Tax-Free Exchanges of Aircraft Under Section 1031
Exchanges of Personal Property
Under Section 1031
© 1999 KEITH G. SWIRSKY
A. The Definition of "Like-Kind" for Personal Property
For the purpose of determining whether personal property is like-kind with respect to other personal property, the Regulations provide a so-called "safe harbor," i.e., an objective method of property classification which is immune from challenge by the IRS. Under this safe harbor, depreciable tangible personal property will be considered exchanged for like-kind property if it is exchanged for property of a "like-class." Properties are of a "like-class" if they are within either the same "General Business Asset Class" or the same "Product Class."
1. General Business Asset Classes. There are 13 General Business Asset Classes. They were established by the IRS for another purpose, but now serve also to determine which properties are like-kind for purposes of Section 1031. Any property that falls within one General Business Asset Class is like-kind to any other property in the same General Business Asset Class. The General Business Asset Classes, established in Rev. Proc. 87-56, 1987-2 C.B. 674, are as follow:
a. Office furniture, fixtures and equipment;
b. Information systems (computers and peripheral equipment);
c. Data handling equipment, except computers;
d. Airplanes (airframes and engines), except those used in commercial or contract carrying of passengers or freight, and all helicopters (airframes and engines);
e. Automobiles, taxis;
g. Light, general purpose trucks;
h. Heavy, general purpose trucks;
i. Railroad cars and locomotives, except those owned by railroad transportation companies;
j. Tractor units for use over-the-road;
k. Trailers and trailer-mounted containers;
l. Vessels, barges, tugs, and similar water transportation equipment, except those used in marine construction; Industrial steam and electric generation and/or distribution systems.
2. Product Classes. Any property that does not fall into one of the General Business Asset Classes, will be like-kind with respect to property in the same Product Class. Product Classes are determined by reference to a 4-digit Product Code. These Product Codes were established as part of the Product Coding System of the Standard Industrial Classification Codes set forth in the Standard Industrial Classification Manual (Office of Management and Budget, 1987), which is indexed and available in most libraries. Industry Group No. 372 covers Aircraft and Parts. The four-digit Product Classes in this Industry Group are as follows:
a. 3721, covering aircraft and helicopters; b. 3724, covering aircraft engines and engine parts including, for example, aircraft engine cooling systems, heaters, engine mount parts, exhaust systems, external power units, lubricating systems and internal combustion components; and c. 3728, covering aircraft parts and auxiliary equipment, not elsewhere classified, including, for example, ailerons, body assemblies, power transmission equipment, brakes, lighting, propeller parts, deicing equipment, flaps, fuel tanks, landing gear, refueling equipment, rudders, wheels, wiring assemblies and seat ejectors. Many other parts, exclusive of aircraft engines and engine parts, are lumped into this category.
In general, property listed in each four-digit Product Class may be exchanged for other items within the same class. The IRS has not yet formalized its position on whether aircraft engines may be exchanged for other aircraft engines attached to a fully functional airframe (i.e,. an aircraft). In such a circumstance, it may be advisable to structure the exchange in the form of two mutually independent transactions, one involving a tax-free exchange of engines, the other a purchase or sale of the balance of the aircraft.
3. Other Personal Property. Other property involved in a like-kind exchange may include: intangible personal property, non-depreciable personal property, or personal property held for investment. These types of property are not assigned to specific like-kind classes. There is so much variety within such categories of property that no classification system is feasible. Little guidance in this area currently exists.
4. Goodwill. The Regulations provide that goodwill (or going concern value) of a business activity is not like-kind to goodwill of another business activity, regardless of whether the business activities are similar.
B. The Definition of "Like-Kind" for Different Forms of Ownership
1. Exchanges of Leaseholds for Fees
Even when two properties are of like-kind under the conditions outlined above, they may differ from one another with respect to the form of their ownership. For example, one property may be owned outright (a "fee interest"), while another may be possessed under the terms of a lease. In such a circumstance, does a leasehold and a fee interest constitute property of like-kind?
The answer, with respect to real estate, is clear. The Regulations provide that a lease with thirty years or more remaining is of like-kind with respect to a fee interest in real estate. Treas. Reg. § 1.1031(a)-1(c)(2). Evidently, a long-term lease is viewed by the IRS as equivalent to full ownership for purposes of Section 1031. Leases of real estate which are of a shorter duration are not considered to be like-kind to a fee interest.
With respect to personal property (such as aircraft), no clear authority exists on whether and when a leasehold could be considered like-kind to a fee interest. It seems reasonable to assume that the rule applying to real estate should apply equally to non-real estate, viz., a long-term lease of personal property should be of like-kind with respect to a fee interest in such property. If so, one must also determine what constitutes a "long-term" lease with respect to different kinds of personal property. While a thirty-year lease is sufficiently long for real estate, it seems that a leasehold in aircraft or an automobile need not be thirty years in length in order to be considered long-term. One might argue that the appropriate length of a long-term lease should be the "class life" assigned to each General Business Asset Class. The class life for non-commercial aircraft, for example, is six years. As a legal matter, until this matter is addressed in regulations or precedential tax authority, the tax-free treatment of an exchange of a leasehold in personal property for a fee interest in the same kind of property remains uncertain.
2. Exchanges Involving Fractional Ownership Interests
The like-kind issue arises also with respect to an exchange of a fee interest for a fractional interest in property. In such a circumstance, the properties being exchanged are of like-kind, but the respective forms of ownership differ: a fee interest represents absolute and exclusive ownership of property, while a fractional interest represents partial ownership.
As with the leasehold-fee question discussed above, the issue of fractional interests has been resolved for real estate, but not for personal property. With respect to real estate, the IRS has indicated that a taxpayer may exchange tax-free an undivided fractional interest (a "tenancy in common") for a fee interest. Rev. Rul. 73-476, 1973-2 C.B. 300; P.L.R. 9525042 (March 22, 1995). However, with respect to personal property, no definitive authority exists. It seems reasonable to assume that, as with real estate, a fractional interest in personal property, such as aircraft, should be of like-kind with respect to a fee interest in such property. Such an analogy between real and personal property may draw support from a recent change in the Code which states that personal property predominantly used within the United States is not to be considered like-kind with personal property that is predominately used outside of the United States. P.L. 105-34 § 1052(a). This provision is codified alongside a similar rule that is applicable to real estate. IRC § 1031(f). However, the analogy of personal property to real estate should not be assumed to apply in every case. The ownership of fractional interests in real estate is generally defined by state statute, while the ownership of fractional interests in personal property is generally governed by contract.
The IRS can be expected to examine each such contract on a case-by-case basis, in order to determine whether the particular fractional interest in personal property provides ownership rights that are equivalent to the rights enjoyed by an owner of a fractional interest in real estate. To the extent that such a contract does provide equivalent rights, a fractional interest should be considered like-kind to a fee interest. In fact, the contracts and agreement utilized by the aircraft fractional ownership programs may have to be carefully reviewed and revised to avoid undermining customary "ownership" rights. Until such time as this matter is addressed in regulations or precedential tax authority, the tax-free treatment of such a transaction remains uncertain.