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Engaging in a Tax Free Like-Kind Exchange of Aircraft (Part 2)

The first part of this article- (February p140- World Aircraft Sales Magazine)- outlined some of the primary reasons for engaging in a tax free like-kind exchange of aircraft. The article also provided a basic description of the procedure whereby an aircraft owner may engage in a forward like-kind exchange of that owner's aircraft.

This month- we’ll focus on the procedure whereby an aircraft owner may engage in a reverse like-kind exchange of aircraft- which is similar to a forward like-kind exchange except that the aircraft to be purchased is acquired by the aircraft owner prior to the sale of the aircraft to be relinquished. Also- this second and final part of the article covers several common issues that arise in connection with the implementation of a like-kind exchange of aircraft.

Reverse Like-Kind Exchanges
As stated above- a reverse like-kind exchange of aircraft occurs when an aircraft owner decides to purchase a new aircraft prior to the sale of its existing aircraft. This is often the case because an aircraft owner may have a hard delivery date for a new aircraft and has not sold its existing aircraft prior to that date.

Also- in many instances- an aircraft owner will locate a replacement aircraft prior to finding a buyer for its existing aircraft. Finally- an aircraft owner may not want a gap in ownership of aircraft and will decide that it makes better sense to acquire the new aircraft before placing the relinquished aircraft on the market.

As is often the case in a forward like-kind exchange of aircraft- in a reverse exchange- the aircraft owner is not normally dealing with the same parties when buying and selling its new and relinquished aircraft. However- because the aircraft owner is acquiring the replacement aircraft first- the transaction does not automatically fit within the requirements of the like kind exchange statute.

Due to this- the aircraft owner must again comply with IRS procedures that have been established to enable the aircraft owner to comply with the requirements of the like-kind exchange statute while still structuring its purchase and sale in the best manner possible. In a reverse like-kind exchange situation- this procedure is substantially more complicated than the steps to be followed in a forward like-kind exchange.

There are two reverse like-kind exchange structures that have been endorsed by the IRS. They are commonly referred to- respectively- as a 'front-end' reverse like-kind exchange and a 'back-end' reverse like-kind exchange. In both of these types of exchanges- the exchanging aircraft owner is required to enter into a Qualified Exchange Accommodation Agreement with an unrelated third party- who will act as a Qualified Exchange Accommodation Titleholder (QEAT).

The terms of the Qualified Exchange Accommodation Agreement must meet certain requirements as set forth in IRS guidance. The QEAT fills a role that is essentially similar to the QI in a forward like-kind exchange- which enables the creation of a direct exchange of aircraft between the owner and the QEAT although the QEAT is really only an intermediary in the transactions.

In a front-end reverse like-kind exchange- using the established IRS procedures- the aircraft owner ‘sells’ its existing aircraft to the QEAT. The QEAT then holds title to the relinquished aircraft until such time as it is purchased by a third-party buyer. The QEAT acquires title to the replacement aircraft before transferring that title to the aircraft owner to complete the like-kind exchange at the ‘front-end’ of the transaction.

Thereafter- the aircraft owner owns the replacement aircraft and the QEAT holds title to the relinquished aircraft until the sale of that aircraft to a third-party unrelated purchaser is completed (which must typically be accomplished within 180 days of the acquisition of the replacement aircraft by the QEAT/aircraft owner).

When the QEAT acquires title to the relinquished aircraft- it issues its promissory note to the former owner thereof in an amount equal to the estimated fair market value of the relinquished aircraft. Then- when the relinquished aircraft is sold- the amount of the note is adjusted to match the purchase price proceeds (per applicable IRS guidance)- which are then ‘paid’ by the QEAT to the former owner of the relinquished aircraft in exchange for the cancellation of the QEAT’s note.

In a back-end reverse like-kind exchange- the QEAT first takes title to the replacement aircraft and holds title to it until such time as the replacement aircraft owner is able to complete the sale of the relinquished aircraft. The QEAT acquires the funds to purchase the replacement aircraft by borrowing them from the aircraft owner or some similar arrangement. The QEAT owns the replacement aircraft until the sale of the relinquished aircraft occurs at which time title to both aircraft is transferred into the hands of their rightful owners. Hence- the use of the term ‘back-end’ to describe this form of reverse like-kind exchange.

Again- the QEAT technically acquires title to the relinquished aircraft before transferring that title to the purchaser of the relinquished aircraft and then- to complete the exchange- transfers title to the replacement aircraft to the exchanging owner. The owner can lend the QEAT the proceeds to purchase the replacement aircraft or give its guarantee to an outside third party lender of those funds to enable it to deliver the funds to the QEAT.

