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Back To The Basics:

Engaging in a tax-free Like-Kind Exchange of aircraft.

Most aircraft owners who upgrade from one aircraft to another consider whether to engage in a tax-free like-kind aircraft exchange. The key benefit to engaging in a like-kind exchange of aircraft is the deferral of gain recognition and tax on that gain on the old aircraft for sale. In a properly implemented like-kind exchange- the aircraft owner may sell an old aircraft and acquire a new aircraft without necessarily having to recognize any gain on the sale of the old aircraft.

In the case of aircraft- this deferral of gain is often particularly important because most aircraft owners deduct depreciation on their aircraft- which lowers the owner’s tax basis in the aircraft. Even in an economy where aircraft values are not increasing- the recapture of these depreciation deductions in connection with the sale of an aircraft can result in a significant income tax liability.

Therefore- aircraft owners are wise to consider utilizing a like-kind exchange structure in any situation where they are selling one aircraft and acquiring another- more valuable aircraft to replace it.

This two-part article will (i) provide a primer on the key considerations an aircraft owner must address when determining whether to engage in such an exchange- (ii) outline the steps that are required to do so and the factors that will influence the structure of the exchange and (iii) describe ancillary issues that must be addressed when making the decision as to whether or not to engage in a like-kind exchange.

A direct exchange of one aircraft for another between the two owners of those aircraft is the simplest form of exchange. However- since most aircraft owners sell their aircraft to one party and buy their replacement aircraft from a different party- a direct exchange of aircraft is not normally possible. Due to this reality- the IRS has sanctioned several methods of engaging in a like-kind exchange- each of which allows an aircraft owner to accomplish the exchange and defer its tax gain even when the owner has different sellers and buyers of the aircraft being purchased and sold.

There are- however- many issues- both legal and financial- that an aircraft seller must analyze when determining whether to structure his or her purchase and sale of aircraft as a like-kind exchange.

Let’s consider for the remainder of the first part to this article a description of the basic steps involved in the simplest form of such IRS sanctioned exchanges- called a “forward like-kind exchange.” Next month- we will review the steps required to engage in a more complicated form of exchange- which is referred to as a “reverse like-kind exchange” and tackle some of the ancillary issues relating to all forms of like-kind exchange.

The forward like-kind exchange is the most straightforward form of deferred like-kind exchange. In order to utilize this structure- an aircraft owner must be selling its existing aircraft before purchasing another aircraft. In a forward like-kind exchange- the owner basically creates a fictional aircraft purchaser/ seller- referred to in tax parlance as a Qualified Intermediary- who will take title to the aircraft being sold and transfer that title to the purchaser of that aircraft and who will- thereafter- take title to the newly acquired aircraft and transfer it to the exchanging owner.

In doing this- a direct exchange- in effect- occurs and the aircraft owner meets the requirements of the like-kind exchange statute. This permits the aircraft owner to achieve its ultimate goal – the deferral of gain recognition and the income tax thereon upon the sale of the relinquished aircraft. It is important to keep in mind that- to take advantage of this benefit- the aircraft owner should follow specific safe-harbor procedures that the IRS has promulgated.

First- prior to selling the old aircraft (and preferably prior to the execution of a purchase and sale agreement for either aircraft)- the aircraft owner must engage a Qualified Intermediary to act as the titleholder for the aircraft being sold to the outside third party purchaser and for the aircraft to be purchased from another outside third party.

The aircraft owner will need to enter into an Exchange Agreement with the Qualified Intermediary that sets forth each party's rights and responsibilities as they relate to the exchange process. This Agreement also typically provides a roadmap for the implementation of the like-kind exchange.

Typical provisions contained in the Exchange Agreement will relate to the procedure for the proper escrow of the proceeds of the sale of the relinquished aircraft until the aircraft owner purchases the replacement aircraft (i.e. the owner may not have actual or constructive receipt of the sales proceeds during this period) and the qualifications of the Qualified Intermediary to act as such (for example- the Qualified Intermediary may not be an agent of- related to- or the “alter ego” of the aircraft owner).

Additionally- the Exchange Agreement often contains certain exhibits that the aircraft owner and Qualified Intermediary will use to provide notices to each other and to the purchaser of the relinquished aircraft and the seller of the replacement aircraft regarding the like-kind exchange. For example- the aircraft owner must identify the replacement aircraft within 45 days of its sale of the relinquished aircraft. A well-drafted Exchange Agreement will provide a proper form for doing this in the form of an exhibit to the Agreement.

Other exhibits that are typically included are notices to the purchaser of the relinquished aircraft and the seller of the replacement aircraft stating that the owner is engaging in a like-kind exchange and that the Qualified Intermediary will take title to each aircraft for purposes of the like-kind exchange and transfer that title to these parties.

Furthermore- the rules relating to this type of exchange require that the purchase of the newly acquired aircraft occur within 180 days of the sale of the relinquished aircraft with special rules that an aircraft owner must follow when the purchase and sale transaction span the owner’s tax years.

As mentioned above- the contents of the Exchange Agreement create rights and responsibilities and allocate costs and liabilities between the aircraft owner and the Qualified Intermediary. In addition- the contents of the Exchange Agreement and the compliance with the terms thereof by both parties will determine whether the like-kind exchange transaction has been validly undertaken. If not- the aircraft owner might withstand the worst of the consequences resulting from this failure- which in most cases will result in a large tax liability.

Since the potential tax liability resulting from a failure of a like-kind exchange to meet the IRS requirements relating to it could be quite large- and the responsibility for that liability will be based on the terms of the Exchange Agreement relating to the obligations of each party thereto- it is always advisable to engage a qualified aviation tax advisor to review the exchange agreement.

This will give the aircraft owner maximum assurance of its rights and responsibilities with respect to the exchange and those of the Qualified Intermediary as well.

Next month- we will describe a more complicated form of like-kind exchange transaction- which is often utilized in aircraft transactions in which the purchased aircraft is acquired first and the relinquished aircraft is thereafter sold to an unrelated third party buyer. In addition- we will highlight certain ancillary issues that an aircraft owner must consider in conjunction with the implementation of a like-kind exchange.

Christopher B. Younger is an attorney at Ober|Kaler- and a member of the firm’s Aviation Tax and Transactions group. He is a tax and FAA specialist concentrating in the areas of corporate aircraft transactions and aviation taxation. Ober|Kaler’s Aviation Tax and Transactions group provides full-service tax and regulatory planning and counseling services to corporate aircraft owners- operators and managers. The group’s services include Code Section 1031 tax-free exchanges- federal tax and regulatory planning- state sales and use tax planning- and preparation and negotiation of transactional documents commonly used in the business aviation industry- including aircraft purchase agreements- leases- joint-ownership and joint-use agreements- management and charter agreements- and fractional program documents.

Mr. Younger can be reached at the Baltimore office of Ober|Kaler located at 120 East Baltimore Street- Baltimore- Maryland 21202- telephone +1 (410) 685 1120- email: cbyounger@ober.com

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