Like Kind Exchange for Equipment Lessors

Although frequently modified and clarified, Internal Revenue Code Section 1031 Like-Kind Exchange, has been consistently renewed by Congress and has remained substantially unchanged since its enactment in 1921. Originally, Congress offered the following rationales as justification for non ' recognition of gain in an exchange:

1. Difficulty in valuing exchanged property and administrative convenience ' “horse trades” and similar exchanges justify non-recognition of gain or loss because of the administrative burden and uncertainty in valuing the properties involved make administration of the tax laws surrounding such exchanges impractical.
2. Continuity of investment ' where a taxpayer does benefit from or otherwise “cash out” its investment in business property, but rather merely replaces one business asset with a second business asset of like kind and of equal value, the taxpayer should not be taxed on its continuation of business investment.
3. Lack of liquidity ' where a taxpayer needs proceeds from the disposition of old assets in order to acquire new assets of sufficient value to maintain the size and scope of its business activity, the taxpayer lacks the wherewithal to pay taxes in regard to the reinvestment without adversely affecting its ability to continue its business at the same or increasing levels of activity.

Unlike the horse trades contemplated in 1921, most modern exchanges utilize the services of a Qualified Intermediary to buy and sell exchanged properties from third-party buyers and sellers at independently negotiated arm's-length prices. This intermediary process eliminates the administrative and valuation challenges described in #1 above and by itself, probably does not justify LKE today on the basis of valuation or administrative convenience. However, the “Continuity of Investment” and “Liquidity” rationales espoused for LKE in 1921 are just as valid today as they were when the original rules were adopted.

Like Kind Exchange provides a means for U.S. businesses to upgrade and renew their business assets without the deleterious effects of imposing up to a 40% tax burden on the upgrade process. Without LKE, taxation of business asset replacements and upgrades would necessitate that businesses use a substantial portion of the value of their old assets to pay taxes on the sale of the old assets rather than reinvesting theie entire value in new property. As a result, taxation of asset replacements and upgrades functionally results in reduced business investments and productive business activity. If LKE no longer existed, then businesses would be reluctant to replace old and obsolete assets making them ever less competitive in the global marketplace as they fall further and further behind in updating the form and function of their business assets relative to their global competitors and overall business and economic activity would be reduced. In early 2015, a coalition of industry associations and taxpayers commissioned a study, “Economic Impact of Repealing Like-Kind Exchange Rules” by Ernst and Young. The study concluded that repeal of LKE would reduce U.S. GDP by $61 to $131 billion over 10 years, and increase the effective tax rate for small business by 40% to 50%.

Why Are Changes in the LKE Being Considered Now?

Over the last several years, there have been growing concerns that the U.S. tax code may assign a disproportionate tax burden on lower- and middle-income wage earners while simultaneously hindering the competitiveness of U.S. business around the world. As a result, legislators and the White House have increasingly focused their attention on the potential for comprehensive tax reform to simultaneously create a simpler and fairer tax code. In addition, this reform would make U.S. business more competitive in the global economy, primarily by reducing U.S. corporate tax rates (which are currently second only to Japan on a nominal basis) as well as U.S. individual tax rates.

While the public conversation over “tax reform” is really just beginning, to date, it has generally focused on how the U.S. might trade some of its more complex deduction, credit and deferral provisions for reduced and flatter corporate and individual rates (without of course, exacerbating problems with our expanding federal deficit). These conflicting trade-offs and goals have necessitated a closer examination of the relative tax “revenue” that might be generated from the modification or even repeal of certain “tax benefits,” including tax revenue that might be generated from a modification or repeal of LKE.

In addition to the “trade-off” discussions above, there is also a growing, if uninformed, body of public opinion that LKE represents a “tax loophole” that serves little public good and is available only to those wealthy enough to afford the resources needed to navigate the complex rules surrounding LKE. More recently, the use of LKE to defer taxes on sales of art and collectibles in particular have come under increasing attack. Unfortunately, alleged abuses regarding these types of assets may be tainting a more supportive public policy argument for LKE's role in supporting business investment and enhancing the global competitiveness of U.S. economy and businesses. See Daniel Grant, “With 1031 Exchanges, Art Investors Avoid Taxes,” The Wall Street Journal, Feb. 1, 2015; Graham Bowley, “Tax Break Used by Investors in Flipping Art Faces Scrutiny,” The New York Times, April 26, 2015.

What Changes Are Being Proposed to LKE?

