Tax reform remains in the spotlight as Congress considers the Trump Tax Reform package, and industry professionals are keeping a close eye on how changes to the U.S. Tax Code may impact the general aviation industry. While the proposed reform package is in the early stages of Congressional consideration, many view the latest efforts as a significant threat to the 1031 exchange, a tax tool frequently used by aircraft owners to minimize the tax impact of the sale of their current aircraft when purchasing a replacement aircraft.
What exactly is a 1031? How is it useful? What will happen if it is eliminated? This article explores 1031 basics and possible alternatives to the exchange should it no longer be available.
Generally, taxpayers must recognize gain or loss on the sale or other disposition of property pursuant to Secs. 61(a)(3) and 1001 of the Tax Code. Pursuant to Tax Code Section 1031, property held for productive use in a trade, business, or for investment may be exchanged for like-kind property, deferring the gain on disposition.
Aircraft and aircraft equipment are considered depreciable tangible personal property, and provided they otherwise qualify, this ability to exchange the aircraft means that the sale of an aircraft need not trigger the recapture of depreciation taken when a new aircraft will be placed in service. Because the tax depreciation life of business aircraft is significantly accelerated, and business aircraft needs change along with the demands and mission needs of the company or companies the aircraft supports, sales of business aircraft often trigger a significant tax gain that would be subject to tax, most frequently at the ordinary income tax rate. When that aircraft is simply being replaced by a more suitable business tool, the use of the exchange preserves the tax incentive for upgrading and placing new equipment in service by deferring the gain until the final replacement aircraft is sold.
Whether an aircraft is considered a business asset for the purpose of an exchange requires an examination of how the current aircraft is being used at the time of the exchange, along with the intended use of the replacement. Provided that the use profile evidences 50-percent or more business use (with some allowance for compensatory use provided as a fringe benefit), the exchange should qualify.
In practice, 1031 exchanges attempt to accommodate the realities of selling and replacing business property by recognizing that the aircraft purchase need not be a direct trade-in to be treated as an exchange. Rather, through the use of an exchange intermediary established before the aircraft is sold or the new aircraft is purchased, a taxpayer may structure the exchange wherein they either sell the original aircraft first and hold the funds to purchase the replacement or, alternatively, they purchase replacement aircraft while still seeking a buyer for the aircraft they seek to dispose (a reverse exchange).
While these various approaches allow for some flexibility, and the exchange is a valuable tool, they are imperfect in practice. Why? Exchanges are mired with technical requirements, strict time limits, safe harbor provisions that recently have been called into question, and transactional hassle and expense. Failure to use highly qualified advisors, including legal and tax counsel, before the transaction occurs can be costly, not only possibly resulting in failure to preserve the federal deductions, but also creating sales and use tax and property tax liability. Further, some state income tax schemes do not follow the federal rules in recognizing exchanges, requiring multiple accounting methods for the single asset.
The 1031 exchange has long been viewed as potentially at risk, but recent reform efforts are viewed as the greatest threat to the exchange to date. If the exchange is eliminated, what will this mean for general aviation aircraft? The answer depends entirely on other provisions that might be enacted to address the acquisition of tangible personal property placed in service for business. The current Trump plan (as of September 27, 2017) contemplates 100-percent expensing of business assets. Should 100-percent expensing pass, it may serve as a simple and straightforward fix to the need for the exchange. Recapture would no longer matter if the new property were subject to a full write-off significant enough to offset any potential gain.
However, the details of the expensing election applicability will be critical in examining such an impact, given many possible traps wherein it would fail to preserve the critical role currently served by the exchange provisions. Would expensing elections be limited by the taxpayer’s profitability? Would failure to take 100-percent of the election in year one bar the availability of offsetting depreciation recapture?
Tax reform creates new and exciting opportunities for business investment, and may provide a critical opportunity for businesses to acquire and operate general aviation aircraft, increasing excitement and growing the market. In times of reform, finding a trusted advisor willing to examine your needs from a variety of angles to best determine if a 1031 exchange or some other approach makes sense for your business can provide you the opportunity to meet the aviation needs of your business while allowing you to focus on the flying.
Suzanne Meiners-Levy, Esq. is a Shareholder in Advocate Consulting Legal Group, PLLC, which serves the needs of general aviation clients throughout the country. For more information see www.advocatetax.com
 See, e.g., CCA201605017.
 See, e.g., Estate of Bartell, 147 T.C. No. 5 (2016), reviewing the requirements of a reverse 1031 exchange and allowing a non-safe harbor exchange.
 See, e.g., PA PIT Bulletin 2006-07 (explaining the limited applicability of 1031 exchange provisions in Pennsylvania.