In both front-end and back-end reverse like-kind exchanges of aircraft- the fiction of a direct like-kind exchange is maintained through the use of the QEAT. The QEAT in effect purchases the relinquished aircraft from the owner thereof or purchases the replacement aircraft from its seller.

In this way- like-kind exchange treatment is preserved- the IRS sanctioned reverse like-kind exchange procedures are followed and- provided that all other requirements- including the 180-day time limitation for completion of the transaction- are met- the IRS should respect the tax deferred character of the like-kind exchange transaction.

Related/Ancillary Issues
There are several related/ancillary issues that one must consider when engaging in a forward or reverse like-kind exchange of aircraft. A properly implemented like-kind exchange of aircraft results in the deferral of recognition of gain inherent in the sale of the relinquished aircraft. This concept of the deferral of gain is important to understand because- upon the eventual sale or other disposition of the replacement aircraft in which a like-kind exchange is not utilized- the gain (or possibly loss) that is realized on the sale of that aircraft must also be recognized for federal income tax purposes.

The newly acquired aircraft in a like-kind exchange typically takes a carry-over basis that is equal to the owner’s basis in the relinquished aircraft. The characterization of any gain realized upon the sale of the new aircraft would also normally retain the same tax characteristics as would have been inherent in the sale of the relinquished aircraft (such as Code Section 1245 depreciation recapture that is normally treated as ordinary income rather than capital gain). For these reasons- an aircraft owner should always consult with his or her tax advisor to determine whether or not a like-kind exchange of an existing aircraft makes financial sense when analyzed in its entirety.

Other tax considerations
Another substantial issue that must always be addressed when engaging in a like-kind exchange of aircraft relates to state sales and use taxes that may apply when aircraft title transfers take place. In many instances- the mere transfer of title to an aircraft will trigger a sales or use tax liability if it is not structured properly. Given the fact that the values of aircraft that are exchanged can be quite high- the resulting liability can also be large. If not properly avoided- this liability could negate all or part of the income tax benefits of engaging in a like-kind exchange.

Furthermore- in many instances- the procedures required for engaging in a like-kind exchange of aircraft will impact the availability of certain credits or exemptions from sales and use taxes (such as the credit for the value of an aircraft trade-in that is available in many states). Again- in the area of sales and use taxes as they relate to the transactions that are part of a like-kind exchange of aircraft- it is imperative that the planning be completed prior to engaging in the like-kind exchange and preferably prior to entering into any purchase agreement for the relinquished or replacement aircraft.

Intermediary parties
A third issue that frequently arises in like-kind exchanges of aircraft pertains to the outside third party buyers/sellers of the aircraft that are being exchanged and to lenders that are financing all or a portion of the acquisition price for the replacement aircraft.

Most sophisticated buyers and sellers of aircraft have enough knowledge of the availability of like-kind exchanges and are prepared to work with an aircraft owner to complete the like-kind exchange in accordance with IRS requirements. However- there are occasionally aircraft buyers and sellers who are unaware of the existence of this tax benefit and who may be wary of working with an aircraft owner and its QI/QEAT to complete the transaction in accordance with IRS requirements.

In such a case- it helps to have an intermediary party who can work with the uninformed aircraft seller or buyer to give them the comfort they need to proceed with the transaction so that it is properly structured to comply with all legal requirements.

Likewise- if there is a lender involved in the transaction- the owner must communicate with his or her lender before an aircraft owner contemplates engaging in a like-kind exchange of aircraft. It will be necessary for the aircraft owner and lender to determine what specific requirements the lender has relating to the like-kind exchange process that will need to be followed so that the lender is satisfied and is willing to make its loan or to exchange the collateral for an existing loan from the relinquished to the replacement aircraft.

There are a myriad of other smaller issues that must be considered in connection with the completion of an aircraft like-kind exchange. It is- therefore- always advisable to engage a competent tax advisor who can assist you with all of the steps involved in completing your like-kind exchange in accordance with all legal requirements and in as efficient a manner as possible.

As can be seen across both parts of this article- there is much complexity involved in the completion of a like-kind exchange of aircraft. There are also many ancillary issues that must be addressed when a like-kind exchange of aircraft is contemplated.

Whether or not a like-kind exchange of aircraft makes financial sense will often depend on a complete analysis of these issues and a comparison of the financial savings resulting from the like-kind exchange versus the outcome of trading aircraft without the use of a like-kind exchange.

Aircraft owners are therefore advised to consult with a qualified aviation tax advisor when determining whether to engage in this process.


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