates to the identification rules only, and even if the personal property is worth less than 15% of the real property, the personal property must still be exchanged only for other like kind personal property.
A 1031 exchange of a business typically involves more than just a simple exchange of real property. Provided that the owner determines which types of real property and personal property are being disposed of and purchased, these assets can be matched up in accordance with the guidelines and regulations published by the IRS, and the owner will have a successful 1031 exchange.
For more information on Personal Property exchanges, go here.