In Chief Counsel Advice (CCA) 201025049 dealing with equipment for rent or sale, the IRS has concluded that a taxpayer could not demonstrate that the equipment was devoted to use in its trade or business and that it looked to such use of the equipment to recover the cost of the equipment. Instead, the taxpayer held the equipment primarily for sale and, as a result, it could not claim depreciation deductions for the equipment and could not treat exchanges of the equipment as like-kind swaps under Code Sec. 1031.
Background. Under Code Sec. 167(a), taxpayers may claim a depreciation deduction for the exhaustion, wear and tear of property used in a trade or business or held for the production of income. However, under Reg. §1.167(a)-2, depreciation deductions can not be claimed for inventories or stock in trade.
Under Code Sec. 1031(a)(1), gain or loss is not recognized on the exchange of property held for productive use in a trade or business or for investment if the property is exchanged solely for property of like kind which is held either for productive use in a trade or business or for investment. Nonrecognition treatment is not allowed under Code Sec. 1031(a)(2)(A) for an exchange of property that is stock in trade or other property held primarily for sale.
Facts. Corp X distributes, sells, rents, services, and finances an unspecified type of equipment. It orders the equipment directly from the manufacturer and identifies certain equipment as rental property before receiving it from the manufacturer. When it receives the equipment, Corp X capitalizes the cost of the equipment that has been designated as rental property and claims depreciation deductions on this equipment from the time it is available for rent. Apparently, Corp X capitalizes the cost of equipment other than designated rental property as “inventory” (as defined in Code Sec. 471) upon the receipt of the equipment from the manufacturer. Corp X’s rental equipment is available for rent by the hour, week, or month, and it reserves the right to withdraw the rented equipment during the rental period and substitute similar equipment. The rental agreements permit a renter to buy the rented equipment, but the information provided IRS does not indicate the amount of rent, if any, that would be applied against the purchase price in the event a renter buys the equipment. However, Corp X has indicated that the sales price would be the subject of further negotiation between it and the renter/purchaser.
Corp X structures its sales of property designated as rental equipment as like-kind exchanges under Code Sec. 1031. It negotiates sales with customers and assigns the sales contracts to a qualified intermediary (QI). Corp X then orders replacement property from a manufacturer and assigns its rights to acquire the equipment to the QI. The trustee under the exchange agreement collects the proceeds from the sale of the relinquished property and makes disbursements for purchase of the replacement property on Corp X’s behalf. The replacement property is assigned an order number and is entered into Corp X’s fixed asset depreciation system. Corp X sends a monthly statement to the QI and the manufacturer informing them of the replacement property and includes a statement to the effect that under Code Sec. 1031, Corp X has assigned its rights to acquire the equipment to QI.
An analysis of Corp X’s Year 1 fiscal year results shows that 91% of its income was generated from sales while 9% was generated from its rental operation. Also, a substantial amount of the equipment designated as rental equipment was sold by Corp X before the equipment generated any rental income.
Neither depreciation nor tax-free swap treatment is available. The CCA says that where an asset can function as both merchandise held for sale and as an asset used in a trade or business, the taxpayer’s primary purpose for holding that asset determines whether that asset is inventoriable. On the facts, the CCA concludes that Corp X’s equipment should be treated as inventory held primarily for sale to customers in the ordinary course of business. While Corp X does rent or hold some equipment for rent, it did not show that the equipment is actually devoted to use in its business and that it looks to consumption through this use to recover the cost of the equipment. A significant fact leading to the CCA’s conclusion is that a substantial amount of the equipment designated as rental equipment was sold by Corp X relatively soon after acquisition and before the equipment generated any rental income. Based on the available facts, the best that could be said is that for a relatively short period, Corp X rents or holds for rent some of its equipment pending the sale of that equipment.
As a result, the CCA concludes that Corp X cannot depreciate its equipment under Code Sec. 167. What’s more, because it holds the equipment primarily for sale, Corp X’s exchanges are not eligible for tax-free swap treatment because of Code Sec. 1031(a)(2)(A).
For more informaiton regarding this ruling or other 1031 exchanges issues, contact Alexandra L. Hart at AHart@AllStates1031.com or by phone toll-free at 877-395-1031.
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