WEDA Legal Notes
When the new tax law passed last December, a lot of attention was focused on the pro-taxpayer benefits of lower tax rates. As dealers and business owners, you rightfully focused on how the new tax law would affect your business and your personal tax situation. However, it is also important to be informed about the impact of the new tax law on your customers and be prepared to answer their questions. In this article, I will explain how the tax law changes the nature of your customer’s tax treatment relating to trade-in transactions and identify some important considerations for future changes to the tax law to prevent adverse consequences in how you do business with your customers.
1031 Transactions and Trade-Ins
Many of you are familiar with a “1031 transaction,” which is also commonly referred to as a “like-kind exchange.” The 1031 refers to the federal tax code section that lets you sell property for a profit without paying taxes as long as you reinvest the proceeds into similar replacement property. The impact of a 1031 transaction is that it lets you continually defer taxes until you cash out of the investment (or reinvestment). This is a popular strategy in real estate deals but many people don’t realize that 1031 transactions have also been used for other types of property.
Whether you know it or not, you have been involved in 1031 transactions on a daily basis with your customers when they traded used equipment to you. Prior to the new tax law, your customers could give you used equipment on trade as partial payment for new equipment and then use Section 1031 to avoid paying tax on any profit in the difference between the trade-in credit you gave and their tax basis in the trade-in after the customer has taken into account Section 179 expensing, bonus depreciation or regular depreciation.
Chart 1 is an example of the tax treatment of the 1031 transaction/trade-in from the vantage point of your customer on a hypothetical purchase of a combine for $500,000 with $200,000 assigned to the trade-in:
Bad News … Good News … Bad News
Bad News First – Unfortunately, the new tax law upends the long-term status quo for your customers because it eliminated 1031 transactions for all property except real estate. As a result, starting in 2018, when your customer trades equipment to you, the IRS will view this as a sale of the trade-in to you for a purchase price equal to the trade-in credit. Using the example above, your customer will now have a $150,000 taxable profit ($200,000 credit minus $50,000 tax basis), taxed at ordinary income tax rates, in the year of the trade … OUCH! I know that some dealers have heard from customers expressing concern about this change and its potential impact on trade-in transactions.
Some Good News – Fortunately, the new tax law also includes some good news that alleviates this issue. Under the new tax law, your customer will be able to expense the full value of any equipment purchased in the year of the purchase. Using the same hypothetical purchase/trade-in example above, the tax consequences to your customer in 2018 are illustrated in Chart 2:
As you can see, even though we get there in different ways, the net income result for your customer will generally be the same or similar under the old and the new tax law.
Because of this, for the time being, the change in tax law should not have an adverse impact and, in fact, could have a positive impact for customers that have not been able to accelerate depreciation on their trade-ins through the pre-2018 Section 179 expensing or bonus depreciation rules.
Long-Term Bad News – Even though the changes discussed above effectively offset each other, there is potential trouble on the horizon. The trouble looms because the full expensing rules for purchases of equipment by your customers will expire in 2023 and then will be phased out completely (at the rate of 20&/year) by 2027. However, while the expensing rules are set to expire, there is no corresponding change to 1031 to allow it to apply to equipment. This combination may result in your customers experiencing negative tax consequences (compared to the pre-2018 law) in trade-in transactions.
Even though the new tax law eliminates the 1031 transaction treatment for your customers on trade-in transactions, the full expensing rules for equipment purchases will generally offset this change. But if the tax law continues as currently structured, beginning in 2023, we could start seeing negative tax impacts involving trade-in transactions. If this occurs, customers might be tempted to hold on to equipment longer (until the value more closely matches the depreciated tax basis in the equipment). This could have a significant impact on new equipment sales by dealers, especially those actively engaging in annual roll transactions with customers. Due to this risk, this is a situation that will need to continue to be monitored and I encourage you to contact the association to work with it to develop a strategy for mitigating this risk through future changes in the tax law.
Article Written By Lance Formwalt
LANCE FORMWALT is the leader of the Equipment Dealer Group at Seigfreid Bingham, P.C. The firm also serves as legal counsel to the Western Equipment Dealers Association (WEDA). Lance may be contacted at email@example.com or 816-265-4106. Also see www.sb-kc.com.