Although “tax reform” has been a topic of legislative and executive interest for a great number of years, only recently have changes to LKE been included in the discussion. Legislatively, significant changes were first proposed as part of the “2013 Cost Recovery and Accounting Tax Reform Discussion Draft” released by the Senate Finance Committee under Chairman Max Baucus in November, 2013. In that Discussion Draft, the Committee proposed changes to the U.S. system of cost recovery and depreciation that replaced the current Modified Accelerated Cost Recovery System (“MACRS”) with a new pooling approach that classified all business assets into four “pools” of assets, and applied a flat-cost recovery rate to the undepreciated year-end balance of each pool. While the draft also proposed a complete repeal of LKE, the pooling approach effectively maintained deferred tax treatment to the extent the “pools” had positive balances as of the end of each tax year. Dispositions of depreciable assets were only taxed to the extent the disposition caused a “pool” balance to be negative at the end of the tax year in which case the taxpayer was required to recognize taxable gain to the extent of that negative balance.

The second LKE specific proposal came when House Ways and Means Committee Chairman David Camp released “The Tax Reform Act of 2014 Discussion Draft” in February 2014. That discussion draft proposed a complete overhaul of the entire tax code, which substantially curtailed or repealed many current deductions and credits as a trade-off for reduced tax rates. As part of that proposal, the current MACRS depreciation system was replaced with a return to depreciation under the less favorable Alternative Depreciation System (“ADS”). In addition, the Camp proposal completely repealed LKE for asset dispositions after 2014. Interestingly, a Joint Committee of Taxation (“JCT”) analysis of the proposal was the first to place a budgetary value on LKE repeal, which it estimated (or “scored”) to be $40.9 billion in “revenue” for the budget period from 2014 to 2023. Eventually, Chairman Camp formalized this discussion draft without modification when he introduced HR 1, titled “Tax Reform Act of 2014″ in December 2014.

Most recently, President Obama released his 2016 budget proposals (the “Green Book”) in February 2015. In it, the President proposed that LKE deferral for real estate gains be limited to $1 million per taxpayer (aggregated for related parties) per year. As justification for its proposed change, the White House argued that the valuation and administrative convenience rationale for initially adopting LKE in 1921 (described in #1 above) was no longer applicable. However, the administration's arguments failed to mention, and as a result gave no credence to, the still valid “continuity of investment” and “liquidity” rationales previously described. In addition to a limitation on real estate exchanges, the proposal repealed LKE for art and collectibles. However, LKE for personal property (including tax leased business assets) was unaffected. For this limited change to LKE, the JCT estimated “revenue” of $10.5 billion for the budget period 2015 thru 2024.

The revenue “scoring” of various tax provisions is important for budgetary purposes because it puts a concrete value on the provision for purposes of negotiating tax reform ideas and trade-offs. In addition to its estimates of tax revenue for LKE proposals in the Camp and Obama proposals, the JCT also valued potential LKE revenue in two other documents. In its Aug. 5, 2014 “Estimate of Federal Tax Expenditures for Fiscal Years 2014-2018″ the JCT projected that the tax expenditure (i.e., potential “revenue”) for the retention of LKE for the four-year period 2014 to 2018 was $98.6 billion. (Note ' this estimate of the potential value of LKE for budgetary purposes is the highest that has been published to date and may be attributable to the presumed future exchange of depreciable business assets that were acquired in years preceding 2015 and may have been subject to special 30%, 50% and 100% bonus depreciation). Finally, in its Feb. 6, 2015 “Background Information on Tax Expenditure Analysis and Historical Survey of Tax Expenditure Estimates,” the JCT lists LKE as the second largest corporate tax expenditure at $68 billion for 2014 to 2018.

What Can Lessors Do to Protect LKE?

Predicting legislative action is best left to professional political prognosticators and public policy wonks. However, while comprehensive tax reform is not currently expected to get any traction until sometime well after the 2016 elections, we are reminded of the phrase, “If you are not at the table, then you are on the menu.” The table for Tax Reform is being set now and the equipment leasing industry is well advised to get involved in their legislative processes as soon and as actively as is possible in order to help set the proverbial tax reform table and make sure their interests, whether specifically regarding LKE or otherwise, are addressed and served by the legislative leaders who represent them in Washington.

Jeff Nelson is a managing director and initiative leader for PricewaterhouseCoopers LLP's Like Kind Exchange (LKE) and Tax Depreciation Services (TDS) practice. He can be reached at [email protected].

Under the general rules of Like Kind Exchange (“LKE”), no taxable gain (or loss) is recognized, and no tax is due, where property held for use in a trade or business (including tax leased property) is exchanged solely for like-kind property that is also to be held for trade or business purposes. Assuming all requirements of LKE are met, if you dispose of an business asset and subsequently reinvest your sales proceeds to acquire a “like-kind” replacement asset of equal or greater value, then the recognition of taxable gain (along with the lessor's obligation to pay tax on that gain) is deferred until the replacement asset is sold or, in the case of subsequent follow on exchanges, until the replacement's replacement asset is sold in a taxable disposition.

