Depreciation and Like Kind Exchanges of Aircraft › EdutechResources › resources › by... · 2012-05-08 · • Used to calculate depreciation when MACRS doesn’t apply (e.g

Depreciation and Like Kind

Exchanges of Aircraft

Live NBAA Webinar| May 8, 2012

Presented by: Jeffrey S. Towers

TVPX 1031 Exchange Co.

2

Are you a Certified Aviation Manager or

interested in earning points towards your initial application?

Today’s Webinar is eligible for Certified Aviation Manager (CAM)

Initial and Recertification points.

To qualify for credit you must respond to all poll questions.


Upcoming Tax Webinars

May 15 State Aviation Taxes

May 22 Personal Use: Impact on the Employee

May 29 Personal Use: Impact on the Company

June 5 Federal Excise Tax

June 12 Advanced Tax Topics: Issue-Spotting & Recordkeeping

June 19 Aircraft Tax Planning & Impact on Budgeting for Flight

Departments


Topics

1. Aircraft Acquisition and Operations

a. General Income Tax Concepts

b. Regular Depreciation

c. Section 179 Deductions

d. Bonus Depreciation in 2012 and 2013

e. Issues Affecting Entitlement to Deductions

2. Aircraft Sale and Replacement

a. Depreciation Recapture

b. 1031 Exchange Basics

c. Exchange Rules and Structures

4


Part 1: Aircraft Acquisition and

Operations

General Concepts • Many aspects of business aircraft ownership and operation are

subject to federal and state income taxes

• Certain costs related to aircraft operations are treated as “ordinary and necessary” expenses under IRC §162 for which a deduction is allowed in the year of payment

– Must be appropriate for carrying on taxpayer’s business and reasonable in amount

– Costs that are expensed do not impact the tax basis, discussed below

• The cost of purchasing an aircraft and some major repair costs must be capitalized, meaning that the costs are added to the tax basis and allowed to be depreciated over time

• From a time value of money perspective, expense deductions are better than depreciation because you get the benefit sooner

5


General Concepts

• A starting point for discussion of depreciation is the concept of tax basis

• Tax basis equals the original purchase price of an aircraft, less one time adjustments for 1031 exchanges, section 179 deductions and bonus depreciation, less annual adjustments for regular depreciation, plus the cost of capital improvements by the taxpayer

• Tax basis is used to determine:

– the amount of the allowable annual deductions and

– the amount of taxable gain or loss on a sale

• difference between the adjusted tax basis and the sales price

6


Regular Depreciation

• A business aircraft owner is allowed an annual deductions on its

income tax return for depreciation

– business aircraft are used in a “trade or business” and are

subject to “exhaustion, wear and tear, and obsolescence”

over time (IRC §167)

• Depreciation deductions reduce the tax basis on a dollar for

dollar basis until the basis has been reduced to zero

• Depreciation deductions are only allowed on the business use of

an aircraft

– Transporting taxpayer’s own personnel and property

– Leasing without crew

– Commercial or contract carrying of passengers or freight

7


Calculating Depreciation

• Need to determine

– Depreciation method

– Recovery period

– Convention

8


Depreciation Method

• IRC §168(b) provides that business aircraft are depreciated using one of two methods:

– Modified Accelerated Cost Recovery System, generally referred to as MACRS, and

– Alternative Depreciation System, generally referred to as ADS or straight line depreciation

• MACRS used to calculate depreciation unless disqualified for reasons below

• MACRS deductions are weighted heavily in the first few years of ownership

– Time value of $ benefit

9


MACRS Schedules: Recovery Period

• One of two MACRS schedules could apply to

business aircraft

– 5-year MACRS: Fixed wing aircraft (except those

used for commercial or contract carrying of

passengers or freight) and all helicopters

– 7-year MACRS: All aircraft used for commercial or

contract carrying of passengers or freight except

helicopters

• If aircraft use falls partially in each category, the

MACRS schedule for the predominant use (more than

50%) applies

– If aircraft is leased, look through to lessee’s use to

determine predominant use

10


Qualifying for MACRS • Under IRC §280F aircraft must be predominantly used (more

than 50%) for a “qualified business use”

– Use in a trade or business of the taxpayer

• Could be Part 91, Part 135 or a combination

– If qualified business test not met taxpayer must depreciate

using straight line

• Caution!: Certain business uses of aircraft do not count as a

qualified business use unless other qualified business uses

comprise at least 25% of the aircraft use in each year

– Lease to 5% or more owner or related party

– Use of aircraft as compensation to 5% or more owner or

related party (i.e. – personal use)

– Use of aircraft as compensation by anyone who is not a 5%

or more owner or related party unless income tax is paid (e.g.

