Like-Kind 1031 Exchanges with Aircraft
Zarb, Bert J., The CPA Journal
Owning an aircraft for business purposes is typically undertaken for efficiency and for keeping up with the constantly changing business environment. Acquiring an aircraft usually entails a hefty capital outlay, coupled with significant maintenance and operating costs.
Corporate aircraft ownership has, for a long time, attracted the attention of the IRS, the SEC, the media, and investors. In one notable case, the CEOs of the 'org three" U.S. auto makers were chastised by members of Congress for using their respective corporate jets to fly to Washington, D.C., to plead for federal bailout funds.
There exist myriad laws, rules, and regulations aimed at identifying and preventing abuses in corporate aircraft ownership. Some of these rules come into play when an aircraft is sold or disposed of. Because aircraft retain a high resale value, the sale or disposal of an aircraft could result in a substantial realized gain with significant tax consequences. If depreciation is taken on an aircraft, part of any realized gain may also be subject to the depreciation recapture provisions of ERC section 1245. Consequently, taxpayers may avoid selling the aircraft so as not to be subject to tax. (In the case of corporations, capital gains and ordinary income are taxed at the same corporate tax rate. This contrasts sharply with the lower capital gains rate for individuals.)
A technique that can be used to alleviate the incidence of such a tax is to exchange the aircraft under the provisions of IRC section 1031. A section 1031 taxdeferred exchange remains one of the most powerful tax deferral strategies available, and it can be applied to several high-cost items other than aircraft, such as boats, buildings, machinery, equipment, cranes, and bulldozers.
Section 1031 Exchange
Typically, when a business asset such as an aircraft is disposed of at a gain, that gain will be taxable in the year it is realized. Such a gain will not be currently taxed, however, if the transaction is structured as a like-kind exchange under the provisions of IRC section 1031. In order to qualify as a tax-free event, it must involve a direct exchange of like-kind realty or like-class personalty. A section 1031 exchange defers the payment of tax that would otherwise be due upon the sale of business or investment property, but it does not eüminate the tax. This deferment of tax on a gain from an exchange stems from the fact that when a business exchanges an old aircraft for a new aircraft, the investment in the new (replacement) aircraft is considered to be a continuation of the investment in the old (relinquished) aircraft. When the replacement aircraft is subsequently disposed of - in what will be deemed a taxable transaction - the tax on the gain is due. The tax can be deferred indefinitely, as long as the replacement aircraft is continually exchanged for like-kind property.
The application of the like-kind exchange provisions under section 1031 is mandatory rather than elective. This means that if a taxpayer desires to recognize a gain or a loss, the transaction will have to be structured in such a way that it will fail the statutory requirements for a like-kind exchange. In such a case, the tax basis of the aircraft received is increased by any gain recognized up to its fair market value.
In order for a like-kind exchange to qualify under the tax-free provisions of IRC section 1031, no "boot" should be received. Although the term boot does not appear either in the tax code or the regulations, it is tax practitioners' jargon for cash, debt relief, or the fair market value of non-like-kind property received or given in the exchange. Thus, if the value of the replacement property is greater than the value of the relinquished property and boot is received, then that receipt of boot triggers recognition of gain in the amount of the lesser of the boot received or the realized gain.
While the replacement aircraft should be of equal or greater value than the relinquished aircraft in order to fully defer all tax, the gain deferral on the exchange of aircraft used in a trade or business or held for investment will be lost if the exchange is between related parties and either aircraft is sold within two years of the exchange. …