The benefits of LKE for equipment lessors are clear. LKE programs (which seek to institutionalize LKE as a normal part of a lessor's lease origination and remarketing processes) allow lessors to defer federal and state taxation of gains when lessors systematically dispose of their off-lease equipment and subsequently replace that equipment with new leases of like kind equipment. The LKE deferral rules enable lessors to reinvest 100% of their proceeds back into their business instead of using a significant portion of those proceeds to pay federal and state income tax on gains. If a lessor's applicable federal and state tax rate is 40%, this gain deferral provision means that for every $1 million in taxable gain, lessors will have additional cash of $400,000 to reinvest in their leasing business. For the typical lessor, this additional cash can generate increased ROI for their lease portfolio of 75 to 150 basis points. As a result, LKEs provide significant economic advantages and facilitate businesses ongoing or increasing investments in their businesses.

Why LKE Was Originally Enacted

Although frequently modified and clarified, Internal Revenue Code Section 1031 Like-Kind Exchange, has been consistently renewed by Congress and has remained substantially unchanged since its enactment in 1921. Originally, Congress offered the following rationales as justification for non ' recognition of gain in an exchange:

1. Difficulty in valuing exchanged property and administrative convenience ' “horse trades” and similar exchanges justify non-recognition of gain or loss because of the administrative burden and uncertainty in valuing the properties involved make administration of the tax laws surrounding such exchanges impractical.
2. Continuity of investment ' where a taxpayer does benefit from or otherwise “cash out” its investment in business property, but rather merely replaces one business asset with a second business asset of like kind and of equal value, the taxpayer should not be taxed on its continuation of business investment.
3. Lack of liquidity ' where a taxpayer needs proceeds from the disposition of old assets in order to acquire new assets of sufficient value to maintain the size and scope of its business activity, the taxpayer lacks the wherewithal to pay taxes in regard to the reinvestment without adversely affecting its ability to continue its business at the same or increasing levels of activity.

Unlike the horse trades contemplated in 1921, most modern exchanges utilize the services of a Qualified Intermediary to buy and sell exchanged properties from third-party buyers and sellers at independently negotiated arm's-length prices. This intermediary process eliminates the administrative and valuation challenges described in #1 above and by itself, probably does not justify LKE today on the basis of valuation or administrative convenience. However, the “Continuity of Investment” and “Liquidity” rationales espoused for LKE in 1921 are just as valid today as they were when the original rules were adopted.

Like Kind Exchange provides a means for U.S. businesses to upgrade and renew their business assets without the deleterious effects of imposing up to a 40% tax burden on the upgrade process. Without LKE, taxation of business asset replacements and upgrades would necessitate that businesses use a substantial portion of the value of their old assets to pay taxes on the sale of the old assets rather than reinvesting theie entire value in new property. As a result, taxation of asset replacements and upgrades functionally results in reduced business investments and productive business activity. If LKE no longer existed, then businesses would be reluctant to replace old and obsolete assets making them ever less competitive in the global marketplace as they fall further and further behind in updating the form and function of their business assets relative to their global competitors and overall business and economic activity would be reduced. In early 2015, a coalition of industry associations and taxpayers commissioned a study, “Economic Impact of Repealing Like-Kind Exchange Rules” by Ernst and Young. The study concluded that repeal of LKE would reduce U.S. GDP by $61 to $131 billion over 10 years, and increase the effective tax rate for small business by 40% to 50%.

Why Are Changes in the LKE Being Considered Now?

Over the last several years, there have been growing concerns that the U.S. tax code may assign a disproportionate tax burden on lower- and middle-income wage earners while simultaneously hindering the competitiveness of U.S. business around the world. As a result, legislators and the White House have increasingly focused their attention on the potential for comprehensive tax reform to simultaneously create a simpler and fairer tax code. In addition, this reform would make U.S. business more competitive in the global economy, primarily by reducing U.S. corporate tax rates (which are currently second only to Japan on a nominal basis) as well as U.S. individual tax rates.

While the public conversation over “tax reform” is really just beginning, to date, it has generally focused on how the U.S. might trade some of its more complex deduction, credit and deferral provisions for reduced and flatter corporate and individual rates (without of course, exacerbating problems with our expanding federal deficit). These conflicting trade-offs and goals have necessitated a closer examination of the relative tax “revenue” that might be generated from the modification or even repeal of certain “tax benefits,” including tax revenue that might be generated from a modification or repeal of LKE.

In addition to the “trade-off” discussions above, there is also a growing, if uninformed, body of public opinion that LKE represents a “tax loophole” that serves little public good and is available only to those wealthy enough to afford the resources needed to navigate the complex rules surrounding LKE. More recently, the use of LKE to defer taxes on sales of art and collectibles in particular have come under increasing attack. Unfortunately, alleged abuses regarding these types of assets may be tainting a more supportive public policy argument for LKE's role in supporting business investment and enhancing the global competitiveness of U.S. economy and businesses. See Daniel Grant, “With 1031 Exchanges, Art Investors Avoid Taxes,” The Wall Street Journal, Feb. 1, 2015; Graham Bowley, “Tax Break Used by Investors in Flipping Art Faces Scrutiny,” The New York Times, April 26, 2015.