– using SIFL rates)

• Aircraft must be predominantly used (more than 50%) in U.S.

11


Qualifying for MACRS

• If aircraft is used for non-qualifying use (such as

personal use) in any year during the depreciation

period, the depreciation deduction for that year is

reduced by the percentage of non-qualifying use, but

the tax basis is reduced by the full amount

• If use of an aircraft fails to satisfy the predominant use

tests for business use or U.S. use in any year during

the depreciation period, MACRS no longer applies

and any prior deductions which exceed the amounts

allowed under straight line depreciation must be

“recaptured”

– Tax on recaptured amount becomes due

12


Straight Line Depreciation

• Used to calculate depreciation when MACRS doesn’t apply (e.g.

– 50% or more non-business use or 50% or more non-U.S. use)

• Equal deductions each year during the depreciation period

• One of two straight line schedules will apply to business aircraft

– 6-year straight line: Fixed wing aircraft (except those used for

commercial or contract carrying of passengers or freight) and

all helicopters

– 12-year straight line: All aircraft used for commercial or

contract carrying of passengers or freight except helicopters

• Correct category for mixed use aircraft is determined in the same

manner as discussed above with MACRS

13


Conventions • Conventions are used to determine the amount of depreciation

that can be taken the first year, which also affects the

depreciation amounts in subsequent years

• Half Year Convention: an aircraft purchased anytime before the

end of the taxpayer’s 3rd quarter will be treated as if it had been

purchased in the middle of the year

• Mid-Quarter Convention: an aircraft purchased anytime during

the taxpayer’s 4th quarter will be treated as if it had been

purchased in the middle of the quarter, assuming that 40% or

more of all MACRS property purchased by the taxpayer was

acquired in the 4th quarter

14


5/7 MACRS

Mid-Quarter Convention

Placed in Service in Fourth

Quarter

Year

1

2

3

4

5

6

7

8

5-Year

20.00%

32.00

19.20

11.52

11.52

5.76

7-Year

14.29%

24.49

17.49

12.49

8.93

8.92

8.93

4.46

5/7 Year MACRS

Half-Year Convention

Year

1

2

3

4

5

6

7

8

5-Year

5.00%

38.00

22.80

13.68

10.94

9.58

7-Year

3.57%

27.55

19.68

14.06

10.04

8.73

8.73

7.64

15


Straight Line Method

Half Year Convention

Straight Line Method

Mid-Quarter Convention

Placed in Service in Fourth

Quarter

Year

1

2

3

4

5

6

7

8

9

10

11

12

13

6

8.33%

16.67

16.67

16.67

16.66

16.67

8.33

12

4.17%

8.33

8.33

8.33

8.33

8.33

8.34

8.33

8.34

8.33

8.34

8.33

4.17

Year

1

2

3

4

5

6

7

8

9

10

11

12

13

6

2.08%

16.67

16.67

16.67

16.66

16.67

14.58

12

1.04%

8.33

8.33

8.33

8.33

8.34

8.33

8.34

8.33

8.34

8.33

8.34

7.29

16


Polling Question #1

Depreciation deductions may only be taken for the

business use of an aircraft – true or false?

17


Bonus Depreciation

• Only applies to new aircraft

• Allows taxpayer to take depreciation early

– Time value of $ benefit, but doesn’t increase the overall

depreciation that can be taken

– Decreases the tax basis in the aircraft on a dollar for dollar

basis

• Currently 50% of cost for most aircraft

– 100% available on some categories of aircraft

• Available in 2012 and to a limited extent in 2013

18


Qualifying for Bonus Depreciation

• Only applies to aircraft that qualify for MACRS

– More than 50% qualified business use (same tests as above)

