When it comes to doing a tax-deferred exchange, most people only think about real estate.  The truth is, Section 1031 applies to virtually any asset held for productive use in a trade or business, or for investment.  Airplanes, boats, artwork, livestock and heavy equipment are often exchanged.  One taxpayer even exchanged a baseball bat used by Ty Cobb along with other sports memorabilia for a bat used by Joe DiMaggio and deferred approximately $80,000 in taxes.

Unlike real estate exchanges, determining whether property qualifies as “like-kind” is more difficult when dealing with personal property.  Personal property can be grouped using either a “like-kind” or “like-class” standard.  Like-class provides more certainty and is generally preferred by the IRS.  Items of personal property are like-class if they are in either the same General Asset Class or the same Product Class, as outlined in IRS Reg. 1.1031(a)-2.  There are 13 General Asset Classes.  If the property does not fall within a General Asset Class, look to the Product Class.

Product Classes consist of depreciable tangible personal property listed in the North American Industry Classification System.  Property listed in a “miscellaneous” class will not be presumed to be like-kind. You must then look to the nature of the underlying assets to demonstrate to the satisfaction of the IRS that the property is like-kind. That will hold true for the many items of personal property that do not fall within a General Asset Class or Product Class.  For Example:

• A computer may be traded for a printer, since they are both within the same General Asset Class (00.12).
• The trade of an airplane (class 00.21) for a heavy truck (class 00.242) is taxable, because they are in different General Asset Classes. Because both properties are within a General Asset Class, they may not be classified within a Product Class.
• A grader may be traded for a scraper. Neither is in a General Asset Class, but they are both in the same Product Class (NAICS Code 333120).

The IRS has indicated that it will take a very restrictive position, one which favors like class over like kind. FSA 199941005 (6-10-99).  The Taxpayer combined machinery and equipment into a single exchange group, using the like-kind standard.  The IRS rejected that position, instead requiring three exchange groups, based on like class.

Recently, the IRS seems to be becoming more flexible.  In PLR 200912004 (3-20-09) the IRS stated that cars, light general purpose trucks and vehicles that share characteristics of both, such as crossovers, sport utility vehicles, minivans, and cargo vans are like-kind for §1031 exchange purposes.  Even though they may not be in the same asset or product class, these vehicles share enough characteristics to be considered like-kind for §1031 purposes.

Can one business simply be exchanged for another?  The answer is “No”. The assets of the businesses may not be aggregated. Each of the underlying assets must be classified into exchange groups, as set forth above. Once the exchange groups are identified, an exchange may take place between the like-kind groups.

Other rules also apply.  Personal property located in the United States is not like kind to personal property outside the U.S.  Stock in trade or other property held primarily for sale (i.e., inventory) is specifically excluded from Section 1031 treatment.  You may identify personal property “to be manufactured” as Replacement Property, but unlike a build-to-suit exchange of real property, personal property must be 100% completed by the end of the exchange period.

The IRS has traditionally held that the goodwill of one business is never like-kind to the goodwill of another, even if the businesses are similar. If an exchange involves an ongoing business, you must make an allocation of the purchase price to goodwill, or risk having the IRS make an allocation for you. FSA 19951006 (9-10-99).

However, the treatment of goodwill is also evolving.  In a case involving newspaper mastheads, advertiser and subscriber accounts, the IRS agreed that these assets were distinct from goodwill, but because they are so closely related to (if not a part of) goodwill they were not like-kind property.  FAA 20074401F (11/5/07).  In its analysis the IRS said that Newark Morning Ledger v. U.S., 507 U.S. 546 (1993), which held that an intangible asset is not goodwill for purposes of depreciation if the asset can be separately described and valued apart from goodwill, was not relevant.

Despite that pronouncement, in a recent Chief Counsel Advisory the IRS came to a different conclusion.  Finding that Newark did apply, the IRS held that “except in rare and unusual situations” intangibles such as trademarks, trade names, mastheads, and customer-based intangibles can be separately described and valued apart from goodwill and do qualify as like-kind property under §1031.  The advisory concluded by stating that the IRS should not follow the positions in TAM 200602034 and FAA 20074401F on this issue.

No classification system exists for intangible or non-depreciable personal property.  The determination of like-kind property depends on the nature or character of both the underlying property and the rights involved.  For example:

• A copyright on a novel may be exchanged for the copyright on another novel, since the underlying asset in each case is the same.
• The copyright on a novel may not be exchanged for the copyright on a song. Even though you are exchanging copyrights, the underlying assets are too dissimilar (i.e., novel v. song).

What about incidental personal property?  Strictly speaking, for purposes of a §1031 exchange there is no such thing as “incidental” personal property. An exchange of any property must be handled in the manner outlined above.

However, for purposes of the identification rules only, incidental personal property may be disregarded when using the “200% Rule” or the “95% Rule”, both of which require a valuation of the identified property.  In those instances, property is incidental to a larger property if:

• In standard commercial transactions, the property is typically transferred together with the larger item of property, and
• The aggregate fair market value of all of the incidental property does not exceed 15% of the aggregate fair marker value of the larger item of property.

So remember, §1031 exchanges are not limited to real estate.  Call First American Exchange whenever you intend to dispose of assets used in your trade or business, or held for investment.  We can help you harness the power of tax-deferral to build wealth for you and your family.