Some May See a Tax Advantage When Trading Old Assets for Leased Property
What happens when a business trades its used equipment for replacement property that is under an operating lease? It may produce a harsh tax result for a profitable business, but that same transaction may represent good tax planning and efficient cash flow management for a struggling business.
Background on like-kind exchanges
When a business trades old equipment for replacement property of a like-kind, no gain or loss is recognized. These trades of tangible personal property are routine for most businesses, and are tax-free under IRC Section 1031, provided that the old and new equipment items are within the same six-digit product class of the North American Industry Classification System (NAICS) codes.
Tax trap when converting to a lease
On the front side of a transaction, a business owner may find that an equipment dealer’s leasing program presents economic and cash flow advantages. If the taxpayer trades equipment that was owned into a leasing arrangement and receives a discount on the lease payments for the value of the relinquished equipment, a taxable gain must be recognized. Section 1031 like-kind exchange treatment is not available because the replacement property is not owned. Effectively, the old equipment has been sold for the discount in the future rent payments. Taxable income must be recognized on the sale of equipment based on the value of the rental discount received (i.e., debit prepaid rent asset and credit sales proceeds of old equipment). The prepaid rent is then amortized and deducted over the term of the new lease arrangement.
Although this is a mere timing matter, it can surprise a business owner with an unexpectedly large amount of income in the year of the transaction. The income recognition is reported as Section 1245 ordinary depreciation recapture. There is no eligibility for installment sale deferral.
Tax opportunity in low income years
However, a business that is low on cash and needs to replace machinery might consider swapping owned equipment for a discounted operating lease on the replacement assets. If the business is in proprietorship or partnership form where business net income is subject to the self-employment tax, this could be a highly tax-efficient transaction.
The income recognition from failing like-kind exchange treatment is reported as ordinary income depreciation recapture, not subject to self-employment (SE) tax. But the subsequent amortization of the prepaid rent over the term of the lease is a business expense that reduces SE tax.
Also, the lease cash outlay is reduced in two ways: The value of the traded property has reduced the lease payments, and the expected residual value of the replacement property has also reduced the lease cost. The trade off, of course, is that no equity is being built in the form of ownership of the replacement equipment.
Purchase versus lease
Equipment dealers may offer a variety of financing arrangements as a means of enticing transactions, and knowing whether you are entering a purchase or a lease is not always black and white. For income tax purposes, in order to understand whether the transaction is treated as a purchase or an operating lease, we look to the substance of the arrangement to conclude whether the benefits and burdens of ownership have passed to the lessee.
Tax court cases over the years have identified a series of factors that are relevant in determining whether a lease is treated as an operating lease or a capital purchase. These factors include:
- Whether legal title is passed
- How the parties have treated the transaction
- Whether the purchaser is acquiring an equity interest in the property
- Which party bears the risk of economic loss or physical damage to the property
No one factor controls, but a key indicator of a capital lease is whether there is a bargain purchase option at the end of the lease term.
How we can help
In the right scenario, a properly executed exchange can allow businesses in low income or high income years to find a tax advantage. To know whether a like-kind exchange would work for you, be sure you consider some of the finer points of a 1031. CliftonLarsonAllen has deep experience in like-kind exchanges and can help you evaluate your options with confidence.