– More than 50% U.S. use

• If aircraft is used for non-qualifying use (such as personal use) in

the year of acquisition, the bonus depreciation deduction is

reduced by the percentage of non-qualifying use

• If use of an aircraft fails to satisfy the predominant use tests for

business use or U.S. use in any year during the depreciation

period, the aircraft no longer qualified for bonus depreciation and

the bonus amount must be recaptured

– Tax on recaptured amount becomes due

19


Qualifying for Bonus Depreciation

• Must have a recovery period of 20 years or less

• Original use (i.e. - first use) must begin with taxpayer

• Either (i) acquired by taxpayer before January 1, 2013 with no

written binding contract entered into before January 1, 2008 or

(ii) acquired by the taxpayer under a written binding contract

entered into after December 31, 2007

– Acquired means that taxpayer paid or incurred the cost

– Written binding contract means an enforceable contract that

does not limit damages to an amount less than 5% of the

purchase price

• Aircraft must be “placed in service” by the taxpayer before

January 1, 2013 or in limited cases (discussed below) before

January 1, 2014

20


Bonus Depreciation • 100% depreciation available in 2012 for purchases of

“transportation property” and “certain aircraft”

– Must satisfy all the tests for 50% depreciation above

– Aircraft must be acquired and placed in service before January 1, 2013

• Additional rules for 100% depreciation in 2012 on transportation property (aircraft used in the trade or business of transporting persons or property) and other aircraft with long production periods

– Costs more than $1,000,000.00 and has a production period over 1 year

– Subject to IRC §263A “self constructed property”

• Manufactured for taxpayer under a written binding contract signed before manufacturing began and manufacturing must start after December 31, 2007 and before January 1, 2013

21


Bonus Depreciation

• Additional rules for 100% depreciation on “certain aircraft” placed

in service in 2012

– Must not be transportation property

– At the time of entering into the contract for purchase taxpayer

made a minimum nonrefundable deposit of the lesser of 10%

of the purchase price or $100,000.00

– Costs more than $200,000.00 and has a production period in

excess of 4 months

• If transportation property or certain aircraft do not qualify for

100% bonus depreciation in 2012 they may still qualify for 50%

bonus depreciation

22


Bonus Depreciation

• Transportation property and certain aircraft meeting

the above qualifications also qualify for 50%

depreciation in 2013

– No other aircraft qualify for bonus in 2013

• With transportation property the bonus depreciation is

calculated on the adjusted basis attributable to the

manufacture of the aircraft before January 1, 2013

23


Polling Question #2

Bonus depreciation is available for purchases of new

and used aircraft – true or false?

24


Section 179 Deduction

• Allows taxpayer who is purchasing new or used equipment or

capital items to deduct the cost of qualifying purchases

– Reduces tax basis like depreciation

• Amount of deduction capped at $125,000.00 in 2012

– Deduction decreases on a dollar for dollar basis for annual

purchases of Section 179 property that cost in the aggregate

over $500,000.00

• Purchases totaling $625,000.00 or more = zero deduction

– Not much benefit for purchasers of most business aircraft, but

might have value for the cost of certain upgrades or

equipment purchased to support aircraft operations

25


Section 179 Deduction

• Only MACRS property qualifies for 179 deduction

– More than 50% qualified business use and more than 50%

U.S. use must be maintained each year during the

depreciation period or the 179 deduction is recaptured and

tax must be paid

• If the aircraft is used partially for a non-qualifying use such as

personal use in the year for which the deduction is taken, the

amount will be reduced in proportion to the non-qualifying use

• Deduction can only be used to offset taxable income in the year

of the acquisition

– May not be carried forward and applied in a later year when

taxpayer has taxable income and needs an offsetting

deduction

26


General Rules for Expensing and

Capitalization of Repair Costs

• The cost of “incidental repairs” which do not materially increase

the value of the aircraft or substantially prolong its life, but just

keep it in “ordinary efficient operating condition” can be

expensed (IRS Reg. §1.162-4)

• The cost of repairs which add to the value of the aircraft,

substantially prolong its useful life or adapt it to a different use

must be capitalized (IRS Reg. §1.263(A)-1)

• The above concepts seem straightforward, but create challenges

when applied to the complex maintenance requirements of

aircraft

– Example: An engine shop visit (ESV) will be repeated multiple times

over the useful life of an aircraft, but each time the resulting repair

work can be quite substantial and expensive

27


Expensing and Capitalization Guidance • Revenue Ruling 2001-4 addressed treatment of costs of a “heavy

maintenance visit” (HMV) that would reoccur several times over the

useful life of a commercial aircraft

– Included removal of engines, landing gear and interior, repainting,

addressing service bulletins and airworthiness directives, extensive

repair and replacement of minor parts “for the purpose of preventing

deterioration of the inherent safety and reliability levels”

– Three scenarios:

