When an aircraft owner decides to replace his aircraft, the aircraft being sold may retain a significant portion of its residual value and if the aircraft has been held for a relatively short depreciation period for tax purposes, the sale of the aircraft may trigger a substantial amount of gain. Furthermore, the gain may be taxable at ordinary income rates due to prior depreciation deductions. These factors can result in a substantial tax liability for the seller of an aircraft.
However, an owner who is replacing one aircraft with another may be able to minimize taxes and preserve capital through the use of a Section 1031 exchange (named for the section of the U.S. Internal Revenue Code that sets the rules for such transactions).
The requirements for an aircraft exchange are similar to those of a real property exchange, which include the following:
1. Both the relinquished aircraft and the replacement aircraft must be used in a trade or business, or held for investment.
2. The relinquished and the replacement aircraft must be like-kind pursuant to the regulations.
Aircraft exchanges can be structured either as a forward like-kind exchange, where the relinquished aircraft is sold prior to the acquisition of the replacement aircraft; or as a reverse like-kind exchange, where the replacement aircraft is acquired before the relinquished aircraft is sold. Reverse exchanges are fairly common with aircraft, as many owners often will first acquire the new aircraft before completing their sale to ensure that they will have uninterrupted access to aerial transportation.
It is imperative that a like-kind exchange be planned and carried out in accordance with Internal Revenue Service regulations so that the tax benefit is not lost. Some flexibility is allowed in making the new aircraft selection, but only in limited circumstances. The proper planning with the right team, which may include lenders (if the aircraft purchase is financed), brokers, insurance agent, escrow agent and aviation counsel – and most assuredly will require an intermediary known as an exchange agent or Section 1031 accommodator – will also help make sure the entire transaction flows smoothly. It should also help minimize any sales, use or property taxes.
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