Like-Kind Exchanges
Section 1031 of the Internal Revenue Code provides an exception to the overall rule that gain realized on an a sale or exchange of property must be recognized as income. In the case of aircraft, the exception applies when it’s held for business use, not personal use, and is exchanged for another aircraft, “like-kind” property, which is also to be held for business. The fundamental rule to qualify for the standard 1031 exchange exception is that the taxpayer must never have actual or constructive receipt of the sale proceeds.
Deferred Exchanges
A “deferred like-kind exchange” is a set of sales structured to avoid reporting taxable gain via falling within a safe harbor established by IRS regulations. In essence, the way it works is that the proceeds of the original aircraft sale are placed in escrow and the escrow money is used to buy the replacement aircraft. The replacement aircraft must be identified within 45 days after the original sale and the closing on the identified aircraft must occur within 180 days after the original sale. A “qualified intermediary or QI” is used as a straw man in the aircraft closings which facilitate a normal transaction in every other respect.
Reverse Exchanges
The courts and the IRS have long sanctioned deferred like-kind exchanges where there is a gap in time of up to six months between an aircraft owner’s sale of an existing aircraft (the “trade-in aircraft”) and its purchase of a new aircraft. However, there has been significant uncertainty about whether the owner may acquire a new aircraft before disposing of the old one in a tax free exchange, a so-called reverse like-kind exchange. As there are frequently many reasons to want to purchase a new aircraft prior to selling an existing one, the IRS’s failure to address this issue has been of particular concern to aircraft owners. Even a one day gap between purchase and sale could cause significant uncertainty, or make tax benefits unavailable. Luckily, this situation has changed, due to guidance issued by the IRS. Aircraft owners can now clearly obtain the substantial tax deferral benefits of a like-kind exchange, and, at the same time, effectively acquire the new aircraft on their preferred time schedule.
In order to understand the IRS’s guidance, it may be helpful to understand how these transactions were carried out in the era of uncertainty before the guidance was issued. The new guidance mirrors the techniques used by creative attorneys to accomplish these transactions and effectively endorse them. In the past, the most common technique has been the use of a “parking company.” Typically, the parking company borrows funds, acquires the new aircraft, and leases it to the client. The client holds title to the trade-in aircraft until a sale can be arranged. The client then exchanges the trade-in aircraft for the new aircraft with the parking company, and the parking company sells the trade-in aircraft to its ultimate buyer. This type of reverse exchange is known as a “back-end” exchange, because the exchange of the new aircraft for the trade-in occurs at the end of the transaction.
In a “front-end” reverse exchange, the parking company will acquire the new aircraft and immediately enter into an exchange with the client, so that the parking company ends up holding the trade-in aircraft and leasing it to the client. The client then arranges a sale of the trade-in aircraft and assigns the sale contract to the parking company. The parking company may obtain the purchase money from a bank loan guaranteed by the client, or it may be borrowed from the client.
The objective of tax planning for reverse exchanges with a parking company is to assure that the parking company is not viewed as the agent of the client. September 15, 2000, the IRS removed much of the uncertainty in Revenue Procedure 2000-37, 2000-40 IRB 1 (Sept. 15, 2000) which sets forth the requirements for a parking company that will not be viewed as the client’s agent. Effective for transactions occurring on or after September 15, 2000, the IRS respects a reverse exchange accomplished through the use of a qualified exchange accommodation arrangement (“QEAA”). Revenue Procedure 2000-37 specifically endorses certain techniques commonly used to enable the parking company to acquire the aircraft or to shift risk away from the parking company.
This IRS guidance is a welcome development for aircraft owners who find themselves needing to acquire a new aircraft prior to the sale of an existing one. In the past, even one day gap between purchase and sale could deny aircraft owners the benefit of tax deferral on the sale of depreciated aircraft assets. The guidance is restrictive, and there is a great deal more planning and documentation involved in arranging a reverse exchange, as compared to a deferred exchange, but it effectively allows aircraft owners to strategically time the purchase of a new aircraft before the sale of a trade-in aircraft without significant uncertainty about the ultimate tax outcome.