• HMV but no material upgrade, addition or replacement of major

structural component = expense

• HMV + replacement of significant number of skin panels to

address severe corrosion = panel costs capitalized (materially

added to the value) and other costs expensed

• HMV with extensive work to extend useful life = all capital

expenditures. Work constituted a “restoration”. Done in

conjunction with replacement of major components as part of a

“plan of rehabilitation” 28


Expensing and Capitalization Guidance

• FedEx Case involved ESVs in which engines were swapped out

with a temporary replacements

• Court looked at whether the entire aircraft or only the engine

should be the focus in deciding whether a repair materially adds

to the value or appreciably prolongs the life – four factors:

– Does the taxpayer and the industry treat the engine as part of

the aircraft for regulatory, market and accounting purposes?

– Is the economic useful life of the engine coextensive with that

of the aircraft?

– Can the engine and the aircraft function without the other?

– Can and is the engine maintained while affixed to the

aircraft?

29



• The court in the FedEx case concluded that the first 3 factors

were satisfied and even though the engines were sometimes

removed for servicing, that wasn’t sufficient for the engine by

itself to be treated as the relevant unit of property

• Court then looked at whether the ESV repairs were “incidental

repairs” that could be expensed or whether the costs should be

capitalized

• Relies on the “Plainfield-Union” test – if a repair merely restores

an aircraft to its condition after the last ESV and does not

increase the value, usefulness or life of the aircraft the cost is

deductable as an expense

30



• IRS issued proposed and temporary regulations in December

2011 replacing the proposed regulations from 2008

• Components are treated as one unit of property for the purpose

of determining whether repair costs should be expensed or

capitalized if they are “functionally interdependent”

• Regulations include a “safe harbor” for routine maintenance

– The cost of repairs which taxpayer reasonably expects to

perform more than once during the class life (6 or 12 years

for business aircraft) to keep property in “ordinarily efficient

operating condition” are expensed

31



• Exceptions to routine maintenance safe harbor

– Property has “deteriorated to a state of disrepair where it is

no longer functional for its intended use”

– If costs are incurred by taxpayer which relate to a prior

owner’s use, then those costs are not subject to the safe

harbor and must be capitalized if the repair constitutes a

“betterment”

• Ameliorates a material condition or defect that existed

prior to taxpayer’s acquisition or

• Results in a material addition or

• Results in a material increase in capacity

32


Polling Question #3

Repairs to sophisticated equipment like aircraft are always treated as capital improvements for tax purposes – true or false?

33


Potential Impediments to Deductibility • Passive Loss Limitation (IRC §274)

• Aircraft are often leased or subject to timesharing agreements

– Leasing is a passive activity

– Passive losses (e.g. – losses resulting from depreciation) can only offset passive income (e.g. – rent)

– To overcome the limitations the taxpayer must either:

• (a) materially participate in the business of the aircraft leasing company and satisfy the restrictive requirements for leases that are exempt from the limitations or

• (b) group the leasing activity of the aircraft company for tax purposes with a separate business activity that the aircraft company supports and the taxpayer owns and materially participates in

34


Potential Impediments to Deductibility • Hobby Loss Limitations (IRC §183)

• Individuals, S corps and partnerships may only deduct losses from an activity that they engage in for a business purpose

– Taxpayer must have a legitimate intention to make money from the activity

• Regulations set forth 9 factors to determine whether losses are deductable, including:

– Was activity treated like a business?

• Were separate books and records kept?

– What is the profit or loss history of the activity?

– To what degree did the activity involve personal use?

35


Potential Impediments to Deductibility

• Hobby Loss continued

• In some situations the taxpayer may treat the aircraft activity

together with other affiliated businesses to satisfy the hobby loss

rules

– In court in the recent Morton case applied the “unified

business enterprise” approach and determined that the

losses of the aircraft company were deductible because the

aircraft was used to make a profit for the overall group of

companies

36


Potential Impediments to Deductibility

• Entertainment Loss Exclusion (IRC §274)

• Deductions are not allowed for the “entertainment use” of an

aircraft by a “specified individual”

