The 1031 Exchange – Rules of Thumb for Boats
Editor’s Note: The tax code has been changed and 1031 exchanges for boats are no longer allowed.
IRS 1031 Exchange can be used to shield the proceeds of sale of a boat from income tax, when the plan is to use those proceeds to buy subsequent property. This is a quick primer, not legal advice. This is not an area that I recommend for DIYers.
- What is it a 1031 Exchange?
The 1031 Exchange is a vehicle by which investment or business property (including that owned by an entity or individually) can exchange one kind of investment property for another while deferring some or all of the taxable gains on that property. The simplest form of an exchange is a simple swap – my boat for your boat — which assuming no cash changes hands does not trigger tax. Things get increasingly complicated if there is a swap for property and cash, or especially if the property is sold for cash and that money is intended for later reinvestment. This latter transaction is what is known as a “deferred exchange,” and is the kind of transaction that gets most people in trouble most of the time. All exchanges of investment property must be reported to the IRS on Form 8824, which is available on the IRS website: https://www.irs.gov/pub/irs-pdf/f8824.pdf.
- What Kind of Property Qualifies?
The property concerned cannot be primarily for personal use, so in boats, it is most likely to be either commercial stock or boats in charter. Additionally, the property must be considered “like-kind” and so the property on both sides of the exchange must be of a similar nature. Real property cannot be exchanged for personal property, including boats. A car cannot be exchanged for a truck. In all probability, a yacht could not be exchanged for a commercial fishing boat or cargo vessel, although this might be dependent on the specific circumstances.
- What are the advantages?
For a boat owner with a boat in charter, the boat has been depreciated for tax purposes the boat has been depreciated over the time of ownership. For this reason, a ten year old boat, from the depreciation perspective, may be considered by the IRS to have a value of zero dollars. If it is sold for a million dollars in 2018, normally the million dollars would be taxable income to the seller, taxed at the applicable capital gains rate, in the year of the sale. If that money is going to be put back into another boat, then that tax can be deferred to some point in the indefinite future. Avoiding the capital gains on the funds will save the investor 15%-20% in tax, depending on their tax bracket. An investor can downsize in this manner by trading for a less expensive property and paying only the capital gains on any cash received above the trade.
- Deferred Like-Kind Exchanges
As noted, simultaneous exchanges are pretty easy to manage and pretty easy to report. A deferred exchange introduces a number of difficulties and restrictions, because the cash will be in the hands of the investor for a period of time. The first issue is that a replacement property (or properties) must be identified within 45 days of the sale of the original property. Notice of this identification must go either to the seller of the property or to a “qualified intermediary.” Qualified intermediaries have to be qualified to the IRS in advance and they can’t be an agent of the party such as an attorney, broker real estate agent, etc. Assuming that this notice is properly given, the transaction must then close within 180 days of the time that the original property was sold. If either of these deadlines are not met, then the deferment is lost and the funds are taxable in the year obtained.
In sum — boats that have been depreciated for tax purposes – typically commercial or charter boats – can be the subject of a 1031 Exchange, so long as the exchange is carefully crafted, documented and reported to the IRS. A private yacht (including one on which a second home deduction is being applied) is generally not property that can be exchanged. For a boat that has been significantly depreciated but retains a high present value, an exchange can represent a significant savings for the owner. If it is anticipated that the current boat will sell, and then a substitute boat will be identified later, the new boat must be identified within 45 days and the proper notice must be provided either to the seller or to a qualified intermediary. The transaction must be completed in 180 days.