Tax Law Update: Elimination of 1031 Exchanges for Personal Property
One of the changes made in the 2017 Tax Relief Act was the elimination of Section 1031 for personal property. This change has caused some confusion as to how it may affect ag operations.
The first is the assumption that Section 1031 exchanges only apply when trading land properties. The second assumption is that personal property is non-business property. In reality we’re talking about personal property as compared to real (land) property. Personal property used in a business includes assets like tractors, combines, pivots, etc. Prior to the start of 2018, when you traded tractors the deferral of gain was allowed under the Internal Revenue Code Section 1031 just as it is with real estate. The difference was that usually land exchanges happened over multiple days and multiple transactions while a tractor trade occurred at the same time as the purchase.
The elimination of personal property from the rules of Section 1031 will have a significant impact on most farmer’s tax returns. Let’s look at an example of how a tractor trade will be different in 2018.
Trade-in value of old tractor
Net difference or boot paid
When you go to the dealership to trade tractors, nothing is going to change. You will still write a check (or finance) the difference. What will change is how it’s reported on your tax return.
Tractor Example Using Section 1031 Exchange Rules
Using the rules under Section 1031 prior to the 2017 Tax Relieve Act, the remaining value (the original purchase price minus depreciation taken) on the old tractor would have been added to the boot paid. Assuming the tractor was depreciated out, the remaining value of the old tractor would have been zero and the basis in the new tractor would be $50,000.
The $50,000 basis would have counted toward the Section 179 limit or been depreciated using regular depreciation. The depreciation would have been added to your expenses on Schedule F (assuming a sole-proprietorship). If, for simplicity’s sake, it's assumed you were using Section 179, this would amount to a $50,000 deduction on Schedule F, which would reduce both ordinary income taxes and self-employment taxes.
Tractor Example Without Trade Treatment
Starting in 2018, tractor trades will need to be treated as two separate transactions. Even though you will have traded in your old tractor, you will recognize it as a sale on your tax return. Again, assuming the old tractor was depreciated out, the gain on the sale of the tractor would be $150,000 (Gain = Sale Price – Remaining Value). This would be reported on your Form 4797 and treated as ordinary income.
The second transaction is the purchase of the new tractor. Since the gain on the sale of the old tractor has already been recognized, the depreciable basis in the new tractor is $200,000. This is the amount that can be used for Section 179 or which the regular depreciation percentages can be applied to. There was concern that this change would have business owners hitting the maximum Section 179 limit very quickly, so Section 179 now has a limit of $1 million and unlimited bonus depreciation for both used and new property. Essentially we have unlimited accelerated deprecation to use.
By the Numbers
|Old Trade Rules||New Rules||Difference|
|Gain on Tax Return||$0||$150,000||+$150,000|
Effects of the 1031 Change
You may be wondering why we’re talking about a change that makes no bottom line difference; however, there are a few things to note.
- There is a five-year sunset on the 100% bonus depreciation. (There is a phase-out of the percentage between 2023 and 2028.) The $1 million of Section 179 will continue, but if you trade a lot of equipment in a year, this could mean you can’t offset the entire gain with extra depreciation.
- The gain recognized will only be ordinary income (no self-employment taxes) while the depreciation will offset both. This means that if you were recognizing at least $150,000 of income on Schedule F, you will save an extra 15.3% or almost $23,000 in self-employment taxes by recognizing the income and the extra depreciation. This could change the way many farm returns look by showing losses on Schedule F and large gains on Form 4797. Producers will need to think about using the optional method of calculating self-employment taxes to make sure they continue to have a history for coverage under the disability rules. This could significantly reduce retirement benefits paid out someday.
- There are also some unintended consequences at the state level. Nebraskans pay personal property taxes based on the Federal Depreciable basis. In the first example, that would have been calculated on the $50,000. Now it will be calculated on the $200,000 basis. This will raise the amount of personal property taxes paid, starting in 2019. The significance of this will depend on an operation’s value of equipment, frequency of trades, etc. In other states, like Iowa, the state income tax calculation does not allow a full deduction of the unlimited depreciation. Producers in those states will not be able to offset the gain with additional depreciation and should expect state income taxes to be higher than in the past.
- Producers also may want to change how they keep records. In the past, all the accountant really needed to prepare a tax return was the boot paid or the $50,000 difference. Now they’ll need to know the details of the trade so you will want to include both the purchase price and trade allowance in your records.
So is this a good or bad change to the tax rules? In reality, for most producers this is going to be a good change for two reasons. First, there will be an extra self-employment tax savings for Schedule F filers or partnerships. Second, there could be less deferred tax liability for many producers when it’s time to end the operation since the recognition of the gain will occur with each trade rather than just when selling the last asset. There will be no benefit of self-employment tax savings for C or S corporations, but since they don’t pay the tax anyway, they aren’t missing out on a benefit. Mostly this will be a change of how we “normally” do things and will take a little while to fully adjust to.