– Entertainment use = trips for purposes that are generally

considered recreational

– Specified individual = officer, director or owner of more than

10% of any equity class, plus their families and guests

• Upcoming sessions will cover this in detail

37


Purchase of new aircraft solely for 135 use that qualifies for

MACRS

$550,000

-75,000

475,000

-237,500

237,500

-33,939

203,561

purchase price

179 deduction (125,000 – 50,000)

adjusted basis after 179 deduction

bonus depreciation (50%) *

adjusted basis after 179 deduction and bonus depreciation

regular depreciation using 7 year MACRS and half year convention

adjusted basis after 179 deduction, bonus depreciation and 1st year regular

depreciation

First Year Deduction

75,000

237,500

33,939

346,439

179 deduction

bonus depreciation

regular depreciation

total

*Assume aircraft is transportation property that does not have a production period

exceeding 1 year 38


Purchase of new aircraft solely for 135 use that does not

qualify for MACRS *

$550,000

-0

550,000

-0

550,000

-22,935

527,000

purchase price

179 deduction

non-adjusted basis

bonus depreciation

non-adjusted basis

regular depreciation using 12-year straight line and half year convention

adjusted basis after 1st year regular depreciation


0

0

22,935

22,935

179 deduction

bonus depreciation


total

*Assume aircraft is not predominantly used in U.S.

39


Purchase of Used Aircraft for 91 Use that qualifies for MACRS

350,000

200,000

80%/20%

purchase price

cost of new equipment

business/personal use

350,000

-100,000

250,000

+200,000

450,000

-80,000

370,000

-59,200

310,800

purchase price

179 deduction (125,000 x 80%)

adjusted basis after 179 deduction

cost of new equipment

adjusted basis after 179 deduction and capitalization of new equipment cost

bonus depreciation on new equipment (50% of cost X 80%)

adjusted basis after 179 deduction, capitalization of new equipment and bonus depreciation

regular depreciation using 5 year MACRS and half year X 80%

adjusted basis after 179 deduction, capitalization of new equipment, bonus depreciation and


100,000

80,000

59,200

239,200

179 deduction

bonus depreciation on new equipment


total


Assume

40


Part 2: Aircraft Sale and Replacement

Depreciation Recapture

• Example: Taxpayer is selling an aircraft (Relinquished Aircraft) for $10,000,000.00 that it purchased in 2006 for $17,000,000.00. The Relinquished Aircraft was used for Part 91 business purposes and depreciated using 5-year MACRS. Taxpayer is purchasing a new aircraft (Replacement Aircraft) for $15,000,000.00, which will also be used for Part 91 business purposes

• Assuming that the Relinquished Aircraft is fully depreciated and the taxpayer’s tax basis has been reduced to zero, taxpayer will recognize $10,000,000.00 of taxable gain

– depreciation recapture is taxed at ordinary income tax rates. Assuming that taxpayer has a combined state and federal income tax rate of 40%, it will owe $4,000,000.00 in taxes

– The result is much better if the sale and purchase are structured as a 1031 exchange

41


1031 Exchange Introduction • “No gain or loss shall be recognized on the exchange of

property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment.” IRC §1031(a)(1)

• Income tax arising from the sale of business property like aircraft may be deferred if the sold property is replaced with other like kind property in accordance with IRC §1031.

• Rationale: Taxpayer is merely replacing an asset used in its business - not cashing out

• Must be held for business use, not as inventory or for personal use

• Tax can be deferred indefinitely if taxpayer repeats the 1031 exchange process whenever it sells an aircraft that was its replacement property in an earlier exchange

42


1031 Exchange Introduction

• What is the result in this example if a 1031 exchange is used?

• Taxpayer will owe $0.00 in taxes as a result of the sale - all income tax liability will be deferred.

• What’s the trade off?

• The tax basis in the Replacement Aircraft is adjusted downward by the amount of the deferred gain. In our example, the adjusted basis in the $15,000,000.00 Replacement Aircraft on day one would be $10,000,000.00.

• Taxpayer’s annual depreciation deductions for the Replacement Aircraft will be lower than if it had not done an exchange, but from a time value of money perspective, taxpayer is benefiting by saving money now.

43


1031 Exchange Introduction • When might an exchange of a business aircraft not make sense?

• Taxpayer will recognize minimal amount of gain on the sale of the Relinquished Aircraft

• Taxpayer moving to a considerably less expensive aircraft or to an aircraft that will be used for pleasure rather than business

• Taxpayer has losses or other deductions that offset the gain on the sale of the Relinquished Aircraft

• Bonus depreciation or Section 179 deduction applies to the Replacement Aircraft and offsets the gain on the sale of the Relinquished Aircraft

– However, an exchange may still be a benefit if:

• Replacement Aircraft doesn’t qualify

• state income tax rules don’t follow federal rules

• significant use in first year that does not qualify

• state sales tax issues etc.

