By Brian E. Ravencraft
The Tax Cuts and Jobs Act passed in late 2017 amended code section 1031 by superseding the word “property” and replacing it with “real property.” This means that like-kind exchange treatment is still alive and well for real property, but personal property will no longer qualify for a like-kind exchanges and, therefore, will result in a taxable event.
With no code section1031 treatment available to personal property after 2017, equipment or livestock “trades” will be treated as taxable events, with taxpayers computing gain or loss
based upon the difference between the amount realized on the sale of the relinquished asset and the party’s adjusted basis in the asset. As a result, no tax deferrals are available for §1231 gains or §1245 depreciation recapture.
Increased expensing and bonus depreciation options must now be considered in assessing the overall impact of the loss of the 1031 exchange for personal property. The bonus depreciation percentage for eligible property placed in service after 2017, and before 2023 is 100%. The new law also allows the personal property purchased to be new or used (prior to 2018, the personal property had to be new/original use property). Starting in 2023, this percentage is phased down and reduced to zero for property placed in service after 2026. So, for exchanges before 2023, gain on an exchange of personal property can be offset with 100% bonus depreciation taken on the asset acquired in the exchange. For exchanges after 2022 and before 2027, the amount of bonus depreciation available to offset the gain phases down.
This interaction could cause major problems for farmers that routinely retire and reacquire personal property such as tractors and livestock. Presumably these will be fully expensed using 100% bonus depreciation in years that it is available, so that after 2023, these businesses will have large quantities of fully depreciated personal property. In the absence of 100% bonus depreciation, not all of the gain recognized when these assets are routinely retired will be offset with bonus depreciation.
The impact of the expiration of bonus depreciation could be offset somewhat by the new, higher Section 179 expensing limits. For tax years beginning in 2018, taxpayers can elect to expense up to $1 million of the cost of eligible property. The $1 million limit is reduced dollar for dollar (but not below zero) by investment in qualifying property in excess of $2.5 million. For many taxpayers, Section 179 expensing will be available to offset gains recognized when fully depreciated personal property is exchanged. However, businesses that have large quantities of retirements and reacquisitions on a yearly basis may not be able to use Section 179 expensing to offset all of their gains. Also, Section 179 expensing is subject to an overall taxable income limit, which may reduce its availability.
The following example illustrates 2019 tax treatment of an equipment “trade” under the new law.
In 2019, Virgil “trades” a combine with a fair market value of $150,000 and an adjusted basis of $0, plus $100,000 cash and /or loan for a newer combine with a fair market value of $250,000.
In 2019, this transaction will be treated as a sale and a purchase. Virgil must now recognize $150,000 in §1245 recapture — the difference between the FMV of the traded combine ($150,000) and its adjusted basis ($0). This transaction will be reported and taxed as ordinary income (no self-employment tax). Virgil combines the proceeds of the sale, plus an extra $100,000 in cash and/or a loan, to purchase the newer combine. Virgil’s, new basis in his newer combine will be $250,000, the full purchase price of the combine. Virgil will likely use IRC § 179 or 100% bonus depreciation to expense the full amount in 2019. However, as stated previously, if 179 expense is used, the taxpayer may be limited to how much 179 expense can be utilized, especially if all other farm income before depreciation is low. Bonus depreciation does not have such limitations, but it will eventually be phased out.
A few other items to consider…
The new IRC § 199A creates a new deduction for “qualified business income” (QBI). This deduction can generally be taken in an amount up to 20 percent of “qualified business income.” The Internal Revenue Code Section 1245 recapture reported as gain is a component of the complex qualified business income computation, because the §1245 recapture is ordinary income and not taxed as a capital gain.
Also remember, choosing to apply higher amounts of IRC §179 or bonus depreciation to offset the recognized §1245 deprecation recapture gain will result in lower Schedule F income, thus reducing self-employment (SE) income. While this means less SE tax, it also means less retirement income down the road. This can be an important planning consideration.
Be advised, the elimination of like-kind exchange treatment for personal property is permanent, as is the enhanced IRC § 179 deduction. The 100% bonus depreciation, however, is available only through 2022 before it begins to phase out. It will be eliminated fully in 2027.
Finally, most states do not follow or allow full §179 expense or bonus depreciation expense. States usually allow the taxpayer to amortize the depreciation over several years. Therefore, a taxpayer may be able to offset the sale of the personal property with depreciation for federal purpose, but for state purposes, the taxpayer may incur a tax liability in the year of sale.
As part of an overall tax planning review this fall, farmers should determine the potential tax ramifications, as outlined above, of personal property trade-ins so that unexpected tax consequences do not occur.
Brian E. Ravencraft, CPA, CGMA is a Principal with Holbrook & Manter, CPAs. Brian has been with Holbrook & Manter since 1995, primarily focusing on the areas of Tax Consulting and Management Advisory Services within several firm service areas, focusing on agri-business and closely held businesses and their owners. Holbrook & Manter is a professional services firm founded in 1919 and we are unique in that we offer the resources of a large firm without compromising the focused and responsive personal attention that each client deserves. You can reach Brian through www.HolbrookManter.com or at BRavencraft@HolbrookManter.com.