1031 Exchanges of Business Aircraft
By Kevin C. Austin and
Timothy L. Austin
“Really? I can do a 1031 Exchange with my airplane? Wow, I didn’t know that!”
That’s a common reaction from people who are upgrading aircraft and have just learned they can save substantial sums by using a provision of the IRS code usually associated with real estate transactions. Just like in real estate, a business aircraft may be exchanged for another business aircraft under §1031 of the Internal Revenue Code (the Code). Before moving forward with a 1031 Exchange, it’s important to sit down with your tax attorney or tax accountant and do a net present value analysis of the taxes, tax deferrals, costs, and cash flows of a 1031 Exchange considering your (or the company’s) varying federal and state tax rates, in order to determine how much you are really saving versus the alternative. It’s simple economics. The result should almost always show a positive number, but you need to know how much to be comfortable with the decision.
Now is a great time to upgrade or trade-up in aircraft because of the worldwide economic crisis and its effect on the aviation marketplace. Although the value of your current aircraft is depressed, so is the value of the aircraft that you want to purchase. In raw dollars, it will take much less of your money (i.e. new equity) to trade up now than ever before. Fantastic opportunities are out there for anyone buying. However, lower prices on both selling and buying aircraft will also affect the net present value analysis of your 1031 Exchange.
If you are considering a 1031 Exchange for your aircraft, there are eight terms you should be familiar with:
Relinquished Aircraft. This is the aircraft you want to get rid of.
Replacement Aircraft. This is the aircraft you want to acquire.
Forward Exchange. This is when you sell the Relinquished Aircraft before you acquire the Replacement Aircraft.
Reverse Exchange. This is when you sell the Relinquished Aircraft after you have acquired the Replacement Aircraft.
QI or Qualified Intermediary. This is the party that helps you turn a three-party transaction back into a two-party “exchange” that qualifies for 1031 Exchange treatment.
EAT or Exchange Accommodation Titleholder. This is the party that holds title to one of your aircraft while you complete a reverse exchange. The EAT is usually affiliated with the QI.
Parking. This is what they call it when you give title to your Relinquished or Replacement Aircraft to the EAT.
Boot. This is the money, debt forgiveness, or other property you took out of the exchange—and will be taxed on immediately—because you didn’t follow all of the rules. Boot is what happens when the value of, or your equity in, the Replacement Aircraft is less than what you had invested in the Relinquished Aircraft.
You must meet a few basic requirements to qualify your transaction as a tax-deferred exchange. First, both the Relinquished and Replacement Aircraft must be held for productive use in a trade or business (or for investment). This typically disqualifies an aircraft that is used for personal reasons, or at least the portion that is. This will also: (a) disqualify the Relinquished Aircraft if it was recently acquired and has not been held in the business for a reasonable period (as determined by the IRS), or (b) disqualify the Replacement Aircraft if you intend to promptly dispose of it or convert it to personal use, and it will not be held in the business for a similar reasonable period.
Second, the exchange must be a reciprocal transfer of aircraft-for-aircraft (i.e. a trade) and not “a sale” of one aircraft and “a purchase” of another. Third, the Relinquished Aircraft must be of “like kind” to the Replacement Aircraft. This means you can trade a business aircraft for a business aircraft, but you can’t trade a business aircraft for a farm tractor or cruise ship.
All kinds of exchanges can be done including Direct Trade-in, Forward Exchange, and three types of Reverse Exchanges: (a) Parking the Relinquished Aircraft with the EAT, (b) Parking the Replacement Aircraft with the EAT, and even (c) Parking both the Relinquished and Replacement Aircraft with the EAT at different times. In all but the last case the Code provides for Safe Harbors—clear rules—that, if followed to the letter, can provide you with comfort that you have done everything right and that your transaction should avoid challenge by the IRS.
Forward and reverse exchanges have specific time periods in which you must identify (45 days) and acquire (180 days) the Replacement Aircraft or complete the exchange. Watch out if your tax return becomes due and you are still in the middle of the exchange; this may shorten those periods. There are also rules on how you will identify the Replacement Aircraft(s).
The current aircraft market makes it very hard to sell your Relinquished Aircraft in the time period allotted by the Code. If you are coming up on the end of the exchange period and haven’t closed the deal, re-analyze the net present value of your exchange before you make a decision to sell the Relinquished Aircraft at a reduced price. Many times, breaking up the exchange and paying taxes in the current tax period, plus the resulting increase in tax basis on the Replacement Aircraft, is a better option than accepting a “fire sale” price on your Relinquished Aircraft. Don’t be driven by this year’s tax payment; you need to look at future tax years as well.
When to Call for Help
You need to consult with an experienced aviation attorney or aircraft tax advisor if your transaction involves any of the following circumstances:
• The Relinquished or Replacement Aircraft is a fractional or partial interest in an aircraft.
• You are relinquishing or acquiring multiple aircraft.
• The Relinquished or Replacement Aircraft is or will be owned by a partnership or multi-member LLC.
• The Relinquished or Replacement Aircraft is still under construction or “green” (a term used to define a bare aircraft without a completed interior and other outfitting).
• The Relinquished or Replacement Aircraft is predominantly used in charter (commercial operations) and the other aircraft is used predominantly in your business.
Also, when pursuing an exchange, make sure you consider local sales, use, and property taxes on aircraft, as the multiple transactions required by a 1031 Exchange can create multiple taxable events. Sales and use taxes are real dollars that can far exceed the value of the 1031 Exchange when proper planning has not occurred.
There are no reasons to take risks.
Use a reputable and established 1031 Exchange Accommodator to facilitate your transaction, especially one that has experience dealing with the special issues affecting aircraft. Make sure that any exchange funds are held in a Qualified Trust account in a regulated financial institution with FDIC insurance.
Make sure that your QI won’t be “disqualified” by having a family or agency relationship with you or your company, such as your mother, a related entity, or an attorney, accountant, investment banker or broker that has worked for you or will work for you outside of providing certain routine services as specified in the Code.
Don’t cut corners, do it right!
A 1031 Exchange of aircraft can be a great tax minimization tool for business aircraft. It allows you to defer taxes from a current transaction until a future date. And, you can repeat the process again and again, moving up and up in aircraft, deferring your income taxes on each transaction into infinity and beyond; or just until your death, when you get the ultimate reward from the IRS, a “step up” in your asset’s tax basis.
Kevin Austin is the founder of Aero Law Group in Bellevue, Washington (http://www.law.aero/), and Kevin Long is an attorney with the firm. Aero Law Group’s practice includes the representation of more than 300 clients on six continents including emerging and established commercial airlines, emerging-growth companies focusing on aviation, some of the nation’s largest investment banks and bankers in their aircraft and airline investments, and Fortune 500 companies and high-net-worth individuals in domestic and international transactions involving the sale, lease, exchange, and financing of commercial and business aircraft.
The information in this article is not to be construed as legal advice or opinion. Such advice or opinion is given only after being engaged to do so with respect to particular facts and circumstances. The information provided is accurate at the time of writing, but may require revisions or modification as circumstances change. Please be advised that any statements regarding U.S. federal taxes contained in this article are not intended or written to be used or relied upon, and cannot be used or relied upon, for the purpose of (i) avoiding penalties under the Internal Revenue Code, or (ii) promoting, marketing, or recommending to another party any transaction or matter addressed in this communication.