• Always run the numbers before starting an exchange to make sure that the benefit outweighs the cost and effort

44



Forward or Deferred Exchange: A 1031 exchange in which taxpayer sells its Relinquished Aircraft to a third party buyer before it purchases its Replacement Aircraft.

Reverse Exchange: A 1031 exchange in which taxpayer purchases its Replacement Aircraft before it sells its Relinquished Aircraft to a third party buyer. The IRS has established a “safe harbor” for Reverse Exchanges under Rev. Proc. 2000-37.

Qualified Intermediary (QI): A QI is a necessary party in most Forward and Reverse Exchanges. A QI is a third party that is assigned rights from the taxpayer in the contracts to sell and to purchase, receives and holds the net proceeds from the sale (exchange proceeds) and uses the exchange proceeds for the purchase of the Replacement Aircraft.

Exchange Accommodation Titleholder (EAT): A third party used in a Reverse Exchange to temporarily hold “qualified indicia of ownership” to either the Relinquished Aircraft or the Replacement Aircraft. EAT will usually form a separate limited liability company (LLC) to hold each taxpayer’s aircraft.

Boot: Any consideration for the sale of the Relinquished Aircraft that is received by the taxpayer in an exchange, other than like kind property. Boot is taxable. Boot may arise from indirect “receipt” of cash or other non-like kind property

Note: Using exchange proceeds to pay certain common pre-closing expenses such as loan fees and repair costs may result in boot. To be safe, pay such expenses with other funds.

45


46


Two Party Swap (the simplest form of exchange – no QI required):

QI

buyer

seller

taxpayer

taxpayer

Swapping

Party

Ppaparty

Typical 1031 exchange (QI is treated as

the substitute for the swapping party):

46


Issues to Consider Before Hiring an

Exchange Company

• Restrictions on Taxpayer’s Control

– Exchange provider must be independent: May not be a “disqualified person” - close family member, agent, employee, attorney, accountant, broker or entity under common control with taxpayer (Reg. §1.1031(k)-1(g)(4)(iii)(A) and (k); Rev. Proc. 2000-37 Sec. 4.02(1))

– Exchange funds must be under the control of the QI, not the taxpayer: Taxpayers must not actually or constructively “receive, pledge, borrow, or otherwise obtain the benefits of” any sale proceeds from the Relinquished Aircraft. If exchange proceeds are received by taxpayer or taxpayer’s agent, they will be taxable (Reg. §1.1031(k)-1(g)(4)(ii) and (6))

– Taxpayer may not terminate a Forward Exchange prematurely: QI may not release exchange proceeds prior to end of exchange period (usually day 180) except (i) for purchase of a properly identified Replacement Aircraft and (ii) after day 45, to taxpayer if no Replacement Aircraft has been identified or if all identified Replacement Aircraft have been purchased and funds remain in the account (Reg. §1.1031(k)-1(g)(6))

47


Issues to Consider Before Hiring an

Exchange Company

• Use an exchange provider which is financially stable, well qualified to handle aircraft exchanges and which has a reputation of professionalism and integrity

• ask for recommendations from an aircraft professional that you trust

• should carry fiduciary bond and errors and omissions insuranceuse exchange provider who is qualified in your state

– several states have laws regulating exchange providers (e.g. – ME, VA, CO, CA, MN, NV, OR, WA, ID)

• Confirm that your exchange proceeds will be deposited in an FDIC insured account at a secure financial institution.

• FDIC insurance typically only covers deposits up to $250,000.00. For additional protection, a zero interest account that is 100% FDIC insured may be available

• use separate account so exchange proceeds are not commingled with other funds

• consider using a qualified trust to secure QI’s obligation to use the funds only in accordance with the exchange documents and to protect from QI’s creditors

48


Five Exchange Rules to Remember

1. The 1031 Exchange documents must be signed before any closings occur

2. To get the full tax benefit from the 1031 Exchange, the Replacement Aircraft must have at least as much equity and at least as much value as the Relinquished Aircraft

3. The taxpayer who sells must be the taxpayer who buys

• Disregarded entity owned directly by the taxpayer such as a single member limited liability company or owner trust may be used to hold title to an exchanged asset

• The lessee under a synthetic lease is treated as the owner for income tax purposes

