Are 1031 exchange programs the "tail wagging the dog"? Hardly...

Famous last words:

  • "We leave all our tax strategies until the end of the year."
  • "We only have one person worrying about tax issues."
  • "We're not going to let tax strategy determine how we run our business. That's the tail wagging the dog."

Believe it or not, I've heard variations on each of these themes in recent months. It's hard to imagine a competent, responsible CEO opting to jettison valuable assets, discard powerful incentives and erode cash flow, especially now, when cash is as important as it has ever been. But it's happening, and hopefully, from your perspective, the people thinking this way are your competitors.

That last line - the "tail wagging the dog" bit - is especially troubling, because it makes clear that the company simply hasn't understood how fundamental a strong tax strategy is to its overall operational success. However, if you're currently participating in a 1031 like-kind exchange (LKE) program, then you understand that it costs more to pay taxes today than to defer them into the future. As Joe Lane explained in a recent post, "deferring the tax today by replacing the sold asset with a like-kind asset through a 1031 exchange generates a higher financial return":

Regardless of the amount of deferral, any amount not paid in current taxes is, effectively, another source of cash. At a time when credit tightening, widening spreads, and increasingly-burdensome covenants and conditions characterize the capital markets, a careful cost-of-capital analysis will illustrate another real benefit of a like-kind exchange. Some owners measure the value of their LKE not as a tax deferral, but by its impact on their real cost of funds - the avoided cost of issuing debt or equity is significant, and by preserving the cash that otherwise leaves the company in the form of taxes paid, owners can re-deploy that cash to acquire replacement assets at a lower effective cost. Lower effective cost of assets then translates into greater operating efficiencies, which improves margins and profitability or makes the enterprise more competitive in the market. Either way, tapping the cash "hidden" in assets being sold and replaced is by all measures a good thing.

So, sales are down, purchases have slowed and you're still wondering if an LKE program makes sense. The answer is a resounding yes - now more than ever. Why would you unwind a competitive advantage that you've enjoyed over the last half decade or more? In an economy as tight as this one, smart is your best strategy.

Since 2001, dozens of heavy equipment dealers have implemented 1031 exchange programs. During the downturn in 2002 and through three rounds of bonus depreciation, LKE programs continued to flourish, driving literally hundreds of millions of dollars in increased cash flow through the industry.

As dealers find themselves facing shocking new bank covenants, it's critical to maximize every source of available cash flow. For those already deferring gains (and possibly in a net operating loss environment), now is the time to really start managing your existing LKE program, which can do a lot more for you than you may realize.

How to integrate LKEs into your sales strategy

Every day, your sales team is encouraged to not only identify new business, but also to sell, sell, sell. When the economy tightens, the heavy equipment industry is notorious for selling anything that isn't nailed to the floor, whether it's new, used or from the rental fleet. "If we can make a sale, regardless from which fleet, we will make it," is the philosophy.

But does this always make sound economic sense? What if your sales guy just sold a dozer that's participated in several rounds of like-kind exchanges? Say this dozer was similar to five other dozers on your lot, all of which are 2007 and 2008 models. The 2007 dozer he just sold has a remaining tax basis of only 10% of the original cost. The other five dozers were purchased at approximately the same time but were not qualifying replacement assets for LKE purposes, and therefore maintained a high tax basis with little or no tax depreciation.

Did his sale help your bottom line? No, it didn't. Don't get me wrong. Revenue is revenue. But if you couldn't match the sold asset with a qualifying piece of heavy equipment, for some reason, you've now incurred a tremendous tax gain and associated tax bill. You've begun to erode your 1031 exchange program.

But what if one of those other, similar dozers had been sold instead of the low basis dozer? What if your sales guy had sold a 2008 dozer with fewer hours for the same amount? Your tax gain would have been minimized, you'd have moved a non-producing piece of equipment, you would have improved your financial metrics, etc. By providing extra incentives to the sales team to move high-basis assets, you would have saved yourself thousands of dollars in tax gain.

If your challenges during the current economic down cycle include increasing cash flow - or more accurately, preserving your cash - then don't sell your low basis assets if you have a choice. Remember that all gains (sales price minus tax basis) are taxed at approximately 40%.

Take a look at your entire fleet. Prioritize what you sell. Provide extra incentives to dispose of high-basis assets if you believe finding replacement equipment is going to be a challenge. If you need a hand with this process, remember that Accruit offers full-fleet evaluations to help you and your sales team make smart choices that drive greater value to your bottom line.

Meanwhile, here's hoping that you're fortunate enough to be in competition with businesses that see effective cash management as the "tail wagging the dog."