A new federal 100% bonus rule may affect how companies use IRS 1031 tax-free exchanges, or like-kind exchanges (LKE), in the short term. Since 1921, companies have relied on LKEs to defer tax bills indefinitely from the sale and purchase of replacement assets. Tax deferrals of up to 40% of the sale price of the asset improve cash flow.
On December 17, 2010, the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act increased the bonus depreciation deduction from 50% to 100% for qualifying property acquired and placed into service after September 8, 2010 through December 31, 2011. In addition, Section 179 of the IRS tax code increased the depreciation levels of qualifying capital assets acquired during the tax year to $500,000 with a limit of $2,000,000. The 100% bonus depreciation applies once the $500,000 limit is reached.
Depreciation reduces a company’s income tax and represents an incentive to acquire qualifying capital assets. Both the bonus depreciation rule and Section 179 help businesses acquire equipment, such as business vehicles, computers, software, office furniture and equipment, manufacturing equipment and tangible personal property. Bonus depreciation does not apply to used assets, or commercial and residential real estate property with a recovery period in excess of 20 years.
The 2011 bonus depreciation rule may alter the use of 1031 exchanges in the short-term because the cost of the new capital assets can be deducted from income rather than be depreciated over the years. If a company sells a fully-depreciated piece of equipment for $500,000 and buys a new one for $500,000, the company would have no federal tax obligation for the gain from the sale under this bonus depreciation rule.
Brent Abrahm, president and CEO of Accruit, says companies can take advantage of the short-term benefits of the 100% bonus depreciation period while retaining the long-term benefits of LKE programs. Because the 100% bonus rule expires within the year, a company’s tax basis in its fixed assets will be reduced to zero by 2012, which ultimately will lead to large tax gains unless deferred through an LKE program.
In addition, LKE programs can be used to minimize state tax obligations in states that do not follow Federal depreciation rules. Many state taxing authorities have decoupled from the Federal rule. As a result, companies may still be required to pay taxes on the gain at the state level, reducing the actual benefit of the full deduction at state level. “In states that have decoupled from the Federal bonus depreciation rules, the suspension of a company’s LKE program could result in an additional 2011 state tax liability equal to the company’s forgone LKE deferral multiplied by the state’s highest marginal tax rate,” he says. “Depending on the state, that tax bill could amount to as much as 11% of the foregone LKE deferral.”
Abrahm points out that there are a number of additional considerations for continuing to support LKE programs, which include:
- A reduction in state taxes can also reduce the alternative minimum tax (”AMT”) for owners of closely held companies.
- In addition, some states have suspended or eliminated net operating loss (NOL) carryback and carryforward provisions. The impact of bonus depreciation on taxable income should be considered in light of NOL restrictions
- If a taxpayer suspends its LKE program, its state tax liability will increase and possibly result in additional AMT that may not be recouped in future years.
- Used property does not qualify for bonus depreciation. LKE allows used property to be used as replacement property to complete an exchange.
As companies are considering LKE programs or striving to understand the implications of 100% bonus depreciation to ongoing LKE programs, Abrahm would advise companies to consult with their service providers to determine the most favorable path to maximize the benefits of LKE programs and avoid potential negative tax consequences that might result from discontinuing an LKE program.
For additional questions regarding 1031 exchanges, contact Brent Abrahm, president and CEO at Accruit, LLC. Brent can be reached at 303.865.7301 or email@example.com .