4. The property sold must be “like class” or “like kind” to the property purchased

• Type and size of aircraft are generally not relevant

• Different predominate uses (e.g. – use for taxpayer’s business vs. charter use) are factors because the aircraft fall under different classes

• If the like class safe harbor is not met, personal property may still be like kind, but rules are unclear

• An undivided interest in an aircraft is exchangeable for a whole aircraft

5. 45 days to identify the Replacement Aircraft and 180 days to close (or until due date for filing tax return for year of sale, if sooner)

• Deadlines are only extended in the case of certain disasters

49


Identification Requirements

– Identification must be in writing, signed by taxpayer and given to the QI, the seller or someone else involved in the exchange who is not a “disqualified person” (e.g. – escrow agent) on or before midnight of the 45th day)

– Aircraft must be “unambiguously described” and should include make, model, and year at a minimum, based on truck example (Reg. §1.1031(k)-1(c)(3)). More information (e.g. – serial number) strengthens identification, but reduces flexibility

– If an undivided interest will be purchased, the percentage interest should be specified

– Aircraft purchased during identification period are deemed identified

– The number of possible Replacement Aircraft that may be identified are limited:

• Three Property Rule: Taxpayer can identify up to three aircraft of any value and can purchase any or all of the identified aircraft.

• 200% Rule: If taxpayer wants to identify more than three aircraft, then the total value of the aircraft identified must not exceed 200% of the sales price of the Relinquished Aircraft. The identification form should state the fair market value for each aircraft.

• 95% Rule: If taxpayer identifies aircraft that, in the aggregate, exceeds the 200% Rule, then it MUST purchase 95% of the identified aircraft

50


Three Exchange Structures

“Forward” or “Deferred Exchange”

1. The Relinquished Aircraft is sold by taxpayer to a third party buyer

2. The net proceeds from the sale are transferred directly to the QI

3. Within 180 days, the Replacement Aircraft is purchased by taxpayer using the net proceeds from QI

“Exchange First” Reverse Exchange

1. The Relinquished Aircraft is sold by taxpayer to LLC, a special purpose subsidiary of EAT, in accordance with the safe harbor under Rev. Proc. 2000-37

2. The net proceeds from the sale are transferred directly to QI

3. The Replacement Aircraft is purchased by taxpayer using the net proceeds from QI

4. Within 180 days, the Relinquished Aircraft is sold by LLC to a third party buyer

“Exchange Last” Reverse Exchange

1. The Replacement Aircraft is purchased by LLC, a special purpose subsidiary of EAT, in accordance with the safe harbor under Rev. Proc. 2000-37

2. The Relinquished Aircraft is sold by taxpayer to a third party buyer

3. The net proceeds from the sale are transferred directly to the QI

4. Within 180 days, the Replacement Aircraft is purchased by taxpayer from LLC using the net proceeds from the QI

51


Forward Exchange

52


Forward Exchange Timeline

53


Polling Question #4

A taxpayer may start a 1031 exchange after the sale of

its old aircraft has occurred – true or false?

54


Reverse Exchanges

• Taxpayer in a 1031 exchange can’t take title to the

Replacement Aircraft while it still holds title to the

Relinquished Aircraft, so the use of a third party EAT is

required

• Under the safe harbor for Reverse Exchanges, EAT and LLC

are not treated as taxpayer’s agent for income tax purposes

• Qualified Exchange Accommodation Agreement must be

entered into between the taxpayer, EAT and LLC

• In a Reverse Exchange where LLC acquires the Replacement

Aircraft (Exchange Last), identification of the Relinquished

Aircraft needs to either be included in the exchange documents

or it must be given within 45 days from the date that LLC

acquires the Replacement Aircraft

• The taxpayer must complete its reverse exchange within 180

days after LLC acquires the Relinquished or the Replacement

Aircraft

55


Reverse Exchanges

– The taxpayer and EAT may enter into agreements that are not “arm’s

length”, including agreements to indemnify the EAT, leases, loan and security

agreements, guaranties and management agreements.

