Academic journal article Review of Business

A Practical Guide to Deferring Taxes When Replacing Business Property

Academic journal article Review of Business

A Practical Guide to Deferring Taxes When Replacing Business Property

Article excerpt

Executive Summary

Following the 2007-2008 financial crisis, there is an increasing trend in Like Kind Property Exchanges (LKPEs). In 2013, partnerships and C corporations engaged in over $53 billion and $57 billion of LKPEs, respectively.

The magnitude of these transactions suggests that LKPEs may represent a powerful tax planning tool. The purpose of this article is to raise financial managers' awareness of significant savings through LKPEs when replacing business assets.

The impact of relevant factors on realizable tax savings are assessed through multiple net present value (NPV) analyses for both flow-through entities and C corporations.

Perhaps most importantly, the Excel template used in these analyses is available upon request. This article concludes with a discussion of methods to minimize potential risks associated with an LKPE.

Introduction

The decision to replace a long-term business asset should factor in the impact of potential tax liabilities on cash flows due to gains from the disposal of the original asset. With the traditional sale approach, the company takes ownership of the proceeds at the sale of the original asset and then reinvests in the replacement asset.

A realized gain occurs if the sale price of the original asset exceeds its basis (i.e., historical cost minus accumulated tax depreciation). The recognition of realized gains leads to higher taxable income and higher tax liabilities. Therefore, the sale approach has a negative impact on expected end-of-year cash flows.

To mitigate the potential adverse cash flow effect, financial managers can structure the replacement as an LKPE, thereby delaying tax payments. Exhibit 1 shows that LKPEs increased substantially for both partnerships and C corporations following a dramatic decrease after the 2007-2008 financial crisis. In 2013, partnerships and C corporations engaged in over $53 billion and $57 billion of LKPEs, respectively. (1)

Replacing property via an LKPE helps a business avoid current year taxes by deferring the gains, and therefore changes its cash flow analysis of when to replace an asset.

An LKPE also offers a means of diversifying the company's asset portfolio.

Despite the potential benefits, LKPEs can produce undesired results. For example, if the asset disposal generates a realized loss, the involved party will forgo immediate tax savings.

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This article provides a primer on tax law requirements of LKPEs and presents example analyses to compare net present values (NPVs) of an LKPE and a sale. The presented analyses can serve as a guide to the optimal transaction type for replacing a business asset by a flow-through entity or a C corporation. (2)

The corresponding Excel template is available upon request so that financial managers can approximate the potential tax savings of an LKPE per their unique set of factors. We also discuss practical considerations on structuring asset replacement transactions to defer taxes while minimizing potential risks.

Like Kind Property (LKP)

Deferral of a gain in an LKPE occurs only if all of the governing Code [section]1031 requirements are satisfied. (3,4) Code [section]1031(a)(1) prescribes that:

--there must be an exchange of the original asset with the replacement property.

--the involved assets must be held for business or investment purpose, and

--the replacement property must be considered as an LKP of the original asset.

As such, the identification of qualified replacement assets is critical before engaging in an LKPE.

There are two types of business assets under LKPE rules: real vs. personal property. Real property is immovable, while personal property is moveable. (5)

The recent increase in real estate property values should provide companies with an incentive to consider using an LKPE when disposing of real property. …

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