What Changes Are Being Proposed to LKE?

Although “tax reform” has been a topic of legislative and executive interest for a great number of years, only recently have changes to LKE been included in the discussion. Legislatively, significant changes were first proposed as part of the “2013 Cost Recovery and Accounting Tax Reform Discussion Draft” released by the Senate Finance Committee under Chairman Max Baucus in November, 2013. In that Discussion Draft, the Committee proposed changes to the U.S. system of cost recovery and depreciation that replaced the current Modified Accelerated Cost Recovery System (“MACRS”) with a new pooling approach that classified all business assets into four “pools” of assets, and applied a flat-cost recovery rate to the undepreciated year-end balance of each pool. While the draft also proposed a complete repeal of LKE, the pooling approach effectively maintained deferred tax treatment to the extent the “pools” had positive balances as of the end of each tax year. Dispositions of depreciable assets were only taxed to the extent the disposition caused a “pool” balance to be negative at the end of the tax year in which case the taxpayer was required to recognize taxable gain to the extent of that negative balance.

The second LKE specific proposal came when House Ways and Means Committee Chairman David Camp released “The Tax Reform Act of 2014 Discussion Draft” in February 2014. That discussion draft proposed a complete overhaul of the entire tax code, which substantially curtailed or repealed many current deductions and credits as a trade-off for reduced tax rates. As part of that proposal, the current MACRS depreciation system was replaced with a return to depreciation under the less favorable Alternative Depreciation System (“ADS”). In addition, the Camp proposal completely repealed LKE for asset dispositions after 2014. Interestingly, a Joint Committee of Taxation (“JCT”) analysis of the proposal was the first to place a budgetary value on LKE repeal, which it estimated (or “scored”) to be $40.9 billion in “revenue” for the budget period from 2014 to 2023. Eventually, Chairman Camp formalized this discussion draft without modification when he introduced HR 1, titled “Tax Reform Act of 2014″ in December 2014.

Most recently, President Obama released his 2016 budget proposals (the “Green Book”) in February 2015. In it, the President proposed that LKE deferral for real estate gains be limited to $1 million per taxpayer (aggregated for related parties) per year. As justification for its proposed change, the White House argued that the valuation and administrative convenience rationale for initially adopting LKE in 1921 (described in #1 above) was no longer applicable. However, the administration's arguments failed to mention, and as a result gave no credence to, the still valid “continuity of investment” and “liquidity” rationales previously described. In addition to a limitation on real estate exchanges, the proposal repealed LKE for art and collectibles. However, LKE for personal property (including tax leased business assets) was unaffected. For this limited change to LKE, the JCT estimated “revenue” of $10.5 billion for the budget period 2015 thru 2024.

The revenue “scoring” of various tax provisions is important for budgetary purposes because it puts a concrete value on the provision for purposes of negotiating tax reform ideas and trade-offs. In addition to its estimates of tax revenue for LKE proposals in the Camp and Obama proposals, the JCT also valued potential LKE revenue in two other documents. In its Aug. 5, 2014 “Estimate of Federal Tax Expenditures for Fiscal Years 2014-2018″ the JCT projected that the tax expenditure (i.e., potential “revenue”) for the retention of LKE for the four-year period 2014 to 2018 was $98.6 billion. (Note ' this estimate of the potential value of LKE for budgetary purposes is the highest that has been published to date and may be attributable to the presumed future exchange of depreciable business assets that were acquired in years preceding 2015 and may have been subject to special 30%, 50% and 100% bonus depreciation). Finally, in its Feb. 6, 2015 “Background Information on Tax Expenditure Analysis and Historical Survey of Tax Expenditure Estimates,” the JCT lists LKE as the second largest corporate tax expenditure at $68 billion for 2014 to 2018.

What Can Lessors Do to Protect LKE?

Predicting legislative action is best left to professional political prognosticators and public policy wonks. However, while comprehensive tax reform is not currently expected to get any traction until sometime well after the 2016 elections, we are reminded of the phrase, “If you are not at the table, then you are on the menu.” The table for Tax Reform is being set now and the equipment leasing industry is well advised to get involved in their legislative processes as soon and as actively as is possible in order to help set the proverbial tax reform table and make sure their interests, whether specifically regarding LKE or otherwise, are addressed and served by the legislative leaders who represent them in Washington.

Jeff Nelson is a managing director and initiative leader for PricewaterhouseCoopers LLP's Like Kind Exchange (LKE) and Tax Depreciation Services (TDS) practice. He can be reached at [email protected].