• The favorable terms allowed under the safe harbor may not satisfy the

tests for ownership for income tax purposes if used outside the safe

harbor

– Related Issues in a Reverse Exchange:

• Financing – LLC needs to borrow the funds for its acquisition

• Leasing – LLC will lease the parked aircraft to the taxpayer

• Insurance – LLC needs to be covered by the insurance on the parked

aircraft

• Sales Tax – LLC’s acquisition, use and disposition of the parked aircraft

will have sales and use tax consequences

• FAA/IR – title transfers, security agreements, etc. need to be recorded

with the FAA and registered on the International Registry

56


Exchange First

57


Exchange Last

58


Exchange First Timeline

59


Exchange Last Timeline

60


Considerations for Selecting Type of

Exchange

• Timing

– Forward Exchange = Relinquished Aircraft closing first

– Reverse Exchange = Replacement Aircraft closing first

– If a taxpayer in a Reverse Exchange needs to close in a hurry, an Exchange Last structure may be preferred. In an Exchange Last, the parties only need to deal with a closing on the Replacement Aircraft on day one. In an Exchange First, the parties will need to coordinate closings on both the Relinquished Aircraft and the Replacement Aircraft on day one

• Depreciation

– A taxpayer needing a Reverse Exchange may prefer to use an Exchange First structure so that it is sure to have the Replacement Aircraft on its books immediately and can take the maximum amount of depreciation for which it is eligible in year one

– If the taxpayer can benefit from the bonus depreciation deduction, they would prefer to take title to the new Replacement Aircraft directly from the manufacturer and would use a Forward Exchange or an Exchange First structure. If they were to use an Exchange Last, when the LLC transfers the aircraft to the taxpayer to complete the exchange, the taxpayer may not be the first user and therefore may not qualify for bonus depreciation

61


Considerations for Selecting Type of

Exchange

• Financing

– If a Reverse Exchange is needed, an Exchange Last structure may be preferable if either (i) the lenders on the Relinquished and the Replacement Aircraft are different and there is a chance that the lender on the Relinquished Aircraft will not cooperate with the exchange, or (ii) if taxpayer has substantial equity in the Relinquished Aircraft and intends to borrow for the purchase of the Replacement Aircraft

• LLC can borrow up to 100% of the purchase price of the Replacement Aircraft from the third party lender, and pay down the loan with the exchange proceeds

• Reminder: Make sure the loan on the Replacement Aircraft can be paid down with the exchange proceeds without penalty

– By comparison, in an Exchange First, in order for funds to flow through the QI, taxpayer would need to come out of pocket for a loan to LLC equal to the equity in the Relinquished Aircraft

• State Tax

– It is very important that sales, use and excise taxes, personal property taxes, franchise taxes, registration fees, etc. are considered before the exchange begins

– In some states, state taxes strategies may drive the decision on which type of exchange to use

62


Putting it all Together

• Calculating basis in Replacement Aircraft with 1031 exchange

– Determine carryover basis (adjusted basis in Relinquished

Aircraft at time of sale) and excess basis (additional amount

paid for replacement aircraft)

– Deduct bonus depreciation from carryover and excess basis

separately

– Deduct regular depreciation from carryover and excess basis

separately

– Carryover basis – usually use balance of depreciation

schedule from Relinquished Aircraft (e.g. – balance of 5 year

MACRS)

– Excess Basis – use new depreciation schedule (e.g. – new 5

year MACRS)

63


• DISCLAIMER

This presentation is intended to provide general information about depreciation,

1031 exchanges and related issues. Such information should not be relied upon

as a substitute for legal or tax advice from an experienced tax advisor, who has

applied the tax rules to the specific facts and circumstances of your particular

situation. You should ask your chosen tax accountant or legal counsel to provide

you with tax advice in a form that you can rely upon before you acquire or

operate an aircraft or enter into any 1031 exchange. Information contained herein

and any information that you have otherwise received from us was neither

intended nor written to be used and cannot be used for the purpose of avoiding

tax penalties under U.S. law or for promoting, marketing or recommending to

another party any tax related matters.

64


Depreciation & Like Kind Exchanges:

Questions for Today’s Presenter?


Jeffrey S. Towers TVPX 1031 Exchange Co.

9 Damonmill Square, Suite 3A2 Concord, MA 01742-2894

phone: 978-610-1234 fax: 978-287-0055

[email protected]

Upcoming Tax Webinars

May 15 State Aviation Taxes

May 22 Personal Use: Impact on the Employee

May 29 Personal Use: Impact on the Company

June 5 Federal Excise Tax

June 12 Advanced Tax Topics: Issue-Spotting & Recordkeeping

June 19 Aircraft Tax Planning & Impact on Budgeting for Flight

Departments


Documents

Depreciation and Like Kind Exchanges of Aircraft › EdutechResources › resources › by... · 2012-05-08 · • Used to calculate depreciation when MACRS doesn’t apply (e.g